Financial advice

Profit projections

Should franchisors make earning claims to prospective franchisees? Legal expert Manzoor Ishani explains how to get it right

 

The British Franchise Association (bfa) has issued timely advice to its members concerning profit projections. It is common for franchisors to provide prospective franchisees with financial information on their business, which can be called various things, such as financial projections, business plans, profit projections or financial illustrations.

Their purpose should be to give the prospective franchisee information not only about how much a franchise would cost to buy, what the setting up costs would be (including shop fitting, van leasing, purchase of initial stock and equipment, cost of initial advertising and marketing to launch their business etc.), but also the anticipated income and ongoing costs of running business. These costs would include such items of expenditure as wages, rent, utilities, council tax, purchase of stock, insurance premiums, advertising and last but not least, regular payments to the franchisor in the form of franchise fees (usually expressed as a percentage of the gross income - after VAT - of the franchisee).

In the case of the franchisee's income, the franchisor will estimate what, in their opinion and from its own experience of running a similar business, the franchisee can reasonably expect to earn from running the franchise business he or she is looking to buy.

Given that most applicants have not owned a business of their own previously, they rely implicitly on these ‘projections' and will access their capital requirements on the basis of what they are told by their franchisor. In the absence of any previous experience of running the type of business they are proposing to buy (usual in the case of new franchisees), this is the only information they have to assess the business prospect on offer.

So what do franchisors base their projections on? Ethical franchisors do not offer franchises for sale until they have thoroughly market tested their business and shown it to be successful. They draw on their experience of actual costs, expenditure and income to formulate their ‘business model'. They use this business model to produce the ‘projections' (after adjusting it for local/regional variations; for example, higher wages and rent in London than elsewhere), which they give to their prospective franchisees.

So far so good, but the business model is only as good as the information on which it is based. All too often, once franchisors have produced the business model, they themselves take it as gospel and either forget (usually the case) or fail to update it in the light of changing circumstances. The economic climate changes with the passage of time and with it the cost of running a business. Even if one ignores the recent economic crisis, some businesses are subject to rising costs of operation by virtue of their nature (for example, a food outlet may have to comply with new health and safety regulations), quite apart from any change in the general economic climate.

Given what is said above, franchisors should make it a practice to regularly review their financial model and to update it in the light of experience/reality. Franchisees should not take any ‘projections' at face value and should ask searching questions as to the basis on which they are produced and when they were last reviewed and adjusted.

Most ethical franchisors own and run at least one outlet on similar lines to that required of their franchisees and for the franchisee, what better proof (of the accuracy of what they are being told) then to ask to see the audited accounts of such a business.

The bfa's guidance note referred to at the beginning of this article requires members to state on its projections, the basis on which they are made. "For example, are they based on the performance of the franchisor's own outlets, or a pilot operation, or the average of all franchisees of longer than one year's trading, or the average of the top 10 per cent of the franchisees, or - something else"?

They also require members to draw the attention of prospective franchisees to the fact that what they are being given are projections and not a guarantee that the profit figures stated in such projections will be achieved.

Manzoor Ishani is a senior consultant solicitor with Sherrards (Solicitors), a commercial practice advising franchisors and franchisees in the UK and internationally.