A Basic Guide To Reading And Understanding The Franchise Disclosure Document
Purchasing a franchise provides people with the entrepreneurial spirit the opportunity to be their own boss with the added benefit of being supported by a corporate structure. In fact, it can be the best method of getting into business for yourself. That being stated, it is imperative that you choose a franchise opportunity that is actually as good as it sounds in order to succeed. That is why it is so important that you read and understand the Franchise Disclosure Document or FDD for short. In essence, it is intended to protect your best interests.
The Federal Trade Commission requires every franchisor to provide potential franchise buyers with an FDD no less than fourteen days prior to the signing of a Franchise Agreement, which is the document that binds you to the deal. Although the intent of the FDD is to safeguard potential franchise buyers, the documents are typically written by attorneys that technically represent the franchisor. That means the document is going to be full of language that can be confusing, to say the least.
We highly suggest that you obtain the representation of a franchise/business broker, or attorney that specializes in working with franchise buyers. In the meantime, you should have some basic knowledge of how to read and understand the FDD on your own. The following information will provide you with the basics of all twenty-three (23) items that are listed on a typical Franchise Disclosure Document.
Item # 1: The Franchise Company
The first item in the FDD is basically an overview of both the history and ownership of the franchisor. It includes information about the corporate family and any franchise opportunities that they offer.
Item #2: Business Experience Of The Franchise Executives
The second item in the FDD is all about the people who are responsible for the success of the franchise from a corporate level. It is important for each potential franchise buyer to have an understanding of the people in charge including their experience. In essence, they should have experience managing companies of similar size. At the minimum, a few members of the leadership team should have vast experience in franchising. Be aware of franchise opportunities that have executive teams that are new to franchising, or executives that have been involved with multiple businesses that have failed in the past.
Item #3: Litigation
The third item in the FDD is based on the fact that franchisors are required to disclose any litigation that involves the company itself, or its principals or directors. Litigation does not only include claims that are made against the franchisor, but also any lawsuits that the franchisor has brought against other entities including franchisees. Typically speaking, franchisors may sue franchisees that fail to comply with company standards, which is actually a good thing. On the other hand, you need to keep in mind that in a large network of hundreds or even thousands of franchise locations you can expect that at least one franchise owner is unhappy based on the law of averages. That being stated, if there are multiple lawsuits by franchisees or other outside sources it should be taken as a bad sign.
Item #4: Bankruptcy
The fourth item in the FDD states that the franchisor must disclose if the company has gone bankrupt in the past, or is currently in bankruptcy. The company must also disclose any directors or officers of the corporation who have declared personal bankruptcy. If bankruptcy is recent or still pending, it may not be the best time to make an investment in the franchise.
Items #5, #6, and #7: Initial Fees And Investment
The fifth, sixth, and seventh items in the FDD include information about fees and investment. The fees are often listed as a range from low to high based on the fact that they may vary from state to state and even location to location. For example, rent is typically higher in Chicago than it is in Detroit. Franchises may also offer a range of services. Some of them will be required, while others are optional. It is important to pay careful attention to the fees that are required, along with the services or equipment that you would like to include in your franchise location. That way you can start to create a budget that is specific to your needs. You should also be aware that not all fees are listed in a single table. For example, the costs of inventory and products, and the expenses required to open and operate your franchise for the first 90 days are actually listed separately.
Item #8: Restrictions On Sources Of Products And Services
The eighth item in the FDD is based on the fact that the franchisor has a vested interest in knowing that that the products and or services that you are utilizing meets company standards. The company may sell you products or even insist that you use particular suppliers. This goes a long way in ensuring both consistency and quality across the board for all franchise locations, which of course results in a better overall experience for the customers. If franchisors are receiving large cash rebates from certain supplies, it can be a warning sign of how they conduct business in general.
Item #9: The Franchisee's Obligations
The ninth item in the FDD is a list of your contractual obligations. They are actually cross-referenced with the Franchise Agreement and the remainder of the FDD itself. This is the section where you can see everything that you are responsible for. If the FDD descriptions are not consistent with the Franchise Agreement, it can be a red flag. Although this is rare, it is potentially alarming if it does occur.
Item #10: Financing
The tenth item in the FDD tells you whether or not the franchisor offers a lending program, or if they have deals with lenders who have agreed to help finance its franchisees. It also fully discloses any financial relationship that the third party lender has with the franchisor. When you finance directly through the franchisor it is no different than borrowing the money from a bank or lender. In essence, if you happen to default on the loan, the franchisor can actually terminate your franchise agreement, which means you will lose your franchise.
Item #11: Franchisor's Assistance, Advertising, Computer Systems, And Training
The eleventh item in the FDD outlines the support that the franchisor is responsible for providing to their franchisees. In essence, it will list the level of assistance including training, advertising, marketing, and computer systems. In addition, this section should include disclosures pertaining to the use of sensitive franchise data that the corporation has access to. Watch out for advertising fees that can be potentially siphoned off for other company uses. The bottom line is that every franchisor should have a vested financial interest in fully supporting its brand, not all of them do so in an equal manner.
Item #12: Territory
The twelfth item in the FDD is based on your franchise territory. Franchisors typically offer a specifically defined territory to each franchisee. In essence, the franchisee has a sole license to operate the brand within the defined territory. Whether or not you need a protected territory depends on the nature of the franchise. Any territorial protection only lasts for the duration of your franchise agreement, meaning the franchisor may actually have the power to change your territory when you renew the contract. Always be aware of retail-based franchises that do not provide any geographical protection.
Items #13 and #14: Trademarks And Patents, Copyrights, And Proprietary Information
The thirteenth and fourteenth items in the FDD are straightforward subjects that list the trademark and copyright registrations, and other proprietary information that the franchisor has secured. If a trademark is not registered it should raise a red flag. For example, it is a fairly simple and easy step that anyone with experience operating a business, let alone a franchise, should be well aware of.
Item # 15: Obligation To Participate In The Actual Operation Of The Franchise Business
The fifteenth item in the FDD is based on the fact that franchisors need to be sure that franchisees are actually devoting the appropriate effort and time that is needed to operate their business. In addition, there are some franchises that require franchise owners to run the business themselves, while others allow franchise owners to hire others to manage day-to-day operations. Other similar requirements are spelled out in this section.
Item #16: Restrictions On What The Franchisee May Sell
The sixteenth item in the FDD typically restricts the products and or services that the franchisee can sell in order to protect the brand. They will be listed in this section. This is actually positive for franchise owners due to the fact that it prevents other franchises from damaging the reputation of the brand.
Item #17: Renewal, Termination, Transfer, And Dispute Resolution
The seventeenth item in the FDD provides you with a summary of the franchise relationship and also describes the terms by which the relationship may be terminated by either party. This can be based on the incapacity or even death of an owner-operator. This section also speaks to the manner in which disputes are to be resolved. Typically speaking, most disputes must be settled in the hometown of the franchisor. It is also worth noting that the franchisees typically do not have an automatic right to renew their Franchise Agreement. In essence, they have the right of first refusal on a new a brand new contract, which could, in fact, contain different terms including a modified territory, or royalties. Always be aware of franchises that can terminate the contract without cause.
Item # 18: Public Figures
The eighteenth item in the FDD relates to public figures. Did you know that less than 1 percent of franchise systems utilize public figures in their advertising? However, if the franchise opportunity that you are considering happens to use a public figure to advertise the brand it must be disclosed in this section. You should use the same due diligence in evaluating the public figure as you would in assessing the executive team.
Item #19: Financial Performance Representations
The nineteenth item in the FDD is an interesting one. Believe it or not, only 30 to 40 percent of franchises provide information regarding how much money their current franchise owners are earning. The other 60 to 70 percent must state that they choose not to make such a claim. The reason they utilize this tactic is simple. From a legal perspective, the franchisor simply cannot make a promise or even set expectations of future earnings unless they are willing to guarantee it. That is exactly why the majority of franchisors opt-out. That being stated, this can be a good thing. For example, it is good not to set your expectations too high. However, it does leave the burden of due diligence on the potential franchise buyer. You should beware that some earnings claims are based on corporate-owned locations. That means they are not paying any royalties, and may very well have different labor, product, and rent than you. Speaking of rent, you should also be aware that earnings based on franchise locations that have been in operation for a long time may have long-term leases which lower the cost of the monthly rent.
Item #20: Outlets And Franchise Information
The twentieth item in the FDD provides information that any potential franchise owner will want to know about the franchise system that they are entering. This includes the number of locations that have been opened, transferred, and closed within the last few years. In essence, it will inform you if the franchise is growing, maintaining, or shrinking. It will also clue you in on the profitability of the organization. Perhaps the most important aspect of this part of the FDD is the list of both current and former franchisees. That means you can perform your due diligence by contacting as many of them as possible in order to receive an independent perspective regarding the well being of the company. It will also clue you in on how quickly you can become profitable. Be aware if there are a large number of recent franchise closures.
Item #21: The Financial Statements
The twenty-first item in the FDD concentrates on the finances of the franchisor. In essence, the financial information contained in this section is not only important; it will provide you with a clear insight into the overall health of the company. Most potential franchise buyers review this section with their accountant due to the importance of fully understanding the figures. You should always remember to read the footnotes. If the franchise is new and or growing at a rapid pace, the franchisor may earn the majority of their revenue from franchise sales, which is acceptable. However, if the franchise is well established the majority of the revenue should derive from royalty payments. In essence, no franchise can sustain continued growth forever due to the fact that the market and territories will near saturation with new stores. In this case, if the franchisor does not earn enough money from ongoing royalties it is doomed to fail. This is certainly an important area to be well aware of when making your franchise purchase decision.
Items #22 and #23: Contracts And Receipts
The last two items in the FDD provide you with copies of the contracts that you are required to sign if you decide to proceed with the franchise purchase. This section also includes the Franchise Discloser Document receipt page, which you must sign when you initially receive the FDD. It is incredibly important for you to both read and understand the contracts. You should also keep copies of all of the documents including the signed FDD receipt page. Once again, it is highly advised that you work with a highly experienced business/franchise broker or attorney that will represent your best interests prior to signing any documents.