What do prospective franchisees want? The answer may be as varied as the people involved – but every single one of them wants to know one thing: how much they can expect to earn, if they invest in your franchise system.
Understandably, prospects seek reliable information on operating costs and projected earnings (collectively called financial performance representations or “FPRs” in this article), to help them make an informed decision. However, franchisors need to think carefully about what they can, should, and should not provide to prospective franchisees by way of FPRs.
Below is a summary of the legal rules in Canada relating to the provision of FPRs in franchising. Franchisors must understand the legal parameters, as well as the practical realities relating to FPRs. Beyond what is contained in your legal documents, FPR questions can permeate all levels of your organization – which may make them a hidden area of operational risk. With that in mind, we recommend an approach that goes well beyond legal drafting alone.
1. Option to disclose FPRs in Canada
Six Canadian provinces have franchise-specific legislation with strict requirements about what must be disclosed to prospective franchisees. Those provinces are Ontario, Alberta, Prince Edward Island, New Brunswick, Manitoba, and British Columbia (collectively, the “Regulated Provinces”). There are differences between each provincial franchise statute (collectively, the “Franchise Acts”) and related regulations, but they all share fundamental elements.
Each of the Franchise Acts (other than Ontario) defines earning projections to include “…information given by or on behalf of the franchisor, directly or indirectly, from which a specific level or range of actual or potential sales, costs, income, revenue or profits from franchises, or businesses of the franchisor or of the franchisor’s affiliate of the same type as the franchise being offered can easily be ascertained.”
The upshot is that such information can take many forms, so long as it meets the test.
As for the disclosure of FPRs, none of the Franchise Acts or their respective regulations contain a specific requirement to include either annual operating costs or earnings projections in the disclosure document. Inclusion is optional, but certain obligations kick in, if FPRs are provided.
The relevant sections of Ontario’s Regulations read:
“If an estimate of annual operating costs for the franchise is provided, a statement specifying the basis for the estimate, the assumptions underlying the estimate and a location where information is available for inspection that substantiates the estimate. If an earnings projection for the franchise is provided, a statement specifying the reasonable basis for the projection, the assumptions underlying the projection and a location where information is available for inspection that substantiates the projection.”
The regulations of the other Regulated Provinces are much the same, though New Brunswick, Manitoba, and British Columbia also mandate that if a franchisor chooses not to provide prospective franchisees with FPRs, the disclosure document must contain an explicit statement to that effect.
2. The rules, if the franchisor does include FPRs in its disclosure document
As outlined in the excerpt above, in Ontario if a franchisor does elect to provide FPRs, it must also provide:
- a statement specifying the basis for the estimate of annual operating costs, or the reasonable basis for the earnings projection;
- the assumptions underlying the projection; and
- the place where substantiating information is available for inspection by the franchisee.
The other Regulated Provinces’ Regulations are similar.
3. Trends against FPR inclusion
Given the option, many franchisors in Canada choose to stay silent on FPRs in their disclosure documents (and explicitly state that they are not included, as required). There are definite legal advantages to that choice. So long as franchisors are able to attract franchisees without including this information, many conclude that it is legally wiser to let prospective franchisees obtain what information they can themselves, often through discussions with existing franchisees.
That avoids the risk of making an error in the disclosure document. This danger looms especially large given that FPRs may be directly impacted by differences (or changes) in markets, demographics, individual franchisee performance, economic conditions, location, and a myriad of other constantly shifting factors. Newer franchisors, or those exploring new geographies or business offerings, are especially vulnerable to inaccuracy due to inadequate data. Further, the far-reaching effects of the outbreak of COVID-19 have made franchisors all the leerier about making projections or providing reliable cost estimates.
Errors in a disclosure document can have very onerous ramifications. If a franchisee suffers a loss because of a misrepresentation contained in a disclosure document, it has a right of action against multiple parties, including the franchisor and every person who signed the disclosure document, personally.
This will include at least two directors and officers of the franchisor (if the franchisor has at least two officers and directors). Furthermore, the franchise legislation in the Regulated Provinces deems franchisees to have relied on any misrepresentation in the disclosure document.
4. Trends toward FPR inclusion
Interestingly, however, U.S. franchisors are trending in the opposite direction – with disclosure of FPRs growing markedly in popularity. As of 2021, it was reported that two-thirds of U.S. franchisors were providing FPRs, as compared to just twenty percent in 1995.
A survey of over 3,000 franchised brands in the U.S., covering the period from 2012 to 2016, found that increased transparency through FPR disclosure has been driven by market demand, with franchisors in more competitive spaces making greater FPR disclosure. This trend may be a natural outcome of greater competition, combined with the fact the franchisees and their lenders want to see a system’s profit potential before investing in, or lending to, a specific brand. In the U.S. market, FPR disclosure increases with higher brand investment levels and capital requirements.
Though not always the case, U.S. trends in franchising do tend to move northward into Canada over time. It may well be that FPR disclosure will come to be more prevalent in Canada as competitive forces increase, and as U.S. franchisors continue their expansion across the border.
5. Practical considerations for Canadian franchisors
Franchisors in Canada have much to think about when deciding how to address fundamental questions about costs and profitability raised by prospective franchisees. Decisions need to reflect an understanding of the rules, as well as the business realities and needs of the system.
When considering how to best manage the risks and rewards of FPR disclosure, the following practical considerations may be of help:
Do you have sufficient data to accurately provide FPRs?
- If not, hold off. The significant legal risk of providing incorrect or inadequate financial information is too great. Furthermore, accurate, reliable information should be provided in order to attract the right franchisees and establish a healthy relationship of mutual trust.
What should be the scope of the disclosure, if given?
- Units for which FPRs are provided should have been operating for at least one fiscal year, to give some time to gather data and account for the effects of seasonal changes
- Top-line sales may be the easiest and safest FPRs to disclose at the outset because they are factual
- Your choice of which units to provide information on is important. It’s better to provide the sales figures of all locations (both corporate and franchised), than to only reveal performance metrics of a smaller subset, as you could be accused of skewing figures. That said, it may be worthwhile to group the information based on objective factors relevant to your system. For example, subsets may be based on store size; format; region; urban vs. rural; operating hours; or any other factors, so long as they are fact-based, and can help give the prospective franchisee insight as to the basis and context of the FPRs.
Are you inadvertently providing FPRs already?
The above points relate to whether (and how) FPRs are made in your system’s disclosure document, but consider carefully whether they are being made outside of that document. Whether such information is provided by way of pro forma, income chart, cost calculator, sharing the results of other units, or scribbled notes at a sales meeting – consider whether the franchisor’s staff might unwittingly be making FPRs that will attract liability for you.
Remember that an unvetted FPR can attract liability based on misrepresentation. Further, the provision of FPR information outside of the disclosure document may give credence to later assertions that the information qualifies as a “material fact”.
A material fact is defined in each of the Regulated Provinces’ Acts as a fact “that would reasonably be expected to have a significant effect on the value or price of the franchise to be granted [sold], or the decision to acquire [purchase]” the franchise. If the information is indeed a “material fact”, then failure to include it in the disclosure document could be a material defect in the disclosure document, with serious implications, including possible rescission (cancellation) of the franchise agreement.
Where properly invoked, the rescission remedy obligates the franchisor to refund all money received (other than for inventory, supplies, or equipment); repurchase the inventory, supplies, and equipment; and compensate the franchisee for any losses that the franchisee incurred in acquiring, setting up and operating the franchise. The time period for exercising this right is 60 days for deficient disclosure and two years if the franchise disclosure document was never provided at all. While the law is not fully settled, Canadian courts have found that certain omissions are so fundamental that it is as though the franchisee never received one at all.
The above survey of the law, trends, and practical considerations relating to FPRs and franchise disclosure in Canada is by no means an exhaustive list. Rather, they are a springboard for careful thought and decision-making about each franchisor’s own particular status and needs.
Choices on what FPRs (if any) to include in your disclosure document must be made after a deep and wide analysis of your own system. Furthermore, considerations will change with time.
Franchisors are well-advised to have systems in place to identify, maintain and check their financial performance data – and disclosure documentation – on an ongoing basis. Also, importantly, training and policies must be implemented to control what the franchisor’s staff shares with prospective franchisees, to avoid making FPRs in a way that attracts liability and/or rescission, outside of formal disclosure processes.