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Figures Don't Lie, but Liars Figure: Item 19 Earnings Claims

Author Richard Solomon is a Franchise Lawyer with 50 years of experience in business development, antitrust and franchise law, management counseling and dispute resolution including trials and crisis management.

This is intended to be the last (for a while at least) in a series of Specialized Tutorials targeted at educating potential franchisee investors about the acute need to do really professional level due diligence on the deal itself, in addition to just having some lawyer 'read the contract'. The other Specialized Tutorials in this series, in order of publication, are:

These are a set of articles intended to raise investment care sensitivities. They are offered as a gesture of concern about what I see happening to people who invest in new and in old/over the hill franchise opportunities. The purpose of the deceits practiced by these two groups of franchisor companies is, in the first instance, to portray itself as the investment quality equivalent of an already proven franchise concept/model, and, in the second instance, to portray itself as still being as good an investment vehicle as it once may have been but no longer is.

Is it possible for franchisors to say to prospective franchisees that profitability information is not provided when they do they provide profitability information? It is also a very logical question to ask whether a franchisor can provide false or misleading profitability information so long as a warning is also given that there is no guaranty that you will achieve profitability and that you assume the risk of profit or loss and that there are risks. Since risk is inherent in any investment, warnings about risks do not include or excuse risks that are produced by false statements made to induce the investor to part with his money in the first place.

How does someone who is thinking of investing in a franchise go about vetting the numbers?

This is the hottest button issue in disclosure, because assurances of potential profit are the most effective way to sell a franchise. Only an imbecile buys a franchise because of the bullshit. Real people want to know whether they will make a profit and how much, and how long it will take to reach profitability, and how much it will cost to get there.

Many years ago I published a suggestion in the ABA Franchise Newsletter that, since every franchise agreement empowers the franchisor to receive copies of periodic financial information and tax returns generated by its franchisees, compiling that information ought to be made mandatory, and that information ought to have to be disclosed in a way that displays how the franchisees are really doing. This would include grouping franchisee performance information by levels of profitability (top third, middle third, bottom third), by region of the country, and by showing seasonality if seasonality is a significant factor. I also suggested that the information could be handled in such a way as to eliminate the impact of different franchisees treating various expenses differently for accounting or tax purposes.

If that were to happen, people might be able to appreciate at a higher level of quality just what the performance expectancies might be.

Franchisors, of course, howled at the thought. Why, if that were done, people might be able to see whether your franchise system was more profitable for its franchisees than someone else's franchise system, and the lower performing franchise systems would have a harder time selling franchises. DUH! That's one of the best reasons for doing it!

Since a potential franchisee will not receive that quality of prospective financial performance information, it remains necessary to have access to a fairly high level of sophistication in dealing with what is provided. This article is intended to help to deal with the garbage that is thrown at you now.

Reading this article does not make you my client, and there are many other things that must be accounted for than just the questions raised here. But you can take this to your lawyer or accountant/financial planner, and maybe it will help you both better understand what you are being handed.

Let's get started. Start by first asking yourself who it is that you are dealing with -- who is behind the face you are looking at when you are dealing with the person who is providing you with initial information about a franchise opportunity? If that person identifies himself/herself as a 'FRANCHISE CONSULTANT', you know you are dealing with a liar. There is no such thing as a franchise consultant who sells franchises. While many people do that, they are not consultants in any functional meaning. The reason for that is that they only get paid for selling franchises -- usually by a commission. That's a salesperson, not a consultant. And even if they were consultants, they aren't working for you to help you. If you aren't the only one paying them for assistance, they are salespeople. When they tell you that they are there to help you get the right deal for your circumstances, that is total bullshit. They are there to sell you a franchise -- any franchise that will pay them a commission. You have to be extremely cynical about everything you are told. Doubt everything until it is proven -- and you need to know what proof looks like. What they call proof usually isn't. In once case in my office, the franchisor sales person claimed to be a vice president when he wasn't even an employee of the company. He was an outside salesman. You have to doubt EVERYTHING.

Liar Number One tells you in Item 19 of the UFOC that the company does not give out earnings claims and that no one is authorized to provide earnings information in connection with the sale of its franchises. This is an obvious lie for several reasons. The first reason is that the only reason to make an investment is to make a profitable return on that investment. If there is no representation of profitability potential/earnings potential, then there cannot be any reason on earth to make an investment in their franchise. The second reason is that every one of these franchise companies does make earnings claim information to every potential franchise purchaser. The earnings claims information isn't in Item 19 of their UFOC, but it is provided by other means. Among these other means you will see one or several of the following:

The franchise sales person provides the information either orally, on a blackboard, on a random piece of scrap paper/cocktail napkin/table cloth (and if you hang on to that piece of paper you may have a great exhibit when things later don't go as you thought they should)

The franchise sales person invites other franchisees to come appear at a meeting of franchisee prospects to tell of their experience as a franchisee. These folks always tell about their own wonderful financial performance. The presentation is intended to tell you that this is what you can expect if you buy the franchise. The selected franchisee spokespeople are either all very successful or just shills lying through their teeth. In some instances these shills also receive a 'commission' on every franchise fee taken from each person attending that meeting who buys a franchise. There are probably some successful franchisees in the system, but the point is that you are being provided with information that the franchisor denies providing to you, and that the information -- since it is denied it was ever given anyway -- is never reliable. If you do buy the franchise, you will see in the franchise agreement an Acknowledgement clause that says that you agree that you were never given any earnings claims information. If you sign that agreement knowing that you were in fact given earnings claim information, you may be out of luck even getting it admitted into evidence in court or in arbitration of any fraud claim you may later seek to assert. Some courts are allowing the Acknowledgement clause to exonerate misrepresentation, making the defrauded franchisee seek reversal of those rulings in courts of appeal. That adds time and expense to obtaining relief.

You are provided, as is required, a list of the names, addresses and telephone numbers of all the franchisees of that franchisor so that you can contact them as part of your investigation/due diligence before you buy the franchise, to see what kind of experience they are having with the franchise. But the franchise sales person steers you to certain franchisees. These will always say they are making tons of money and are just thrilled with the franchisor who provides great training and support. If you do buy the franchise, the sales person usually gives them a percentage of the sales commission, or they receive some other form of consideration for their assistance. The franchisor's position is that, notwithstanding the steering, they have no part in providing you with earnings claims information. If you buy that you are too stupid for words. While it may in some strict sense be true that someone else, not the franchisor, provided you with the information, the fact is that the information was provided to you through the efforts of someone affiliated with the franchisor.

The franchisor who claims not to provide earnings claims information to persuade you to buy the franchise, does offer to assist you in seeking an SBA loan. The loan requires that you prepare a 'business plan' (another work of sheer fiction). The business plan requires a pro forma operating statement and balance sheet statement to show the lender what you expect by way of financial performance of the business for which you are borrowing the money. The franchisor either provides you with information to use in preparing the business plan, including the financial pro forma, or steers you to a 'consultant' to assist you and the consultant provides financial pro forma information that the consultant obtained from the franchisor. Then of course, you take your business plan to the franchisor for review, before submitting it to the SBA lender, and the franchisor tells you that you 'did a good job' or that 'your numbers are reasonable', vouching for the numbers/earnings claims information. The lying franchisor's position is that they provided nothing and that you got that only from some third party, not from the franchisor. The franchisor's back up position is that they didn't provide you with the information in order to get you to buy the franchise. They just provided information to help you get a loan. DUH! And -- I actually heard a franchisor person testify to this once -- the ultimate fall back position if the information is false is that the false information wasn't provided to you, but was provided to the lender.

There are other ploys by which franchisors who state in Item 19 of their UFOC that they don't give out earnings claims financial information actually do in some fashion provide it. The fact is that it is almost never true that they don't provide earnings claim information, and if they provide it while insisting that they are not providing it, they are lying to you and you need to run like hell, not buy the franchise.

Liar Number Two does provide earnings claims information in Item 19 which is not reliable for the following reasons, among others:

Especially if the franchisor is a relatively new franchisor, numbers are inherently less reliable if there are none of the franchised stores in the market you intend for your location. That stores seem to be doing well in one part of the country means nothing if you aren't going to be in those markets, for many reasons. If your intended location is 'out of the loop' geographically, your support and advert economies won't be the same either. The advert economies associated with several stores all in one market are important expense issues. If you need a penetration level for your advert message that can be effectively afforded only by a group of stores sharing the budget, the numbers in Item 19 will be significantly out of whack for you.

If the stores are only a few years old, the system has not had time to 'prove' itself. Many things change in a franchise system as the franchisor decides to mandate changes without first proving them out in test market in company owned stores. Without that prove-out test market, every change is just a crap shoot.

If the franchise is one in which a major segment of your cash flow is not paid directly to the franchisee, but is paid first to the franchisor who then makes deductions and, supposedly, passed the net of those deductions on to the franchisee, you are dealing with a thief. Anyone who can come between you and your cash flow will always find ways to nick you. Channeling the money in that manner is the hallmark of the crooked franchise.

If company owned stores' financial information is part of the mix that went into the earnings claim data, that is being done only because those company owned stores are performing better than franchisee owned stores. That skews the earnings claims and makes them false as applied to what you would be doing if you were to buy the franchise. One way the liar reassures you is to say that the stores are identical to the kind of stores that you would be operating as a franchisee. The may be identical in the sense that the sell the same products or services, but they are not identical in any sense relating to financial performance prospects for any franchised store.

If the working capital requirements do not include money for you to live on until you reach break even, then the working capital number in the total investment required disclosure is inadequate. If it doesn't say that living expenses are included in working capital, then living expenses are not included. If it does say that living expenses are included in working capital, you need to have that broken out. The odds are that you are being short changed.

If the earnings claims say that the information was compiled in accordance with generally accepted accounting principles, that is probably not true, and it is a hallmark of misrepresentation. The purpose of making that statement is to make the numbers seem more reliable than they are. There is no other purpose to make that statement. Ask to see substantiation of the Item 19 information. If they won't show it to you before you sign a franchise agreement, it's a scam. If they tell you stories like they can't show it to you before you sign the contract because it's a trade secret, you know you are dealing with hard core crooks.

If after you make adjustments for royalties, advertising fund requirements, lease and other occupancy expenses for the area where you intend to locate, insurance expenses for your area, labor expenses for your area, state and local taxes for your area, and every other expense you can think of, you end up with less than 15% of gross sales as your pre tax net income, you are just buying a job, not a real business, and there will be no room for any adverse change in any significant expense item. One thing that is never covered in the earnings claims data is the cost of borrowed money -- the interest and the principal payments that you will have to make every month. You need to add that information to the equation. You will be told that that money comes out of the non cash deductions on your tax return -- the depreciation and amortization expenses that are not actual cash payments. You need to figure out whether that is correct arithmetic or not. If the total of all payments to the franchisor, other than for goods you have to buy from them, approaches 10% of gross sales, then the franchisor has an effective 40% share of your total potential pretax net profit (if you do as well as the earnings claims data suggests) with no investment risk in your business. Moreover, the franchisor's income expectation from your business is a function of gross sales and does not require that you make any profit at all before those payments are owed. If you can't find a better way to get into that business, you might be better off keeping your day job. There are some exceptions to this statement, but they are very rare.

If Item 19 of the UFOC states that no one is authorized to provide any information regarding sales or profits other than what is stated right there in Item 19, and the sales person does provide other or additional information regarding prospective profitability, then you ought to be able to recognize that you have just been lied to in Item 19. And it is important to recognize that the same techniques of arranging for third parties to provide the earnings claims information, or approving or praising the pro forma information in your business plan, also make the disclaimer in Item 19 a falsehood, just as in the instance of the franchisor who claimed not to provide any earnings claim information at all.

Franchisors who provide sales information in Item 19, but who do not provide additional profitability information there, and whose employee or sales representative provides the additional information to enable a profitability estimate to be prepared, or who arrange for a third party to provide it, or who do it by approving or praising your business plan pro forma, are also lying to you when they deny that such information is provided as part of their franchise sales procedure. They know that you are not buying any business opportunity in order to achieve sales numbers, and that it is only profit potential that you are seeking. They also know that by using only gross sales numbers in the 'official' statement made in Item 19, they don't have to tell you how many of their franchisees are achieving that level of profit performance. Gross income isn't net income. DUH!

These are just a few of the many issues that you will encounter in trying to figure out where the ball is being hidden in the Item 19 disclosures. The inventiveness of the crooked mind is limitless. Regulations can't protect you. You have to protect yourself.

You cannot allow yourself to sign contracts in which you agree that something that happened, and that you ought to know happened if you were paying attention, did not happen. You have to go through what was said to you and see whether the contract is requiring you to agree that something that was an important consideration to you in making your investment decision did not in fact ever happen. If things important to you are excluded, either by not being provided for in the contract or by your having to pretend that they never happened, you are dealing with a thief. That's another reason always to take careful notes on everything that is said to you, orally or in some brochure or written on a cocktail napkin. Being alert and diligent throughout the sales process can save you hundreds of thousands of dollars in lost investment, lost profits and attorney fees and expenses.

If you really want to know how the system is performing, you should include as part of your due diligence contacting business brokers in cities where this franchisor has franchised stores located, and finding out whether any of them are for sale. If you agree to sign a confidentiality agreement that says you are using access to the financial information only in connection with your effort to find a business to buy, you will be able to find out which of this franchisor's franchisees is trying to sell the franchised business and get access to the federal tax returns and the profit and loss/operating statements and balance sheets for the past five years. Compare that to what the franchisor is telling you in Item 19. Do the same thing with businesses in the same business that are for sale and that are not affiliated with this franchisor. No one ever overstates profitability on their tax return.

When someone tells you things that you could figure out are untrue if you just pay attention, and you then sign a contract in which you agree that they didn't tell you that, and you later find out that there are many things that are not as they were described to be, after you have parted with your investment funds and taken on a lot of debt and other liabilities, is it realistic for you to expect to find an effective remedy in a lawsuit or in arbitration? No matter how enthusiastic you have become because of a sales pitch, you have to have the good common sense to back away when someone is lying to you. If they lie to you about financial information, you can bet they are also lying to you about numerous other things that you won't spot until it's too late. The overwhelming likelihood is that even if you still have a legal remedy, you won't have resources to pay lawyers and related other expenses to get an effective day in court. Your absolute best remedy is, obviously, not to buy a franchise from people like that in the first place. There are other ways to be an effective business owner than buying a franchise. And the failure rate amongst independent small business start-ups is now believed by everyone who has looked at it to be no higher that franchised start-ups.

Of course, you could also do what I call Ultimate Due Diligence. Keep your investment in your pocket for a year and go get a job in a store owned by a franchisee of the franchise you are interested in. You will really learn the truth about the franchise by doing that. You may work for a year for very low wages, but you won't have lost your total investment; you won't have loans that you can't pay back; you won't have continuing personal liability on a location lease that you can't pay off; and you won't have to file for bankruptcy. You will also know so much about how to run the business that you won't need to make some franchisor a 40% partner in your net profit for ten years just to get a bit of start-up assistance. Most folks who do this end up NOT buying the franchise. They know too much to be fooled by then.

Not only are the financial experiences vastly different from what was initially stated, but the ways in which the franchisor can abuse the extremely one-sided terms of any franchise agreement may also become apparent in the context of any particular franchisor's willingness to do anything to anyone if it can generate higher fees and more sales, regardless of the effect upon the franchisee's businesses. Anyone who reads the Bloomberg News Service and the Houston Chronicle story this month about Krispy Kreme, that was last year's darling of the franchise industry and the stock market, will see what happens when the charming face you saw on discovery day decides that he isn't getting as much out of the franchisees as he might. Its franchisees in Colorado, Minnesota and Wisconsin recently filed for bankruptcy, and the Houston area developer has now taken all his stores out of the Krispy Kreme franchise system. There won't be any more KK doughnuts in the Houston market, the fourth largest metro market in the USA.

Think of how many folks went around the last few years thinking how lucky the owners of Krispy Kreme franchises must be. Think of how many Krispy Kreme shareholders held on to the stock thinking, like the poor victims of Enron's executive managers, that this was a dream come true company. The level of skullduggery that we are experiencing in business these days is reminiscent of the chicanery that pervaded markets back when abuse was so great that the Securities Act was passed. Occasionally the business climate becomes so untrustworthy that only extreme measures on behalf of your own best interests will suffice. And even then, there will still be risks of something that, despite everyone's best efforts, some smart thief managed to contrive and to conceal.

The lesson is that there is absolutely no substitute for having taken the trouble to have a non-franchisee experience with any franchisor before you invest your capital. Working in the system for a year, working for a franchisee, no matter the pay level, is far better than just signing a long term contract and plunking down upwards of $250,000 to $500,000. I've been telling folks this for years, but in the main most are so totally sold on the hot air they were told by the franchise sales folks that they only realized what I was saying when they were broke.

Franchising is probably today's most high risk investment. It is so high risk because so many people are being cut loose from large corporations that there is a sea of small business investment capital looking for a home. This target rich small business investment environment has attracted predators who are at least the moral equivalent of hungry sharks. Due diligence is more important than it has ever been.

Try not to allow yourself to become so enthusiastic that you want to believe what shouldn't ever be believed without proof. This article is about only one of many, many traps for the people with some money looking for a future in the context of a franchise investment. There are many bad people out there who will rob you blind given half a chance.

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