The Problem With Earnings Claims
There's no question that franchisees like earnings claims to be in an FDD. But that doesn't mean they should be using them in a loan application.
A recent report on Small Business Administration lending by the Government Accountability Office included an interesting section explaining the problem with earnings claims and their relationship to loan applications. You'll be able to read about that report in the next issue of Franchise Times, but we wanted to cover the loan application issue more specifically here.
Lenders ask borrowers to provide first-year revenue projections in their loan applications. Several franchisees told the GAO that they simply used their franchisor's earnings claim to provide that information. The problem is that earnings claims are not first-year projections. Worse: the revenue in those claims is usually higher than what a franchisee in that system can expect to make its first year.
Franchisors may or may not include earnings claims in their FDD, which they must file with the FTC and with various states that require franchise registrations. We've seen many earnings claims, and they tend to take numerous forms. But almost all of them analyze the revenues earned by locations that have been open at least a year, and many look at units open 18 months.
As part of its report, the GAO looked at the earnings claim of a specific franchise for a 10-year period, and compared it to the revenues posted by new units during their first year. On average, the agency found, the average unit volumes for the franchise's existing locations were 1.43 times higher than was the revenues for locations during their first year.
Obviously, that kind of difference between projections and reality can be substantial. And in the case of this franchise, many of the operators that the GAO interviewed defaulted on loans or even went bankrupt. Many had problems with unexpected expenses and working capital.
To use, the issue serves as a reminder of the importance of due diligence. Franchisees should not rely on the earnings claim for a first-year revenue projection. Instead, they should talk to existing franchisees and others to get an idea of what that first year is like. Given how difficult a startup business, even a franchise, can be, that information is vital.