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Misleading financial projections - the inside story

Updated: May 16, 2023


Coins in a jar

The most common source of misrepresentation claims by franchisees are the financial statements, or projections, showing how much money the franchisor is claiming can be made. These forecasts usually cover the first three years.


From these a prospective franchisee can see when a new franchised branch will break even and how soon it will become profitable. Also, the amount of free cash that will be available to provide a satisfactory level of income. Clearly these issues are vitally important when deciding which franchise to choose. At this point the prospective franchisee needs to be able to rely on the truthfulness of the franchisor and the accuracy of the figures.


As a result, the British Franchise Association’s ‘code of ethics’ states:-


‘Any recruitment, advertising and publicity material, containing direct or indirect references to future possible results, figures or earnings to be expected by individual franchisees, shall be objective and shall not be misleading.’


So far, so good. But the code also states:-


‘The prospective franchisee is responsible for carefully analysing the information material to the franchise relationship, including choosing to take appropriate professional advice, before signing the franchise agreement.’

Analysing franchise financials

How? one may well ask, can a prospective franchisee ‘carefully analyse’ the franchisor’s projections? How can a professional, presumably an accountant in the case of financial information, comment on the forecast level of monthly sales? The answer to both questions is, quite obviously, they can’t. The prospective franchisee can ask how the projections were calculated but they have no way of checking the accuracy of the data on which they were based. Similarly, the only thing on which an accountant can advise is the format of the forecasts such as the sales, cost of sales, expenses etc. Other than that, all they can check is the arithmetic.


To make this situation more difficult for a prospective franchisee is the fact that almost all franchisors add a disclaimer at the end of the projections. A typical wording might be:-


‘These figures are for illustrative purposes only and are not a guarantee of future profits. Achievement of these figures is dependent on the franchisee territory, the efforts of the franchisee and adherence to the franchise model and practices’


To muddy the water even more most franchise agreements contain a disclaimer clause. A typical wording for that might be:-


‘No employee or agent of ours (the franchisor’s) is authorised to make any representation or warranty not contained in this agreement or the manual (the operations manual) and you have not relied on any such oral or written representations or statements about xxx (the franchisor) the prospects for the same, turnover, profitability or any other matter unless such representations or statements are annexed to this agreement and signed by the parties.’


All these warnings and disclaimers only exist because, as stated previously, the financial projections are one of the most likely area of misrepresentation. In which case, how can a prospective franchisee protect themselves? How can the victim of a franchisor who has exaggerated the earnings win a legal claim? Or, of course, how can a franchisor avoid a claim for misrepresentation relating to the projections?


A prospective franchisee can keep records, with dates and times, of what they have been told verbally by the franchisor. They can also keep emails and, of course, the projections. If it is an established franchise, the accuracy can be checked with existing franchisees. They can even ask for the projections to be added to the franchise agreement as an addendum. (as suggested in the franchise agreement). The franchisor is unlikely to be willing to agree to this but if not, why not. The prospect should also ask the franchisor to explain what the projections are based on. Are they the average of all the existing franchisees in their first three years? There are some practical difficulties with this because if the franchise has been established for long time, inflation and changing products and services may have made historical sales turnover levels irrelevant. That could work both ways if profit margins have been eroded by increasing competition. More relevant would be to ask the franchisor to provide an average of all the franchisees who have started in the last three or four years. Do their territories have similar demographics to the one under consideration? All these factors need to be considered and notes made of the decision-making process. The prospective franchisee should let the franchisor know that this is being done. A genuine franchisor with nothing to hide will be happy to assist.


The situation is more difficult for an existing franchisee who finds that they are not achieving the projected levels of sales or profitability and suspects that they are the victim of misrepresentation. They are faced with the seemingly daunting task of holding the franchisor accountable for issuing false projections. Thankfully, in spite of all the disclaimers, it is by no means impossible. A good starting point is to send an email to the franchisor asking for an explanation of why the actual results have not matched the projections. Also, for the basis on which they were prepared. How long the same projections have been in use and by how much they have changed over time.


The response from the franchisor may easily contain something that will be useful when constructing a misrepresentation claim. This is particularly the case with inexperienced franchisors who, until a claim is formalised and in the interests of saving costs, usually reply directly rather than through their solicitor.


As far as the basis of the projections is concerned, as always, the devil is in the detail. If the franchisor claims that the calculations have been based on the average performance of the existing franchisees, does it include the zero contribution to the calculation by any that have failed and ceased trading? This is often overlooked but it is highly relevant.


Franchisors should be very careful when preparing their forecasts. They should keep records of how the process was conducted and the base numbers involved. Regular updates should be made to keep the figures relevant to current trading conditions. Where necessary this may have to be cross-referenced to the operations manual. Above all it is vital that the figures are accurate.


The underlying takeaway for both franchisees and franchisors is; the financial projections are vitally important. They need to be accurate and easy to understand. To avoid problems, it is sensible to go through them in detail before entering into a franchise agreement.

 


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