How Franchisors Manipulate Item 19 to Mislead Investors

Introduction

When considering a franchise investment, understanding financial performance is critical. One of the most important parts of the Franchise Disclosure Document (FDD) is Item 19, where franchisors present financial performance representations. However, these numbers can sometimes be misleading. Let’s dive into how franchisors might distort these figures and how you can navigate Item 19 effectively.

What is Item 19?

Definition

Item 19 in the FDD provides prospective franchisees with financial performance representations, offering a glimpse into potential earnings if they invest in a franchise.

Inclusion in the FDD

Not all franchisors include Item 19. Common reasons for exclusion:

• Avoiding responsibility for financial claims.
• Lack of historical data (common with newer franchises).
• Poor financial performance that they prefer not to disclose.

For those that do include Item 19, it’s essential to analyze it carefully to make informed decisions.

How Franchisors Distort the Numbers

Averages vs. Medians

Franchisors might use average sales figures instead of median figures:

• Averages can be skewed by high-performing locations, making the system appear more profitable.
• Medians provide a more accurate representation of typical franchisee performance.

Highlighting Top-Performing Locations

Some franchisors only include data from the highest-earning locations, which does not reflect the majority’s experience. Always check if data includes all locations or just a select group.

“One-Year” Success Stories

Focusing on financial performance during a location’s first year can be misleading due to initial surges in interest. Conversely, showing data only for locations open for several years may result in survivorship bias.

Selective Data: Company-Owned vs. Franchisee-Owned

Data from company-owned locations often shows better results than franchisee-owned ones due to:

• Greater resources.
• Experienced management.
  Ensure the data reflects franchisee-owned locations for realistic expectations.

Gross Revenue vs. Net Profit

High gross revenue figures can be impressive but are meaningless without understanding operational costs (e.g., rent, payroll). Look for detailed net profit data or research operational costs independently.

Pro Forma Financials

Some franchisors include pro forma financials, which are projections based on assumptions, not actual performance. Always seek historical data to verify these claims.

Talk to Franchisees

Speaking with franchisees offers invaluable insights beyond what’s in the FDD.

Key Questions to Ask

1. Revenue Ranges
   • Compare average revenue disclosed in Item 19 to actual experiences.
   • Ask if the figures align with their experience or if there’s a wider range.
2. Costs and Hidden Expenses
   • Inquire about unexpected costs or fees not highlighted in the FDD.
   • Learn about overlooked expenses to better understand total investment requirements.
3. New vs. Mature Locations
   • Understand the differences between early-stage and established locations.
   • Ask about the timeline to profitability and periods of struggle.
4. Regional Variations
   • Investigate local factors affecting costs or revenues.
   • Compare their experience to other regions to assess location-specific risks.

Benefits of Franchisee Conversations

Franchisees offer real-world experiences, helping you identify potential challenges and opportunities.

Pros and Cons of Item 19

Pros

• Provides insight into potential earnings and profitability.
• Offers transparency on the franchise’s financial track record (when accurate).
• Facilitates comparison of franchise opportunities.

Cons

• Data can be manipulated to appear more favorable.
• Creates false expectations if not analyzed critically.
• Not all franchisors include Item 19, limiting transparency.

Conclusion

Item 19 is a valuable tool for assessing franchise opportunities, but only if approached with a critical eye. By understanding how franchisors may distort data and leveraging insights from franchisees, you can make a more informed investment decision.

For additional resources, financial models, and franchise insights, visit Vetted Biz. Use these tools to project potential revenue and profitability, and take the next step confidently toward franchise ownership.