What is an item 19 and how do I read it?

What Is An Item 19 And How Do I Read It?

According to ChatGPT:
An Item 19, also known as the Financial Performance Representation (FPR), is a section in a Franchise Disclosure Document (FDD) that provides information about the actual or potential financial performance of the franchised business. The purpose of an Item 19 is to give prospective franchisees a better understanding of the financial aspects of the franchise system they are considering investing in.

It’s important to note that an Item 19 is not a guarantee of financial success or profitability for a franchisee, and prospective franchisees should carefully review and evaluate all information in the FDD before making a decision to invest in a franchise.

Although the second paragraph seems like an obvious one, some prospective franchise buyers may be unaware of the manipulations and misleading information that ends up in the item 19 and take it at face value. Instead of giving prospective franchisees a better understanding of the financial aspects of the franchise system they are considering, these numbers can sometimes sell a dream that can differ significantly from the reality. Because the numbers look great, we’d like to believe them only to be set up for failure and disappointment in the long-term. Here’s what to look for when evaluating an item 19 for a home service or home improvement franchise:

  1. Are the numbers for a corporate owned shop or a franchise location? Corporate territory performance is not indicative of franchisee performance. There are resources that the franchisor has access to that help the business perform such as experienced team members, local notoriety and operating experience. If they didn’t have this, they wouldn’t be the franchisor. Can you compare yourself to your trainer at the gym? In some cases maybe, but in most cases probably not realistic. Don’t make the mistake of forecasting based on a corporate location when starting a franchise.
  2. There is no assurance that you will earn as much. This statement is fair because a lot will depend on you, the franchise owner. The caveat is that the financial representations need to be realistic and representative or the only assurance is that you will not earn as much. Read on to see if the representations are realistic.
  3. Huge discrepancies between corporate locations and franchise results. Although it is normal to have discrepancies (see point #1), when there is a complete and total disconnect, something is off. Are sales ratios completely different? Average job size? Certain concepts disclose average sales ratios double those of their franchisees. Why such a large gap?
  4. Excessively high average job close rates. On that note, the average for home service close rates will range between 20-30% (feel free to fact check this on google) and the best close rates in the industry hover in the 40s. Anything way higher than this, on average, is simply not realistic and I would not base on financial forecasts on this as you will most likely be disappointed. How are these being calculated?
  5. Are the averages and medians far off? They should be relatively close or else the average is not representative. You may have a few locations skewing positively in one direction and misrepresenting the results. There’s a reason why both average and median need to be disclosed.
  6. How many franchisees are represented? Are we looking at the top 20% only or a real average? Big difference! It’s fair to not include all franchisees since some don’t operate a full year or may not be representative for a few good reasons (which should be mentioned) but there should be a decent sample size of franchisee data in order to give you a good idea of actual potential. 20 franchisees represented should be the minimum to have a fair sample size and realistic averages. Smaller than that and the results can drastically be skewed in a much more positive direction than they should be. We don’t want to skew results too positively or negatively. They need to be attainable.
  7. Disproportionate revenue to fixed costs: Multi-million-dollar revenues with expenses for 1 vehicle? How does that work? One vehicle, depending on the service would be able to generate between $500k-$750k of revenue so do your research here and make sure this makes sense… With this metric it should be relatively easy to compute vehicle cost. Are these franchisors giving you the benefit of the doubt or hoping you don’t catch this? Either way, why not disclose properly? Vehicles should represent 2.5%-3.5% of revenue on average depending on scale.
  8. Sweet spot. This is a tricky one I admit. There are sweet spots in businesses where you’re leveraging your fixed costs close to 100%. Although fixed costs are often showed as a percentage (not really another way) it can be misleading. Fixed costs are not linear like variable costs so at different revenue points, fixed costs, as a percentage will fluctuate based on your sales. To make a long story short, if you’re allocating the percentage of fixed costs that are underrepresented for the associated revenue you may either be drastically understating or overstating fixed expenses. This one can be tricky and requires asking the right questions but good to be aware.
  9. Year 1 is going to be the most difficult, no matter the concept. Are franchisees growing or stagnating? How quickly are they able to grow? No business will make you rich in your first year but growth is key in order to pave a path to working on your business and achieving the freedom that comes along with it sooner rather than later. Owning a business is a get rich slowly endeavour. If you want to get rich quick, bet your fortune on red at the casino but you may also lose it all in one shot.
  10. Disproportionate salaries. Are the disclosed management salaries plausible? Are sales commissions high enough to be able to employ someone and give them a living wage? Will someone with a salary of $75,000 be willing and able to run a multi-million-dollar business? Unlikely…
  11. Disclosed expenses. This is the most misleading of all. Showing a net margin without including all potential expenses or only “certain expenses”. Seriously? Vehicles but no fuel? (more common than you think) Fuel should vary between 1-3% depending on the concept, territory size and average job size. A smaller average job size will automatically mean higher fuel costs because you need to get to more jobs per day. No professional fees? Every business needs to provide year end financial statements and you will also likely need a bookkeeper. Is there a convention you must attend? Software you need to operate the business? These should be included in the fixed expenses. Sure, you may incur additional expenses, but the basics should all be included if there is a net margin representation.
  12. Lower royalties but extra fees. Are there extra fees for a call center or are they included in the royalty? Careful when comparing because some franchisors include call center fees in their royalty and some don’t.
  13. Higher than average gross margins. The average home improvement / service gross margin will generally range between 40%-50% on the higher end if the average job size is sizeable ($5000+). Lower average job size services (under $1000) are the exception to this rule and will have higher gross margins but you need way more of them to run a sizeable business (and higher fuel and admin prices). Subcontracted work will automatically yield a lower margin as will services with a lot of competition. More niche services with higher barriers to entry will generally yield higher gross margins. This is what makes Spray-Net special. #shamelessplug All else equal, this generally translates to higher net margins too!
  14. Extremely low fixed costs. All home service / improvement concepts will basically have the same amount of fixed costs. They all share very similar expenses such as a truck, storage, insurance, fuel, marketing, bank and professional fees. These are pretty constant and should not vary significantly between one concept to the next. Be wary if one is claiming much lower fixed costs as they’re likely not including or understating something.

What it boils down to when comparing home service or home improvement franchises is gross margin. All things equal (and they should be), a higher gross margin should net you a higher profit. Is there a lot of direct competition in the space? Is it easy to get into this business or is it very specialized with a high barrier to entry? If so, this is a good place to be. You don’t want to be in a commoditized space because prices will be driven down when all your selling is the same service (essentially time) with a different logo.

According to a study by Franchise Business Review, which surveys franchisees across various industries in the United States, the average net margin for home improvement franchise businesses in 2021 was around 7.7%.

Anything over 15% is very good and low 20s is great (if true). Anything much higher than that and you should begin to question the validity of the representations. If it seems to good to be true, it probably is… The purpose of the item 19 section of the franchise disclosure document is to allow a prospective franchise owner to figure out their payback period and path to profitability. A payback period under 2 years is good and means you’d be making money in your first year to pay back your investment. Less than 2 years is great! That doesn’t necessarily mean you’ll be taking out money right away. It’s important to be able to create conservative, optimistic and realistic forecasts to plan for the worst and aspire for the best but, in order to do so, you need a solid baseline, and misleading or incomplete representations can extrapolate into entirely unattainable forecasts in a hurry. There’s a difference between what we want to be real and what is. Be diligent and prudent when evaluating a concept solely based on these numbers. They’re not always what they seem!

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