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“How much money can I make?” is possibly the most commonly wondered question when prospective franchisees consider a franchise opportunity. Of course the future can’t be foretold, but doing your fair share of due diligence (or research) into the financials of existing locations of a franchise can provide insight as to whether a franchise is a good financial opportunity for you personally.
One of the best places to start your research into whether a franchise opportunity has the potential to be profitable for you is the Franchise Disclosure Document (FDD) of the brand you are interested in. In addition to laying out the costs and obligations of a franchise purchase, the FDD possesses a specific section dealing with potential earnings.
Item 19 in a FDD is for earnings claims, now also called financial performance representations (FPRs). FPRs can give you a clearer picture of what the path to profitability will be like when you buy a franchise, even though they shouldn’t be taken as a predictor of what will occur.
Item 19 financial disclosures aren’t required. It used to be rare for a franchise to disclose earnings for several reasons, potential legal liability from a claim being the reason most often cited.
However, attitudes are changing to the disclosure. In fact, according to FRANdata, an estimated 66% of franchises now report financial performance -- up from 52% in 2014. As Charlie Simpson, vice president and COO of Great Clips has said, “An earnings claim is an opportunity to showcase your company. It provides instant credibility with a candidate because you have one.”
What does an earnings claim or FPR include?
A few common financial figures divulged in Item 19s include:
- Average gross sales for a combined number of units
- Adjusted gross sales for individual units
- Store sales breakdowns by square footage
- Cost breakdowns of goods, labor, leases, etc.
Below are a couple example charts from the Item 19 of an unidentified retail franchise.
Example Adjusted Gross Sales per Month for One Year
Average Cost Breakdown of “Key Components”
Franchisors tend to divulge figures that make sense for their businesses. For example, hotels that submit info can tell things like average occupancy rates and average room rates; car wash franchises can tell daily car counts, average ticket sale numbers, and the like; etc. The length of time covered by FPRs is typically the most recent full year, but can go up to three years.
Additionally, if the FPR relates to past performance instead of future projection, a franchisor traditionally has had more leeway on what to disclose. For example, the franchisor may choose to disclose results from only a subset of outlets that share certain characteristics like location. This is good if those franchises are in your area, not so helpful if you live somewhere else.
To help make things clearer, the North American Securities Administrators Association (NASAA) issued new guidelines for Item 19s in 2017. The hope was for a more streamlined appearance and to provide for a more uniform presentation of the content within the Item.
The guidelines now outline what can and cannot be included, as well as specify the manner of display and calculation of the figures. The changes will not only help franchisors guide their disclosure efforts, but also make it easier for prospective franchisees to compare one franchise’s Item 19 to another.
The new NASAA guidelines will be felt first with franchisors and prospective franchisees in states that require FDD registration in order to operate.
Don’t Forget to Speak with Other Franchisees
Also contained within a FDD is a listing of all the franchisees in the franchisor’s system with their contact information. All of these people have first-hand experience with the exact franchise system you want to run, and can provide valuable insight into the path to profitability. But keep in mind, everyone’s business experience is unique. Simply because one franchisee had success in a certain amount of time doesn’t necessarily mean you will experience the same amount of success in that timeframe.
Here are some good questions to ask a current franchisee of a franchise system:
- Did the start-up costs line up with the franchisor’s given estimates?
- When did you break even?
- When did start to turn a profit?
- Are there seasonal shifts?
- Were there costs that were surprising to you?
While most franchisees will happy to speak with you about their experience, they might be prohibited by the franchisor in giving specific answers about financial because of potential liability (unless the incoming franchisee is buying an existing location). Nevertheless, holding a conversation with current franchisees will help you tremendously in learning about the day-to-day responsibilities of the franchise when making your final decision.
Key to Remember: Revenue ≠ Profit
While researching the financials of particular franchises, one important thing to note is revenue is not the same as profit.
Revenue is the total amount of money a franchise unit attains in a given time period. Profit is revenue minus the amount it takes to run the franchise (operating costs) in that given time period. For example, if you make (x) in revenue and franchise operating costs are (y), your profit will equal (x) – (y).
Operating costs can vary significantly among the franchisees within a system. Here are some common ones:
- Location
- Rent
- Utilities
- Marketing and advertising expenses
- Product pricing (including discounting and promotional practices)
- Owner and employee compensation
- Inventory
- Insurance, taxes, and other business-related expenditures
(Note: operating costs commonly decrease after the first year of operation and stabilize relatively soon thereafter.)