October 28, 2011

Popping the question: disclosing earnings potential to franchise buyers

How much money will this business make? That is the question on the mind of everyone who considers buying a franchise. No rational person would consider buying a franchise without wanting an answer to this question. And yet, it is a very tricky one for the franchisor to answer if it wants to stay within the bounds of the law.

Ontario’s franchise protection statute, the Arthur Wishart Act (Franchise Disclosure), 2000, and its associated Regulation put limits on how information about the profitability of the business can be disclosed to the potential buyer of a franchise.

The Wishart Act radically changed the way franchises are sold. Before the Act came into effect, many franchisors would provide a franchisee with a pro forma statement showing profitability at various sales levels. In some cases, few franchisees in the system had ever actually achieved those sales levels. This had the potential to mislead purchasers. Other times, a franchisor would provide back-of-the-napkin profitability information to the purchaser that could not be verified. The franchisor usually insulated itself with disclaimers that told the franchisee not to rely on the information even though the sole purpose of providing the information was to induce the franchisee to buy the business.

The Wishart Act was supposed to change all of that. It requires a franchisor to deliver to the potential buyer of a franchise a pre-sale disclosure document that discloses all material information about the business and the franchise system. If a franchisor wishes to give information about the potential profitability of the franchise, it must do so in the form of an earnings projection in the disclosure document itself. To ensure that the information in the earnings projection is verifiable, the disclosure document must state the reasonable basis for the earnings projection, the assumptions underlying it and a location where information is available for inspection that substantiates the projection. The disclosure document must also contain a certificate attesting to its completeness and accuracy. Failure to comply with these strict requirements exposes the franchisor and the individuals who signed the certificate to significant liability.

Although the Wishart Act has been around for over ten years now, old practices die hard. This is especially true when it comes to statements about the profitability of the franchise. Some franchisors try to circumvent the Act by giving pro formas or profitability statements outside of the disclosure document. Sometimes this is done for the ostensible purpose of assisting the franchisee in preparing a business plan to obtain bank financing. Another method is to send the franchisee an “information package” containing what are said to be “typical” earnings experiences of other franchisees, along with a disclaimer. Many sales brokers employed by franchisors fall into the trap of giving this sort of information to potential purchasers outside of the disclosure document.

All of these practices are now prohibited in Ontario. The only place where earnings information can be disclosed to a potential purchaser of a franchise is in the disclosure document. If the disclosure document says that the franchisor ‘does not provide earnings projections, then no such information can be provided. If the franchisor does provide earnings information, it must provide it in the disclosure document itself and not in any other format.

The Wishart Act was intended to stamp out all forms of representations about earnings other than those contained in a disclosure document. Circumventing the restrictions in the Act can land the franchisor and any franchise sales people in hot water.