The Importance of Reviewing the Notes to a Franchisor's Audited Financial Statements

Vol. 15, No. 2

By

Weston Patrick, P.A.

Frequently, in addition to the statements themselves, the notes to a franchisor’s audited financial statements in its franchise disclosure document (“FDD”) may contain a treasure trove of useful information for prospects. This is because, typically, the notes are written by accountants and not filtered by counsel. Counsel for prospective franchisees should study the financial statements and notes with care. Conversely, in the process of FDD drafting, franchisor counsel should alert their clients to this potential “pitfall,” with a view toward making certain the notes do not disclose “too much” and are consistent with the rest of the FDD.

Some areas to focus on include:

  1. Litigation matters that are not disclosed in Item 3 but are referenced in the notes, perhaps with the caveat that management does not consider them material.
  2. Financial performance representations that are not disclosed in Item 19, such as supplemental revenue and expense information for one or more corporate units or other numbers from which unit gross sales information can be extrapolated.
  3. References to franchise statistics, such as units open at the end of fiscal years, that are not consistent with Item 20 disclosures.
  4. Statements about dealings between the franchisor and related parties (e.g., its principal owners or corporate affiliates, such as its parent) which indicate that the franchisor’s economic viability or net worth may depend materially on the decision of a related party to pay the franchisor and/or not drain the franchisor of much of its assets. For example, the right of a related party to call a demand note owing by the franchisor at any time, to increase the franchisor’s rent or to simply refuse to pay a receivable owing to the franchisor, may potentially render the franchisor worthless or without capacity to perform.
  5. References to revenues (e.g., vendor rebates) received by the franchisor from suppliers to franchisees that are not disclosed (or are disclosed inadequately) in Item 8.
  6. References to the fact that the franchisor does not own the trademarks (and perhaps other intellectual property) but simply has a license from an affiliate to use them, even though this licensing arrangement is not properly disclosed in Items 1 and 13.
  7. References that call into question a franchisor’s ability to continue as a going concern, which are definite red flags that, among other things, may prevent the franchisor from registering its franchise offering in some registration states.

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