The Franchise Disclosure Document is a big step in the investigation process. When Nat invested in his first franchise, he skipped it (he's more of a ready, fire, aim guy sometimes). He doesn't suggest that approach. Both HYS consultants think you should spend the time to really read the FDD when you have narrowed down your choices.
On this episode, Pete and Nat discuss the FDD, what it contains, and why it is important to your investigation.
Here's a Full Transcript of Our Podcast on the Franchise Disclosure Document and How to Read and Research an FDD
Nat: Pete, what did you think we should talk about today?
Pete: Well Nat, I want to talk about one of my favorite subjects, it's so exciting. I was thinking about this last night. I read before I go to bed, right? And as you get older, I like read three pages, and I fall asleep. And so I was thinking to myself, okay, what do we cover today? And I thought, well, there's nothing more exciting than reading a franchise disclosure document as you're evaluating a franchise concept.
Why don't we talk about the franchise disclosure document, which is the second major step in the process of evaluating franchise companies, specifically a candidate, when they're looking for a franchise. They have to use or go through the franchise disclosure document. How about if we talk about that very exciting topic today.
Nat: Yes, I was chuckling when you said that about falling asleep after three pages because I think last couple nights, I fell asleep after two pages. I've been so tired at the end of the day.
Pete: It is, it's amazing. I have a hard time reading at night, but it's so important as leader. So the franchise disclosure document, I don't know if you know this Nat, it was created, I think, in 1978 by the federal trade commission, designed to protect the consumer, somebody looking to invest in a franchise. Did you know that interesting fact?
Nat: I did not know that. But I do like the fact that there is some consumer protection, right? Because you always kind of want to know what you're getting yourself into before it's too late.
Pete: Yes. As we talk about informed investor, it's very similar to stock prospectus. It's designed to ensure that you're an informed investor. It is a big document as we were talking about reading, right? I have a hard time sitting down and reading two to three hundred pages, which is the average size of the franchise disclosure document.
Let's talk about the franchise disclosure document from the standpoint of structure. So it's 23. They call them items; we'll call them sections, whatever works for you, right? As you talk about this, there are different sections and they kind of cover different areas. Maybe what we do is we kind of break this thing down into categories. Does that sound like a good plan?
Nat: Yes, I like that, it's kind of organize our thoughts. I know that reading the FDD is not always people's favorite thing to do. But if you can kind of know-how to organize it, that always helps.
Pete: Yes. Maybe we started a broader approach. When we get that FDD, and you have to have the FDD two weeks before you could invest in a franchise. So it's a holding period of two weeks where you got to hold this document, right? And what I tell people is if this is the one you're really interested in, you have to read in its entirety.
You have to read all two to three hundred pages long, right? And it's supposed to be written in layman's terms, so you should be able to read through it and understand it. If you don't, you write down your questions, you go back to the franchise development person, and you ask the questions, right? And try to get the answers.
And if, in fact, you read through it, and the franchisor can't explain to you, well, then you get a franchise attorney to help you understand it, right? To give you a better understanding of what the document is all about.
Nat: Yes, there's lots of tools and resources and all that for this. And like you said, I appreciate the fact that the federal trade commission mandated that it's written in plain English. So guys like you and I have a chance of understanding it.
Pete: Absolutely, right? And it can be daunting, right? You get that big document from my standpoint.
Nat: Well, I think a lot of times it's daunting if you're trying to look at or research multiple concepts. Some guys are looking at, they might be looking at three, four, five different franchises. That’s on top of just thinking about one FDD; you might actually be thinking I need to read three or four or five, right?
Pete: Yes. What I always recommend if you are looking at four at the same time, I would not try to read them cover to cover, right? That's 1200 pages, it's too much. And it all starts blending together. And I think when you your consideration set is three or four franchise concepts, then you skim the documents.
You're looking at key sections like 5, 6, 7, 19, or items. And then when you narrow it down to one or two, then you got to read them in their entirety. You must read them in entirety; you must understand what you're committing to and what the franchisor is committing to.
Nat: Yes. Which items kind of talk more about the history of the franchise or the parent company?
Pete: Items 1, 2, 3, 4, and 20 really kind of give you the background on the franchisor. Those are kind of the core documents telling you the history of the franchisor, to the founding or the leadership team stuff like that.
Nat: I like too that, and they're if there are any bankruptcies or litigation in the last ten years, that's all detailed in there. If there's litigation, that might be something you might want to try to better understand before writing that big check, right?
Pete: Yes, and item 20 kind of gives you a list of all the franchisees, right?
Nat: Yes. But I know a lot of guys are always asking me, like how much is a franchise, or what's the [Inaudible 00:04:59.29], what's the net profit? Like always want the numbers, the numbers, the numbers is what about for getting to the numbers Pete?
Pete: Yes. I think when we talk about the FDD, there is kind of three items that really kind of touch on the financial commitment. Items five, six, and seven. Number five, or item number five, we talk about kind of the franchise fee and stuff like that.
Item six would kind of explain the different fees that you have, so it might be marketing fees and royalties and stuff like that. And item seven is from the standpoint of the overall investment.
Nat: When you talked about the one that kind of talks about the "economic expectations" or kind of more the money, total things.
Pete: Item 19, right? Franchisors have the option to put an item 19 financial numbers for the franchise system. Think of it as a macro number; they might put in there. Hey, our average franchisee has revenue a plank, or a top third of our franchisees have operating profits.
Nat: Yes. It doesn't seem like that's necessarily a standardized format. I've seen probably 100 different ways to put that in there. But at least it's a lot of times kind of helpful for guys to start to build their Pro-forma or throw numbers into the spreadsheet or whatever as they're doing their due diligence.
Pete: Well, I think it's important they understand it; again, they're very vague numbers. Which are looking for, I think, is some of the cost stuff from the standpoint of really digging in that comes with validation which is the third major step in investigating a franchise.
Nat: Yes.
Pete: The investment range is interesting, right? When we talk about that item seven, where they talk about the investment range. That's a range because it can vary greatly based on the market, the facility that you pick, or the area that you're in terms of cost of doing business. That's why it's a range. If you look at it, it gives you a kind of a wide range, it could be hey, for this franchise it could be 350 to $500,000 the initial investment.
Nat: Yes. I always kind of in my mind, like I'm always kind of prepared when I'm making an investment that it's going to take twice as long to get open and cost twice as much. That way it's like I, hopefully, that I have a good chance of hitting my goals.
Pete: Did you create a Pro-forma when you started your first franchise?
Nat: I have to be completely honest; I didn't. I'm like the ready, fire, aim kind of guy. I was twenty-nine when I bought my first franchise; I was there, there was a lot of very successful people there, and I kind of looked around in the room, and I'm like, well, I'm probably the dumbest guy in the room.
These guys probably did Pro-forma, I don't know, but it worked out pretty well, pretty good for me, so yes. I wouldn't recommend that as a best practice, but the tools are definitely there.
Pete: No, and I think a Pro-forma is good to do in advance, right? I did that when I did my master franchise; I created a Pro-forma and actually hired an accountant or a firm, CPA firm to kind of do the tax consequent, kind of roll through to come from a tax planning standpoint.
You can always do it on yourself; you can require or bring in other people to help you kind of figure it out. But it's a good road map; the field analogy right is like a battle plan is great, it's priceless to develop it. But the minute the battle starts, it's worthless. And I think that's to some point once you get in and it starts, then it gets real fast.
Nat:Well, the cool thing about like thinking back when I started, yes it's almost like going to school, and you have like a graduating class. You go to training, and you have a graduating class. The nice thing about franchising is a lot of times; there's kind of benchmarks.
When you have a whole system of franchise owners, a lot of historical data, the franchisor can kind of help you make sure you're doing the right things at the right time, and then you're also kind of in this graduating class of maybe ten other owners.
And we had a good little network going, and we were on the phone all the time and kind of helping each other out. And also just looking at the metrics on a weekly basis. And then being able to benchmark against the rest of the system was super helpful too.
Pete: Yes. And I think as we talk about the FDD, and this idea of your responsibilities as a franchisee, clearly those are listed in the franchise disclosure document items 8, 9, and 15. All kinds of lay out what your responsibility is as a franchisee so that you know what you're committing yourself to do.
Nat: Yes. It's exciting kind of making that decision and leap of faith and starting your own business and all that. And also, I can't overemphasize being able to be part of a group of other guys and girls just making changes and building their business, but I like what you're saying about the kind of that franchise support and all that too.
Pete: Well, the franchise supports those are different sections, right? In the FDD, it tells you what you're responsible for but also says what the franchisor is responsible for.
Those are items 8, 11, 12, 14, and 17, all layout what the franchisor is committed to do for you as the franchisee. It kind of lays out the relationship on both sides; this is what you're responsible as a franchisee, this is what the franchisor is responsible to do.
Nat: Yes, exactly. Speaking of other franchises having owners and all that, the other thing in the franchise, the FDD, the franchise disclosure document is a really great resource that people can use in their due diligence and validation, is there's an addendum that has a list of every franchise owner past and present.
And it's fair game to call and strike up a conversation, and kind of see. I always try to coach my guys, my candidates, hey let's try to find some top-performing, some kind of middle-of-the-road performing guys, and some guys that are underperforming or maybe even quit. And then let's try to dig into this and unpack it, see like why did you quit? Or why did you sell your franchise?
Or why did you feel like you weren't successful? And then with the guys that are the top 10% let's talk to those guys, and then let's see who you most identify with because the last thing we want is for there to be any surprises for you nine or twelve months down the road. And that fit is so important, it's almost like a certain profile of owner a lot of times will be more successful.
Pete: Yes, absolutely. And I think to your point, when you do validation, you can open up the FDD, and you can call any franchisee you want. It's your right to do that. I think the tough part about the FDD is it's a trailing document, right? It's a document that's at least a year old when they update the information because it has to be done, re-done, refiled every year. And not only that's not current in many ways. And it's sometimes it's a trailing number, but it can be really helpful to call some of those franchisees.
Nat: Yes, for sure.
Pete: And I like the idea of the range, right? The superstars, the solid performer, somebody that's struggling, and work your way down and get the good understanding of what you're getting. In terms of are the franchisees happy? Are they making money?
Nat: Exactly, yes. I feel like a lot of times; owners will be pretty transparent with kind of how they're feeling, or how they're doing, or how they're supported by the system. And ironically, a lot of the ones maybe that left the system will be pretty transparent with letting you know why they left. And a lot of times, they kind of take ownership of like, hey, it was me, it wasn't the franchisor and that's I think good to know too.
Pete: Yes. I mean the franchisee, I mean from their standpoint, it's a one-on-one call with them, right? You're having a conversation, and they want to pay it forward; they want to explain what their situation was and how they did so.
Nat: Exactly.
Pete: You know, I think as a franchise consultant, we both know that as a franchise consultant, our job is not to explain the FDD from the standpoint of a specific franchise concept. That's the candidate, the person that's looking at a franchise.
That's ultimately your responsibility to read through it, understand it, get your questions answered. A franchise consultant, that's not their role to explain the FDD and try to answer any questions in regards to a specific FDD, that's just not the role of a franchise consultant.
Nat: I always kind of chuckle because we start working with somebody, and we're kind of explaining the FDD, explaining all the jargon and the item seven and the item 19, and guys are kind of like feeling overwhelmed.
And then a couple of months later, they're like they've been exercising those franchise muscles, and they're talking like they're an old veteran. Oh yes, I was looking at the item 19, it's kind of fun to see. It doesn't take that long to get your arms around it. It really is there for consumer protection, so I think that that's great.
Pete: Well, I think one of the things that makes them so long is they also have breakouts for certain states, right? There are multiple registration states, and they have their little section in there.
It may not pertain to you for the state of Minnesota; registration information is in the back of the FDD. There is some stuff that is just not applicable to you as a franchisee if you don't live in that given state.
Nat: Just thinking about like adding to the number of pages, talk a little bit about the franchise agreement, which is also part of that total packet.
Pete: Yes. The franchise agreement that you're going to sign is in the franchise disclosure documents. From the standpoint now, most franchisors you'll find is that the franchise agreement is what it is. You can't redline the franchise agreement, so you can read through it, you can understand it.
Sometimes they'll make an addendum on top of it, a small clarification or something, but pretty much now franchisors, they won't make any changes. Because if they make a material change, then they've got to make that change going forward for everybody. And it's pretty consistent. You're going to hear franchisors say, hey, the franchise agreement is the franchise agreement you're going to sign. That we're not making any changes to it. Everybody else has signed it that way, you're signing it that way. There are certainly public places out there where you can get them.
Actually, people sell them if you're interested in a specific franchise concept. I think our role is to make sure people understand the different sections, understand the importance of doing your due diligence going through the document. But not really going through and explaining and giving them actual FDDs, that's not our role as franchise consultants.
Nat: I think we definitely have that 60-Day Investigation Guide on our website, which would be pretty helpful. And it has, I know, some questions to ask franchise owners, as you're kind of going through the validation and due diligence and all that.
Pete: Yes, and the HIRE YOURSELF book also explains all the different sections of the FDD, and there's some great articles out there on the web explaining FDD. It's an important part of the process, the franchise disclosure document.
And as you go through this process and doing your due diligence, this is the big part of it. Is reading through it and understanding what you're committing to and what the franchisor is committing to because it's a long-term relationship. It's a partnership from a standpoint. You need to clearly understand what that means.
Nat: Awesome.
Pete: All right, Nat, I've had so much excitement today. I think I'm good with the FDD; are you good with the FDD? Just kidding.
Nat: I'm really good with the FDD (franchise disclosure document).
