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Everything You Need to Know About the Franchise Disclosure Document

Posted by HIRE YOURSELF on Jun 15, 2020 8:12:00 AM
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The second big step in franchise investigation is receiving and reviewing the franchise disclosure document (FDD). Before you think about owning a particular franchise, you need to review this document. After the introductory call, the franchisor will offer to send you a copy. This document is essential to your investigation process.

The Federal Trade Commission requires all franchises to have an FDD in place and to provide it to potential investors before any contracts are signed or money changes hands. The FDD is written by attorneys to follow a particular and regimented format, addressing each of twenty-three separate items. It can range from a few dozen pages to a few hundred pages of legalese. 

If you have trouble sleeping at night, try the FDD—it works better than counting sheep.

Though it is tedious, the FDD is an invaluable tool to protect both franchisors and franchisees. This document provides a detailed portrait of the company you’re with which you are considering investing your hard-earned dollars. 

Whereas the introductory call might allow you to get a better sense of the human side of the company you’re interested in, the FDD shares nuts and bolts information. You will learn who runs the company, what kind of background it has, and how it operates. It also clearly defines and details the relationship between franchisor and franchisee, spelling out each party's obligations. The FDD allows a potential franchisee to make an informed business decision with all the facts in hand.

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You may find the FDD too dense and technical to follow. You may want an attorney who specializes in franchising to help you understand it if you have questions. Minimally, if you have questions, write them down and follow-up with the franchisor. 

Whether you ask a franchise attorney to interpret the FDD or choose to manage it on your own, you should have a basic understanding of what each numbered section of the document covers. Knowing what kinds of issues you might want to be on the lookout for can help make sense of the document. 

Remember, your franchise consultant isn't here to do the investigation for you. You need to complete your due diligence to make a final decision on your potential investment. Read the FDD thoroughly, but use what comes below as a helpful guide.

 

Hear Nat and Pete discuss the ins and outs of the FDD on an episode of the HYS podcast.

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Item 1: Company Background

Contains: The name and some history of the franchising company, including disclosure of any parent, predecessor, and affiliate companies.

What to Look For: Is this a new company? Is it a reincarnation of a previously failed company? Or an affiliate of a troubled corporation? Does it have a parent or affiliate company with a track record of success?

Item 2: Franchisor Leadership

Contains: A list of the franchising company's key players and a short professional biography for each.

What to Look For: Understand the levels of experience and success the primary players have had. But look not just in their field, but also in franchising. Success in an industry doesn’t necessarily equate to success in franchising. It’s always nice to see both.

Items 3 and 4: Litigation and Bankruptcies

Contains: If the company or any of the principals are involved in active or pending litigation or bankruptcy proceedings, notice will be here. These items may include claims filed by or against the franchisor.

What to Look For: In an ideal world, a franchisor would have nothing to report in either of these sections. In practice, litigation is a reality that is sometimes unavoidable—especially when you’re dealing with a large corporation. Be wary if you see a pattern of lawsuits filed by franchisees.

Items 5–7: Fees and Initial Investment Estimate

Contains: Item 5 lists initial fees for buying the franchise; these are primarily up-front and one-time costs. Item 6 lists additional and ongoing fees for franchise ownership. Item 7 estimates the expense to open and operate a franchise outlet for the first three months.

What to Look For: By the time you receive the FDD, you will probably have a good understanding of the initial fees for the franchise. The breakdown of long-term fees in Item 6 may be your first clear and detailed view of how the franchisor makes money from each unit in the long run.

Be sure you understand the royalty rates, advertising fees, training and consulting fees, and other expenses to which the franchisor will be entitled.

In the case of Item 7, the numbers provided will offer an invaluable glimpse into the total costs of opening a franchise unit. That said, be mindful of the numbers that are not on this page.

The franchisor’s calculation doesn’t factor in investor costs that lie outside the scope of the FDD. Among those are your living and other personal expenses during the start-up period. Also left unmentioned is the fact that many start-ups take several months to break even. You must sufficiently capitalize to operate until the business begins paying for itself.

Undercapitalization is the biggest potential threat to any start-up. Do your math—preferably with the help of a trusted accountant—to predict your costs during those first few critical months. Develop a robust business pro forma and use it as your guide.

Download:  Franchise Entrepreneurship 101 

Item 8: Restrictions on Sources of Products and Services

Contains: To provide consistent products and services, companies often require franchisees to buy supplies, equipment, software, etc., through their corporate channels. This section details what you will have to buy through your franchisor. 

What to Look For: It’s not uncommon for the franchisor to make a profit margin through supply sales. In an ideal system, the franchiser’s bulk-purchasing power will offer the franchisee savings over what they would pay for these products in the open market. Make a note to ask actual franchisees about the fairness of their product and service costs in your next investigation step.

Item 9: Franchisee’s Obligations

Contains: A list of all the franchisee’s responsibilities to the franchisor, each cross-referenced to its appropriate section in the FDD.

What to Look For: Despite being labeled Item 9, this section of the FDD serves as the organizational center of the whole document. Use this section to review your obligations and to make a list of any questions or concerns about each. Item 9 can be beneficial in figuring out which areas of the FDD are unclear to you and might require further explanation.

Item 10: Financing

Contains: Discloses if the franchisor offers any financing to new franchisees or has established relationships with outside lenders to help franchisees borrow funds.

What to Look For: Consider any franchisor financing options alongside all of your other options, comparing rates and terms with equal weight.

Item 11: Franchisor’s Assistance, Advertising, Computer Systems and Training

Contains: A summary of franchisor support systems for its franchisees.

What to Look For: You want to see a detailed, well-thought-out system of franchisee support under this heading. This is your chance to see the actual components of the system.

Beyond brand recognition, the processes and steps outlined in this section represent a large part of what you’re paying for when you invest. How much and what kind of training will they provide? Will the franchisor send someone to help onsite at your opening? What kind of advertising will your investment buy?

Look for a thorough and supportive system, and be alert to any qualifying language like “up to X hours training” or “X hours training if deemed necessary.” Item 11 should give you confidence the franchisor will support you throughout your partnership.

Want the quick version of the fdd outline?

 

Item 12: Territory

Contains: A summary of the franchisor’s territory protections for your investment.

What to Look For: After reading this section, you should feel assured that another franchise in the same system won’t be opening a block away from your retail unit. Nor will another start catering to the territory of your service unit.

Items 13 and 14: Trademarks, Patents, Copyrights, and Proprietary Information

Contains: These items are self-explanatory disclosure of proprietary protections.

Item 15: Obligation to Participate

Contains: This item simply clarifies if the franchisee is required to manage the unit personally or if a manager can be hired.

What to Look For: Chances are, you would not have gotten this far in the process if the company’s requirements did not match your goals. If your goal is semi-absentee and the franchisor doesn't allow that, you would find that information.

Item 16: Restrictions on Sales

Contains: Clarification of what the franchisee can and cannot offer for sale under the franchising agreement.

What to Look For: This section should be fairly straightforward. After all, part of the appeal of buying a franchise is knowing you’ll be distributing a reliable product using a uniform system.

Item 17: Renewal, Termination, Transfer and Dispute Resolution

Contains: This item is presented as a chart. In addition to defining the basic terms of the agreement, it will cover almost every “what if” scenario you can imagine. 

What if you decide to sell the franchise? What if you break their rules and they want to take it from you? What if you're going to sell? What if they go into bankruptcy?

What to Look For: Keep in mind that when you invest in a franchise, you are not, per se, “buying” it. You are buying the rights to use the name, image, and systems of the franchise for a set period. 

A typical agreement might be for ten years with the first right of refusal if you decide to renew. Be sure you understand this section and what you are getting—most of us have learned just how fast ten years can fly by. You want to know what your position will be at the end of your initial investment.

Item 18: Public Figures

Contains: This section only pertains to a tiny portion of franchise investors.

Item 19: Financial Performance Representations

Contains: Item 19 can be an especially valuable section of the FDD—if the franchisor includes any information for you to review there. Disclosure of facts and figures in this section is voluntary. In many FDDs, all you’ll find under Item 19 is a note declining to disclose. 

What to Look For: Don’t dismiss a franchisor for not providing this information in the FDD— more than half of them don’t do so. However, if you do receive a detailed Item 19 section, consider it an excellent opportunity to grasp the most elusive financial information in franchising.

Franchisors have some freedom to choose which information is presented here. For example, averages or top performers, or the numbers from a sample of five units. They do have to submit only facts and explain where the information comes. 

We love to see an Item 19 on an FDD. It offers a window into financial details you’ll otherwise only have access to if you’re able to talk an existing franchisee into sharing it.

Item 20: Outlets and Franchisee Information

Contains: Tables outlining the number of franchises, number of franchise transfers, and number of anticipated new franchises in a three-year period. Also, it has a list of current and former franchisees.

What to Look For: This section should show a trend of stability or steady growth. You don’t want to see a chart indicating a large number of transfers or closures. The list of franchisees is gold.

You will use it to choose and reach out to a cross-section of franchisees in the next investigation step. They are your best source of useful information about the viability of your investment.

Item 21: Financial Statements

Contains: Audited financial statements from the franchisor (not from franchisees).

What to Look For: One thing any candidate wants to see in a franchisor is financial stability. Is this company healthy, and does it have cash to invest or use to ride out stormy times? 

Another key element to identify in Item 21 is how the franchisor makes money. Occasionally, a franchisor gets along by bootstrapping, sustaining

itself on franchise fees rather than royalties coming in from successful franchisees. This business model will inevitably fall apart in the long run—and you don’t want to be a part of that. Look for solid financials driven by royalties and fees coming in from franchisees.

Items 22 and 23: Contracts and Receipts

Contains: Franchisee contracts for your review and receipt acknowledging you have been given the Franchise Disclosure Document.

What to Look For: For now, these items are just formalities. Save them for your records and possible future review.

The FDD is a long, but important document, as we have said. You need to make sure to take the time to digest all the information and make sure you understand all the separate parts. This overview provides a basic outline of what to expect. Diving into the details is the only way to decide if a franchise is the right investment for you.

If you think you are ready to take the next step. Let's talk about how we can help match you to a franchise during a free 15 minute consultation.

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Topics: Franchise