Until the late 70s, franchising was the “Wild West” of business investing. In the late 70’s things changed when the FTC started requiring that all franchise companies (or franchisors) in the U.S. disclose certain information to their franchisee candidates in a state-registered document. This document, now known as the Franchise Disclosure Document (FDD) must contain 23 standard items, plus the franchise agreement, which is what the candidate will eventually sign if both sides are in agreement.
An FDD can be a huge, sometimes overwhelming document, but one that contains necessary and valuable information. While you should carefully review every item in the FDD, there are certain items that you should pay close attention to.
If you are still researching franchise opportunities, you might be wondering how you get your hands on a company’s FDD. There are a couple ways in which you can access an FDD:
- During the Disclosure Process. An FDD is usually received from the franchisor in the disclosure process, which is when the candidate is collecting information directly from the franchisor about the franchise opportunity. The franchisor generally makes the candidate sign a receipt (these days, this is done electronically) to prove that the FDD was provided.
- From an Online Resource. There are a number of online resources, some free, that also provide FDDs, which are technically public documents. Other websites offer FDDs for sale. We do not recommend buying an FDD, as this is something that the franchisor will provide for free.
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How to Read the Franchise Disclosure Document
The content within an FDD varies from company to company, but the structure is always consistent. The 23 Items of the FDD can be categorized into 5 main groups:
1. The “Who” Group (Items 1-4). This group consists of information about the identity of the franchisor, its parent companies, its predecessors, and its affiliates.
2. The “How Much” Group (Items 5-9). This group includes the fees involved in starting and operating the business (franchise fee, royalty fees, advertising fees, technology fees, etc.) and a low end and high end total initial investment range.
3. The “What” Group (Items 10-18). The items in this group discuss what you receive as a franchise owner.
4. The “How it Works” Group (Items 19-21). Here we find information about the company’s financial opportunity and health.
5. The “Help” Group (Items 22-23). These are items where you’ll want the help of an attorney to understand details before you make a final decision.
Items to Pay Close Attention to in the Franchise Disclosure Document
ITEM 1: THE FRANCHISOR, AND ANY PARENTS, PREDECESSORS AND AFFILIATES
In this item, be sure to look at any acronyms associated with the company name in the introductory section. Labels such as LLC, S corp, or C corp will denote the way the business is registered. Other information contained in this section includes:
- the company’s home state
- the year it opened for business
- the year it started franchising
- the current number of franchise units
- any affiliated brands
- the number of corporate-owned/operated units
You will also find any other line of business the franchisor has franchised in or pursued. It’s generally a good sign when there are no other pursuits listed, as it indicates a dedication to the current brand you are investigating. You will also find a history of acquisitions, with a summary of the circumstances of each. Often, the founder of the company will grow the brand and then sell.
Item 1 of the FDD will also include:
- An explanation of area development arrangements (franchisees permitted to recruit additional franchisees in a given territory)
- A description of the business, its products, and its customers
- Status of the market and the company’s competition (this generally includes a disclaimer stating that a franchisee’s success cannot be guaranteed)
- Any pertinent industry regulations, such as liquor laws and food safety for franchises in the food service sector
ITEM 3: LITIGATION
In item 3 of the FDD, you will find any legal disputes the company is or has recently been involved with. While no cases listed is always a good sign, it is not abnormal for larger companies to have a number of recent cases. It should not automatically be a red flag. Rather, understand the reasons behind them and who is involved.
One thing that can be concerning is if the franchisor has filed a number of claims against its franchisees.
Here’s what you need to know about hiring a franchise lawyer.
ITEM 5: INITIAL FEES
Item 5 of the FDD, is typically just about the franchise fee, a one-time fee that is paid at signing of the franchise agreement. The franchisor may include payment terms and details here, such as any required deposit and whether they allow the fee to be financed. You may also find details about fees for buying additional units. Many companies offer discounts for each new unit you open.
Details on area development rights and special programs (such as discounts for military veterans, women, or ethnic minorities) may be included here, as well as any referral programs they offer, which would entail existing franchisees receiving a small commission for any new franchisees they refer to the franchisor.
ITEM 6: OTHER FEES
Any fees beyond the franchise fee that are part of the franchise agreement are included in this Item. This may include royalties, advertising fees, technology fees, and several others. Each fee listed will include descriptions, amount/calculation, when and how often it’s due, and any additional comments. Many franchisors will enforce “minimum performance standard” for royalty fees, which identifies a minimum amount you will pay each month.
Some other possible fees are:
- Renewal fee – paid upon renewal of term.
- Late fees – charged when a royalty or other payment is missed.
- Approved supplier fee – used to offset the franchisor’s cost in finding and adding new suppliers
- Tuition/training fee – used to offset the cost of initial or ongoing training
- Consultation fee – for visits/consultation of franchisor staff at the franchisee’s physical location
- Transfer fee – charged when a franchisee wishes to sell the franchise unit to another party; may be a flat fee or a percentage of the franchise fee
Always ask for clarification of any fees that seem unclear or unjustified. Consult with the franchisor, franchisees, and your franchise attorney about the structure of these fees and where the money goes.
You may see the terms “may collect” or “right to collect” in relation to some fees. This means that the franchisor may opt to not charge the fee for a period of time, but can introduce it when necessary or applicable.
Item 20 – Outlets and Franchise Information
Item 20 of the FDD, is often overlooked by potential franchise buyers but provides a lot of clues as to how well the franchise company is doing. This section provides data on the number of outlets (also referred to as units, locations, or territories) in operation at the start and end of a given year. It will distinguish between franchise units and corporate-owned units. Typically, Item 20 will show data from each of the previous three years. As with other data, you’re looking for sustained growth as a sign of a healthy system. That said, it is important to remember that some closures and turnover, especially in large systems, is natural.
There are five tables in item 20:
- Net Change in Outlets over 3 Year Period
- Transfers
- Status
- Status of Company-Owned Outlets
- Projected Openings
The tables provided in Item 20 will break out data by state. You might want to notice if data from your state is dramatically different than others, but for most situations, simply looking at the totals at the end of the table should be more helpful.
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Item 21 – Financial Statements
Most franchise companies will provide two or three years’ worth of financial statements. These statements include:
- A Balance Sheet
- An Income Statement
- A Profit & Loss Statement
They will be referred to in Item 21 and included as attachments or “exhibits.” These financial statements are important to show to your accountant to ensure the company is strong and can provide a good franchise opportunity.
An important note here is that many franchise companies are owned by a larger parent company, who may have other brands and businesses besides the one you’re interested in. In this case, the financial statements will reflect the parent company as a whole. This is still very useful information, but not specific to the single franchise brand.
When reviewing the three statements be sure to note the following:
- On the Balance Sheet, you should be mainly interested in positive equity trends.
- On the Income Statement, observe the main sources of the company’s revenue. A strong franchise system will be making most of its revenue from franchise royalties, as opposed to investors or new franchise sales. Younger companies will obviously need some time before they reach that point. There are some such companies that offer good franchise opportunities, but be aware that the risk may be somewhat higher.
- Also look for the reinvestment of revenue into the franchise system and programs to support franchisees. This indicates that the company is focused on strengthening the brand and franchise opportunity for its franchisees.
The Full Franchise Disclosure Document
As you research franchise opportunities, the FDD can help shed light on the franchises you are interested in. But when you are serious about a brand, it is critical that you review the entire Franchise Disclosure Document with a fine-toothed comb and consider working with an experienced franchise lawyer.
