When evaluating a franchise investment, one of the most critical considerations for both prospective franchisees and lenders is the financial performance of existing franchise units. This is where Item 19 of the Franchise Disclosure Document (FDD) comes into play. As a commercial lending company, understanding Item 19 is essential in assessing the viability of a franchise business and determining whether it’s a sound investment for financing.

In this blog, we’ll break down the importance of Item 19, what it contains, and how it impacts lending decisions.

What Is Item 19?

Item 19 of the FDD, also known as the “Financial Performance Representations” section, provides information about the financial results of franchised and/or company-owned outlets. While franchisors are not legally required to include financial performance representations, those that do provide prospective franchisees and lenders with valuable insight into the earnings potential of the business.

Franchisors who choose to include financial performance data in Item 19 must ensure that the information is accurate, substantiated, and presented in a way that does not mislead the reader.

What Does Item 19 Typically Include?

The content of Item 19 can vary significantly from franchisor to franchisor, but here are some common types of financial data it may contain:

  • Average Gross Sales: A breakdown of average sales figures for franchised and/or company-owned units.
  • Median Revenue: Median sales or revenue data, which can give a more realistic picture for prospective franchisees, as it helps avoid outliers skewing the average.
  • Range of Gross Sales: The highest and lowest-performing franchisees’ sales figures, helping to identify the potential variability in performance.
  • Profit Margins or Net Income: Some franchisors may provide profit and loss information, which is crucial for understanding the potential profitability of the business after expenses.
  • Breakdowns by Region or Unit Size: Financial performance might vary based on location or the size of the franchise unit, so some franchisors will include these distinctions.
  • Franchise Unit Success Rates: Information on how many franchise units meet or exceed certain revenue benchmarks.

Why Item 19 Is Important for Commercial Lenders

Commercial lending companies will use this to evaluate the financial strength of franchise opportunities to ensure their clients can confidently repay their loans. Item 19 plays a pivotal role in helping assess the financial health and earning potential of the franchise. Here are a few key reasons why it’s essential from a lending perspective:

1. Predicting Revenue Potential and Loan Repayment

Item 19 provides the necessary data to estimate future revenue, a crucial component of determining whether the borrower will be able to generate sufficient cash flow to cover both operational expenses and loan repayments. Average and median sales data give us a baseline for understanding what kind of revenue to expect under normal circumstances.

From a lending perspective, we use this data to:

  • Forecast Cash Flow: Estimating whether the business will generate enough revenue to cover loan payments after factoring in royalties, operational expenses, and other costs.
  • Evaluate Loan Structure: The stronger the financial performance representations, the more confident a lender can be in offering flexible loan terms. A franchise with solid revenue figures may qualify for more favorable rates or loan structures.

2. Assessing Risk Based on Variability in Sales

While high-performing franchisees can present an attractive investment opportunity, the wide range of sales figures included in Item 19 often reveals potential risk. A significant gap between the top and bottom performers indicates volatility and highlights the importance of careful selection and management of the franchise location.

On the lending side, we consider:

  • Risk of Underperformance: If the low end of the sales range is far below average, it raises questions about what factors contribute to underperformance and whether those risks apply to the borrower’s location.
  • Impact on Loan Terms: Higher variability in performance can lead to more conservative loan terms or requirements for additional collateral, as it introduces more uncertainty into the loan repayment prospects.

3. Analyzing Profitability for a More Informed Lending Decision

While gross sales figures are important, profitability is the ultimate measure of success for any business. Some franchisors include profit margin or net income data in Item 19, which is critical for understanding how much of the revenue actually translates into profit after accounting for expenses.

For commercial lenders, profit data is key because:

  • Cash Flow Is King: Gross sales mean little if high expenses leave a thin profit margin. We need to ensure that the franchise has enough profit after expenses to cover loan payments comfortably.
  • Better Loan Structuring: Higher profitability means a franchisee will have greater flexibility to manage both operational costs and debt, potentially allowing us to offer more favorable terms such as lower interest rates or longer repayment periods.

4. Understanding Industry and Regional Trends

Franchisors may break down financial performance data by geographic region or market size, providing insight into how the franchise performs in different environments. This is valuable for both prospective franchisees and lenders, especially if the loan is for a franchise in a new or less-proven market.

We consider:

  • Local Market Performance: Regional data allows us to assess whether the franchise performs well in the borrower’s target market. For example, if the franchise thrives in suburban areas but struggles in urban centers, that would impact both the lending decision and the loan terms.
  • Economic Trends: Item 19 can also provide insight into industry-wide trends, helping us gauge whether the franchise’s success is aligned with broader market growth or subject to potential downturns.

What Happens If a Franchisor Doesn’t Include Item 19?

Some franchisors choose not to provide financial performance representations in their FDD, which may raise red flags for both prospective franchisees and lenders. While this doesn’t automatically indicate a poor opportunity, it does mean there’s less transparency about the business’s financial performance.

From a lender’s standpoint, the absence of Item 19 can result in:

  • Additional Scrutiny: A lender may require more financial information from other sources, such as detailed business plans, market research, and personal financial statements, to compensate for the lack of revenue and profit data.
  • More Conservative Lending Terms: Without clear financial performance data, lenders might take a more cautious approach, offering lower loan amounts or requiring higher down payments to reduce risk.

Conclusion: The Value of Item 19 for Informed Lending Decisions

Item 19 of the FDD provides crucial financial data that allows commercial lenders to make informed decisions about the viability of a franchise business. By offering insights into revenue potential, profitability, and market trends, this section helps lenders assess risk, structure loans effectively, and ensure that the franchisee has the financial capacity to succeed and repay the loan.

For franchisees seeking financing, a thorough understanding of Item 19—and how it impacts the financial health of your future business—can significantly improve your chances of securing funding and setting your franchise on the path to success.

If you’re considering franchise financing and need guidance on how to interpret the FDD, including Item 19, we’re here to help! Reach out to us today at josh@goldencapsolutions.com