The Franchisor Pre-Sale Pro Forma

As a SCORE volunteer mentor, QuickBooks Pro Advisor, and Retail Operations Expert, I am called upon to review pro forma income and cash flow statements and balance sheets for clients in the process of entering into a franchise agreement.

A pro forma has much in common with general operating financials with the one exception being that the pro forma is a projection and it is typically based on past performance of an operating location. These projections are a valuable part of any prospective franchisee’s evaluation process.

From the Cornel Law School Website:

“The?Federal Trade Commission (FTC) Franchise Rule is a disclosure rule that requires a?franchisor?offering or selling a?franchise?located in the United States of America to provide the prospective?franchisee?with the relevant information about the?franchise.

Under?Subpart B?of the FTC Franchise Rule, the franchisor shall be in breach of the FTC Franchise Rule if it: (a) fails to furnish the prospective franchisee the disclosure document fourteen calendar days before the prospective franchisee signs the?franchise agreement?or makes any payment in connection with the franchise; or (b) if the franchisor unilaterally modifies the terms and conditions of the franchise agreement without furnishing the prospective franchisee with a copy of the revised franchise agreement at least seven calendar days before the prospective franchisee signs the revised franchise agreement. If the prospective franchisee initiated the negotiations that gave rise to the modifications of the franchise agreement the seven-day rule shall not apply.

According to?Subpart C?of the FTC Franchise Rule, along with other formalities established therein, the disclosure document the franchisor shall provide to the prospective franchisee must contain the following material information:

• A cover letter indicating (a) the franchisor's name, type of business organization, principal business address, telephone number, and, if applicable, email address and primary home page address; (b) a sample of the primary business?trademark?that the franchisee will use in its business; (c) a brief description of the franchised business; and (d) the total investment required to begin the operation of the franchise.
• The following 23 items of disclosure information: (1) the franchisor and any parents, predecessors, and affiliates; (2) business experience; (3) litigation; (4)?bankruptcy; (5) initial fees; (6) other fees; (7) estimated initial investment; (8) restrictions on sources of products and services; (9) franchisee's?obligations; (10) financing; (11) franchisor's assistance, advertising, computer systems, and training; (12) territory; (13) trademarks; (14)?patents,?copyrights, and proprietary information; (15) obligation to participate in the actual operation of the franchise business; (16) restrictions on what the franchisee may sell; (17) renewal, termination, transfer, and?dispute resolution; (18) public figures; (19) financial performance representations; (20) outlets and franchisee information; (21) financial statements; (22)?contracts; and (23) receipts. Detailed information about each item may be consulted in?Subpart C?of the FTC Franchise Rule.

Each of the disclosure requirement are pertinent to the decision-making process for the prospective franchisee. We will focus on Subpart C, section 21: financial statements.

Before even evaluating the business potential of a new franchise location, it is important to evaluate the financial condition of the franchisor. Looking at the current (or last year) Balance Sheet is a good place to start. Another is a Cash Flow analysis. With these, and other reports, you can determine the financial stability of the franchisor. Do not accept any financial statements older than the previous fiscal year.

Once you have determined the franchisor financial standings, you can then evaluate any pro forma income statements shared as part of the franchise disclosure.

Like the franchisor financials, do not accept a pro forma more than a year old. I find it quite amazing that each individual that I have assisted has not received updated and more current versions of the pro forma statements. In at least two cases, the pro forma sent for evaluation was at least three-year-old. As projections are based on variables, the pro forma is inaccurate. Here are a few examples:

1.?Credit card fee rates increase over time. Are the rates in the pro forma reflective of current rates?

2.??Are royalties based on gross sales or net sales (exclusive of any promotional discounts)? If there are nationally mandated promotional discounts, it is imperative to know if the promotions are credited before royalties are collected.

3.???Another cost, in the restaurant business specifically, are both promotional costs (discounts) as mentioned above AND the associated fees that are incurred when using the national delivery services.

While no royalty would be paid on the fees, it is important to have an awareness of those fees. As an example, if your location’s online sales are 50% of the total sales, you must consider the 21% average cost of using those delivery services.

And do not forget marketing cost. The last thing you want to do with your new business is to put it into the witness protection program. Everyone should be aware of your new endeavor and that will require a marketing spend.

4.?Labor Cost – this is a variable that is based on location. Is your business located in an area with higher-than-average wages( NYC, Chicago, LA, etc.)? If the franchise pro forma is basing cost (and therefore percentages of gross) on a lower or average labor cost, then you must adjust your calculations to account for the additional cost that you will incur. ?

Most owners must be the manager for a period of time out of necessity. Management cost is high, and the owner can and should be able to function in that role.

?5.?Leasehold Expense – Commercial (and retail) space is expensive and the requirements of where your business is located makes a difference. Is your location mall based, strip center based, a small retail center, or a standalone? Rents, utilities, and shared area expenses will vary. The same can be said for insurance costs.

?6. General and Administrative Expense?- Are the usual and customary operating expenses included? This is where many pro forma projections understate expense, which in turn inflates the bottom line.

?7.?Debt Service – Depending upon how you financed the location acquisition and build out, there may be a loan to repay. Commercial terms are shorter than other loans, typically 15 years.

Of course, not every item can be included in any supplied pro forma. However, it should be a good starting point from which you can evaluate the viability of the franchise in your specific case. Each situation is different.

I do make one caution, regardless of the franchisors pro forma. In most all situations, profitability in the first year is extremely rare. In most cases, it may be 24 months before break even is attained. Yet, my experience is that many distributed pro forma examples show profit in the first few months.

As early profitability, or even positive cash flow, can be challenging, be sure that you have the resources available to weather the storm. The last thing you need is a cash problem early on.

A franchise opportunity give you the ability to have a proven concept and operational guidance to ease entry into a business. However, like any business, there are no guarantees. Do your homework, be prepared, and look under all the covers.

Caveat Emptor!