The New and Expanded Franchise State Cover Page

On May 19, 2019, the NASAA [North American Securities Administrators Association] Membership issued instructions for the new Franchise Disclosure Document [FDD] state cover page.  The state cover sheet is expanding.  It is now 3 pages, not just one.  The pages include:

  • How to Use This Franchise Disclosure Document
  • What You Need to Know About Franchising Generally
  • Special Risk(s) to Consider About This Franchise

The first page, How to Use This Franchise Disclosure Document, is a table with 8 questions in the first column and in the second column, a cross-reference in the franchise disclosure document.  A narrative above tables states the mission of the table. The narrative reads:

Here are some questions you may be asking about buying a franchise and tips on how to find more information:

The question includes:

  1. How much can I earn?
  2. How much will I need to invest?
  3. Does the franchisor have the financial ability to provide support to my business?
  4. Is the franchise system stable, growing, or shrinking?
  5. Will my business be the only [XYZ] business in my area?
  6. Does the franchisor have a troubled legal history?
  7. What’s it like to be [an XYZ] franchisee?
  8. What else should I know?

The next page, What You Need to Know About Franchising Generally, is 7 general statements about franchising on the topics including:

  1. Continuing responsibility to pay fees.
  2. Business model can change.
  3. Supplier restrictions.
  4. Operating restrictions.
  5. Competition from franchisor.
  6. Renewal.
  7. When your franchise ends

The final page, special risk factors page, is kin to the risk factors required by the prior version of the state cover sheet. 

Franchisors must comply with the new state cover page requirements by January 1, 2020.

What Franchisors Need to Do Before Advertising

You have your Franchise Disclosure Document [FDD] updated, and you are ready to sell franchises.  Before advertising, there may be one other step that you need to take.  The following states require that your franchise advertisements be submitted for review before publication or distribution.

·      California ·      Indiana ·      Maryland
·      Minnesota ·      New York ·      North Dakota
·      Rhode Island

·      South Dakota

·      Washington

The word advertisement in this context is used loosely.  For purposes of state review of advertisements, an “advertisement” includes virtually any document or letter given or sent to a prospective franchisee before or during the sale of the franchise, including, but not limited to, any

  • Brochures;
  • Photographs;
  • e-mails or letters sent or given to prospective franchisees;
  • newspaper, magazine, radio or television ads;
  • leaflets, photographs or brochures left in the company’s office;
  • signs or pictures in the office directed at selling franchises; and even
  • recorded telephone messages.

Advertisements in newspapers or other publications of general, regular and paid circulation which have had more than ⅔ of their circulation outside the state during the past 12 months, and radio or television programs originating outside the state, are NOT required to be submitted for pre-publication approval.
However, a newspaper or magazine article about the company that was originally published in another state or in a newspaper or magazine with more than ⅔ of its circulation outside the state must be submitted for approval if you mail copies to prospective franchisees in a state that does require pre-publication approval.

How Long Must Franchisor Litigation be Disclosed?

In Item 3 of the franchise disclosure document [FDD], the franchisor must disclose if it, it’s affiliate who guarantees the franchisor’s performance; an affiliate who has offered or sold franchises in any line of business within the last 10 years, predecessors, parents, and any it’s management have any pending or past administrative, criminal, or material civil action alleging a violation of a franchise, antitrust, or securities law, or alleging fraud, unfair or deceptive practices, Federal, State, or Canadian franchise, securities, antitrust, trade regulation, or trade practice law, or which are material in the context of the number of franchisees and the size, nature, or financial condition of the franchise system or its business operations, or comparable allegations.
Convoluted?  Let’s look at the graphic below:

** last 10 years is calculated from the date a held liable or the date the orders became effective
* Affiliates includes affiliates that offered or sold franchises in any line of business within the last 10 years or affiliate who guarantees the franchisor’s performance

What Financials are Required for Startup Franchisors?

The Federal Trade Commission Franchise Disclosure Laws [FTC Franchise Disclosure Rule] requires disclosures in item 21 of the Franchise Disclosure Document [FDD] of the franchisor’s financials.  Typically, the financials of the franchisor must be audited by an accountant.  This can be costly and timely.
The FTC Franchise Disclosure Rule cuts new franchisors a little slack.  It allows startup financials for new franchisors.  In the first year of franchising, the franchisor financials do not need to be audited.  The franchisor simply needs to include an opening balance.


What is Required

Year 1 Unaudited opening balance sheet
Year 2 Audited balance sheet opinion
Year 3 All required financial statements for the previous fiscal year, plus any previously disclosed audited statements.

For year two, franchisors are going to need to contact an accountant.  But, a full-blown audit is not required. For year two franchisors will need an audited balance sheet opinion.
Year 3 the franchisor is like established zors.  A standard audit is required.
This is the federal law.  Most states accept the federal law startup financials for the franchisors.  But caution, there are a few states that do not accept startup franchisor financials including Minnesota, New York, and Rhode Island, Illinois, and Virginia.

What Happens When a Franchisee Commits a Crime?

franchisee crime

The headline reads: ‘Domino’s scandal: franchisee selling visas’ Pursuant to the undercover investigation, the Domino’s Franchisee is alleged to have offered work visas in exchange for money.

Not good. Domino’s public reputation and goodwill can be harmed by such a claim. Not only will it affect the franchisee’s business, it can affect other franchisees’ businesses and the brand. What should one do? The first instinct is to terminate the franchise; go public and denounce the franchisee. However, such knee-jerk reaction can be the wrong move.
Yes, it is bad. Even a false or unverified allegation can affect the brand and other franchisees. Franchise Agreements commonly, as a matter of course, have a provision that allows for termination in event of a criminal act. This, however, should not give rise to deductive logic and issuance of a termination.   Without the benefit of a criminal conviction, admission, or entry of no contest, there is no substantiation for termination. Many franchisee advocates and perhaps some applicable state relationship laws may show substantiation and even connectedness between the crime and performance and obligations of the franchisee, or harm to the goodwill and reputation of the franchise.
Domino’s, in response to the allegations, has launched an investigation, a prudent measure. In addition, Domino’s will want to get in front of the public news story. Again, caution is called for. Saying the wrong thing can lead to defamation or slander claims and on the flip side public outcry.


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What is a Franchise Pro Forma?

Pro forma_Page_1Per Wiki, a business pro forma:

….models the anticipated results of the transaction, with particular emphasis on the projected cash flows, net revenues and taxes. Consequently, pro forma statements summarize the projected future status of a company, based on the current financial statements.

Pro forma is Latin for ‘as matter of from’ or ‘for the sake of form.’

The answer to what is a franchise pro forma, depends on the figures included.

Pro forma_Page_2
A Pro Forma that lists cost figures only or no figures at all may be an advertisement, but is  not a financial performance representation, according to the recently released   NASAA’s [North American Securities Administrator Association] Franchise and Business Opportunity Project Group’s [Franchise Project Group] Proposed Franchise Commentary on Financial Performance Representations [FPR Commentary].

Discover 10 Franchise FPR Dos and Don’ts.  Click here or go to:

Per the FPR Commentary, if the pro forma does not have any figures or only cost figures, it should not be included in or attached to the franchise disclosure document [FDD].
And, if it is an advertisement, like suggested in the FPR Commentary, it must be submitted to some states before publication or distribution.
The FPR Commentary does not expressly so state, but if the pro forma includes revenue figures, or profits or other figures besides just cost, it may well be an item 19 financial performance representation, which requires inclusion in the FDD and adherence to all the requirements of financial performance representation.

What is required to make an Item 19 Franchise Financial Performance Representation?

With increasing frequency, franchisors are including an Item 19 Financial Performance Representation in their Franchise Disclosure Documents [FDD].
A Financial Performance Representation is defined under the Federal Franchise Disclosure law as:
Any oral written, or visual representation, to a prospective franchisee including a representation in general media, that states, expressly or by implication, a specific level or range of actual or potential sales, income, gross profits, or net profits. The term includes a chart, table, or mathematical calculation that show possible results based on a combination of variables.
Under the Federal Franchise Disclosure law, the making of a Financial Performance Representation is optional. Franchisors can but are not required to make a Financial Performance Representation. Whichever way franchisors choose, they must include prescribed disclosure language.
If a franchisor chooses not to include an Item 19 Financial Performance Representation [FPR] in the FDD, the franchisor cannot discuss the earnings, profits, or sales of potential franchises.
The Federal franchise disclosure law categorizes permitted Financial Performance representations into 2 groups:

Historic Financial Performance Representations
Forecast of Future Financial Representations

For both categories of Financial Performance Representation, the franchisor must have a:

1. Reasonable basis; and
2. Written substantiation for the representation.

After the basic reasonableness and substantiation requirements, the disclosure requirements for historic and future Financial Performance Representations diverge.
Historic Financial Performance Representations must articulate which, when, and how many franchise outlets were used to make the representation in very regulatory explicit terms. Future Financial Performance Representations must layout assumptions, factors, and conditions related to numerous components of the representation.
Historic Performance Representations are more common than Future Financial Performance Representations. Often times Franchisors may simply use franchisee sales reports as the basis for Historic Performance Representations. However, if the franchise system is new and not sufficient samplings of the franchises are reporting to make a reasonable Financial Performance Representation, franchisors may consider a Future Performance Representation.
The reasonable basis for the claims is one of the biggest liability concerns related to Financial Performance Representations. Franchisees and state examiners may challenge the reasonable base of representation, if the representation among other things is:

Based on too few franchisee outlets
Based on corporate outlet with differing operating costs
The date of the representation is too removed from the issuance/effective date of the disclosure document
The characteristic of the outlets used for the representation differ significantly from the franchise opportunity being offered by the franchise disclosure document

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