It’s pretty easy to understate the importance of the financial statements required to be included in a franchise disclosure document (FDD). It’s also fairly simple to overstate their worth. On the one hand, a prospective franchisee certainly wants some level of comfort that their counterparty – the franchisor – has the financial wherewithal to fulfill its training and support obligations and to promote and strengthen the brand. On the other hand, FDD financial statements often provide only an incomplete picture of a franchise system’s financial health. Moreover, federal franchise law is based upon disclosure and not on merit. So, a franchisor may satisfy the FDD financial statement disclosure requirements without having to establish that its financial strength measures up to its promise of support.
It’s important to note at the outset that the franchisor is not synonymous with the brand. In fact, the franchisor is likely to be a limited liability company that is formed principally to shield the brand owner from liability. For example, the franchisor for a Sonic Drive-In is not the publicly traded Sonic Corp. (NASDAQ: SONC). Instead, it’s an indirect wholly owned subsidiary of Sonic Corp., Sonic Franchising LLC. Sonic Franchising and its support affiliate, Sonic Industries Support LLC, disclose robust financial statements in Item 21 of Sonic Franchising’s FDD that show significant assets, healthy revenues and strong cash flows, so the fact that the franchisor is not the publicly traded company is not significant. That’s not always the case, however. Many limited purpose franchise limited liability companies are thinly capitalized and may have no support affiliate or parent guarantee.
The requirements for financial statement disclosure are set forth in Item 21 of the FDD, as supplemented by the Federal Trade Commission’s (FTC) Amended Franchise Rule Compliance Guide and Amended Franchise Rule FAQs (see FAQs 11, 16.D, 17, 30 & 32). It’s also a good idea for franchisors to benchmark for best practices their financial statement disclosures against other franchisor’s FDDs. In addition, certain States expand the reach of Item 21’s audit requirement and conduct what amounts to a financial underwriting of the franchisor.
Item 21: Financial Statements
With limited exceptions, Item 21 of the FDD requires franchisors to include copies of three years of financial statements that are:
- Prepared in accordance with U.S. generally accepted accounting principles (GAAP) and
- Audited by an independent certified public accountant using U.S. generally accepted auditing standards (GAAS).
Item 21 recognizes that GAAP is not static and, accordingly, provides that franchisors must use GAAP as it may be revised by any future U.S. government-mandated accounting principles or as permitted by the U.S. Securities and Exchange Commission.
The FTC also notes that in the absence of an auditing requirement auditing, the franchisor’s “financial statements remain nothing more than the franchisor’s own representation of its financial condition.”
The financial statements must be disclosed in a tabular form that compares at least two fiscal years to provide prospective franchisees “with information with which to assess financial trends, rather than just an isolated snapshot of the franchisor’s finances.” The financial statements must include:
- The franchisor’s balance sheet for the previous two fiscal year-ends before the FDD issuance date and
- Statements of operation, stockholders’ equity and cash flows for the franchisor’s previous three fiscal years.
In revising the federal rule that governs franchising in the United States in 2007, the FTC originally proposed that the parent company of the franchisor (controls the franchisor directly, or indirectly through one or more subsidiaries) disclose in all instances its financial information. After some minor squabbling, that requirement was substantially narrowed such that parent companies need only disclose its financial statements in two limited circumstances:
- When the parent commits to perform post-sale obligations for the franchisor, or
- When the parent guarantees obligations of the franchisor.
The phrase “post-sale obligations for the franchisor” is only intended to require the disclosure of parent financial information “when the franchisor’s parent commits to perform post-sale obligations for the direct benefit of franchises.” Specifically, “Agreements between a franchisor and its parent for administrative and other services for the franchisor’s internal purposes do not trigger the parent financial disclosure requirement.” Moreover, parent financial disclosures are not triggered by the performance of post-sale obligations by a parent’s employees for the benefit of franchisees “absent a formal commitment or guarantee on the part of the parent to perform.” Finally, the performance by a parent of any single or isolated obligation is not alone sufficient to trigger parent financial disclosures.
Nevertheless, where a parent is the sole supplier of a good or service without which a franchise cannot be operated, the parent must disclose its financials under Item 21.
When a parent guarantees the obligations of the franchisor, in addition to including its financial information, the parent must include a copy of the guarantee in the FDD attachments in Item 22 (Contracts).
Item 21 allows – but does not require – a franchisor to substitute the financial statements of an affiliate (an entity controlled by, controlling or under common control with another entity) if:
- The affiliate’s financial statements meet Item 21’s requirements and
- The affiliate absolutely and unconditionally guarantees to assume the duties and obligations of the franchisor to the franchisee under the franchise agreement.
Accordingly, an affiliate of the franchisor does not need to disclose financials unless it qualifies as a “parent” and commits to perform or guarantee the franchisor’s post-sale obligations.
If a subfranchisor steps into the shoes of the franchisor by engaging in pre-sale activities and performing post-sale obligations, it must include its financial statements in the FDD. The term “subfranchisor” is not intended to capture brokers or salespersons who have no post-sale obligations to franchisees.
A start-up franchise system that does not yet have audited financial statements is permitted by the Federal Trade Commission (FTC) to phase in the inclusion of audited financial statements as follows:
The franchisor’s first partial or full fiscal year selling franchises
An unaudited opening balance sheet
The franchisor’s second fiscal year selling franchises
Audited balance sheet opinion as of the end of the first partial or full fiscal year selling franchises
The franchisor’s third and subsequent fiscal years selling franchises
All required financial statements for the previous fiscal year, plus any previously disclosed audited statements that still must be disclosed under Item 21
Despite the phase-in relief, new franchisors must prepare audited financial statements “as soon as practicable” and their unaudited statements must be in a form that conforms “as closely as possible" to audited statements.
In addition, a “start-up” franchisor includes only newly minted franchisors that do not yet have audited financial statements. So, if an existing company has prepared audited financial statements in the ordinary course of business before starting a new franchise system, it may not use the phase-in.
State Regulation of Financial Statement Disclosure
A number of so-called registration states (not all require a “registration”) examine a franchisor’s financial statements and, if the franchisor fails to demonstrate “adequate financial arrangements to fulfill its obligations,” may impose their impoundment authority by requiring an escrow or deferral of the franchisee’s initial fees. See State Franchise Authorities: Backdoor Merit Review.
In addition, in certain registration states there is a more limited phase-in period for start-up franchisors. For example, Virginia requires an audited opening balance sheet for a start-up franchisor’s first partial or full fiscal year selling franchises.
Like any other disclosure item in an FDD, Item 21 should be carefully reviewed to understand what information is provided and, more importantly, what is not disclosed. First, understand whose financial statements are included and whose are not. In many cases, the Item 21 disclosure may cover only a limited purpose entity that may be an indirect subsidiary of the entity with whom you thought you were investing. Second, understand that with a start-up, the financials may be very limited and unaudited. Third, understand that unless an entity qualifies as a parent and commits to perform or guarantee post-sale obligations to franchisees, you may not get any disclosure about that entity’s financial condition, even if that entity may be material to the franchisor’s success. Finally, you owe it to yourself to review the financial statements with a certified public accountant, preferably one who has a decent amount of experience with franchises.
Mike Sheehan is a franchise consultant and franchise attorney. He is the president of Focus Ventures Franchise Consulting (www.focusonfranchise.com) and formerly served as a securities attorney and as general counsel for a Fortune 100 financial services company. His Franchise Focus Blog (www.franchisefocus.blogspot.com) focuses on helpful information, tips and current news for prospective franchisees.
This article should not be construed as legal advice or a legal opinion on any specific facts or circumstances. The contents are intended for general information purposes only and you are urged to consult your own franchise attorney concerning your own situation and any specific legal questions you may have.