13 June 2016
WASHINGTON, D.C.— A franchise buyer’s most fundamental question is, “How much can I make with this business?” Obtaining a straight-forward answer to that question has been like finding the proverbial needle in a haystack. As state and federal regulators look to update their disclosure requirements for franchisors, franchise owners and experts are chiming in that franchisors need to be mandated to provide franchise-level EBITDA operating profit so that buyers can make informed decisions.
In the 2015 book, How Much Can I Make?, which researches the whole gambit of franchises from auto repair to window cleaning, author and researcher Robert Bond argues that the purchase of a business calls for the discipline to think in terms of return on investment. Bond argues that investors cannot make an informed decision without knowing profit. “As a prospective franchisee, the single most important task ahead of you is to get an accurate and reliable sense of a business’s potential sales, expenses and profits,” exhorts Bond. “Without this analysis, you will have only a faint idea of how much you are going to earn as a result of your investment and considerable effort.”
Regulators mandate disclosures. But franchise earnings exempt?
Some 35 years ago, the Federal Trade Commission came up with the Franchise Rule and disclosure protections to calm a public riled by many stories of franchisor abuse in the course of selling franchises. The federal government’s answer had been to copy some of the states in requiring franchisors who sold interstate to fill out forms to answer basic buyer questions. The Franchise Rule requires franchisors to provide all potential franchisees with a disclosure document containing 23 specific items of information about the offered franchise, its officers, and other franchisees. Franchisors are required to reveal all sorts of information, such as predecessors, franchisee litigation, history of bankruptcy, a list of existing and former franchises, and financial statements on the state of the franchisor.
All are mandated to be completed by the franchisor, except one.
The gaping hole in mandated disclosure is that franchisors do not have to disclose franchise-level earnings. What the industry has conveniently overlooked is the key insight that buyers need most – how much does the average franchise make in this system. What can a franchisee reasonably expect if their franchise falls in the mean of the chain?
It is simply voluntary if a franchisor posts franchise earnings. In place of disclosure, franchise sellers tell prospective buyers to dig up business operating profits one by one from existing and former franchisees. Of course, franchise owners are not required to release such private information. If the prospect manages to find one or two franchise owners who will show their financial statements, they may turn out to be outliers. They are likely to be foggy about their own situation and how it relates to the financial situation of other franchises. After all, system-wide information or even regional comparisons is something a franchisor collects to manage the collection of royalties and the franchise network, not franchisees. Franchisees that aren’t selling their own business to the buyer have no obligation to be truthful to a stranger about their financials. They can pull numbers out of the air.
This is a fundamental problem, since buyers are quite limited in what their due diligence can dig up on franchise earnings.
The franchisor is the only source of accurate franchise earnings
“The only source in a position to supply accurate information about a franchise opportunity is the franchisor itself,” declares Bond about the importance of a franchisor providing franchise-level financial performance representations – i.e. franchise earnings.
Robert Purvin, the chairman of the 24-year old American Association of Franchisees and Dealers, thinks not knowing franchise earnings shows an ignorant and incompetent franchisor. “How can a company be dedicated to a franchisee’s success when it fails to monitor the franchisee’s performance?” wrote Purvin about lazy franchisors in his 1994 book, The Franchise Fraud: How to Protect Yourself before and After You Invest.
If a franchisor doesn’t know what franchise profits are, run, warns Purvin. “A prospective franchisee’s elimination of franchise opportunities for which no earnings claims exist provides the safest protection from unethical franchising conduct,” writes franchisee-advocate Purvin.
With over 35 years of experience, franchise researcher Bond also assesses that franchisors need to be required to reveal franchise-level earnings. “It is unfortunate that not all franchisors are required to supply prospective franchisees with operating results,” writes the publisher of World Franchising Network and Bond’s Franchise Guide. “At a minimum, franchisors have information regarding net sales by all of their franchised units and certainly they have complete accounting information from any company-owned units.”
Some franchisors even try to mislead buyers by telling them they are forbidden by the government to say how much franchises make.
Bond, who holds a Master in Business Administration degree from Stanford University, tells about the sorry state of affairs in the industry when it comes to franchisors not revealing franchise earnings that they know to buyers. Writes Bond, “The sad reality, however, is that franchisors are not required to share this information, and roughly only 62 percent do.”
Even so, franchisees say these earnings are misleading. One multiunit restaurant franchisee notes, “Yeah, right. Sixty-two percent of franchisors provide earnings disclosures to franchise buyers in one intentionally confusing and misleading form after another.” He thinks franchisors are purposefully murky in their “disclosures.” Many want the franchise buyer to imaginatively decipher their obscure etchings to imagine the rosiest picture.
Mandate franchisors to disclose average franchise unit EBITDA
A franchisee, who wants to remain anonymous to avoid adverse franchisor action against him, points out the obvious on what the Franchise Disclosure Document really needs in order to require franchisees to make a reasonably informed decision. He says the franchisor needs to be required to reveal an average franchise’s bottom-line EBITDA earnings. “Franchise-level EBITDA for all franchise units need to be required by the state governments,” says the franchisee.
disclosing franchise-level profits
|Brand||2015 U.S. Franchise Unit EBITDA “Profitability”|
|Rally’s||“144% Cash on Cash Return on Investment”|
Consultants for startup franchisors and franchisor attorneys argue that releasing earnings is a mistake. They contend that there is no single metric for a buyer to compare one business to another. Each business is different and so is each sector. They feel that it is best to leave earnings disclosures up to individual franchisors to decide what kind of financial representation, if any, they want to release.
EBITDA, or earnings before income tax depreciation and amortization, measures revenue minus expenses, excluding interest, taxes, depreciation and amortization. Investment firms have used this non-GAAP measurement of operating profit to understand a business’ ability to pay off its debt. In short, EBITDA is a useful measure of comparing the profitability of companies within a segment and across industries for franchises that typically have loans. EBITDA and its EBITDA margin (EBITDA/Revenue) are helpful starting points in comparing the profit of a franchised restaurant compared to another, or even one compared to a franchised quick print shop. Sophisticated investors use additional performing measurements to provide more insights and to make sure a firm is not trying to fluff its EBITDA numbers to make it look like it is performing better than it actually is.
“EBITDA is a great starting point,” says John Gordon, principal of Pacific Management Consulting Group, a chain restaurant consultancy that specializes in earnings and economics. He has been working at restaurant-level economics for over 40 years. “It should have been required to be in the Franchise Disclosure Document years ago.” The business analyst contends that EBITDA works well for franchises, whether a print shop, executive search firm, fitness center or restaurant. The consultant adds this caveat, “Franchisors also omit estimated future capital costs. They typically hide from this, but this information is also critical.”
Franchisees, experts also want earnings by performance quartile, and by first year
But franchisees say they need more.
“Those profit disclosures need to be broken out by quartile,” says the multiunit restaurant owner. He wants first-year EBITDA to be broken out. “Franchise buyers need the same number disclosed by the franchisor for first year,” he demands. He elaborates that looking at first year earnings is particularly informative to a franchise buyer, when compared with franchise disclosures for all years.
He is not alone.
Many franchise buyers, former franchisees, franchisee associations and experts have told this journal that franchise buyers need regulators to require average franchise-level EBITDA by performance quartile. They say state and federal regulators should also demand from franchisors that first year franchises and their average EBITDA be separately listed.
The anonymous franchise owner understands that Rome was not built in a day. After decades of not requiring any earnings, state and federal regulators may not be ready to move so far so quickly. He already capitulates that if he cannot have the basic standard of knowing EBITDA, that requiring disclosure of gross sales could be a baby step. “At a bare minimum, franchisors need to be required to tell gross sales for all franchise units by quartile, and then average gross sales for stores at the conclusion of their first year.” He thinks a high proportion of shaky franchise concepts could be flushed out by franchise buyers if at least average gross sales at the franchise-level were required to be disclosed by franchisors.
“EBITDA is a good starting point for a franchise buyer,” declares analyst John Gordon on what sort of earnings disclosure regulators should require of franchisors.