A very important step in the purchasing of a franchise business is the review of the Franchise Disclosure Document (FDD). However, this can be a very daunting task with FDDs typically covering hundreds of pages.
A FDD is a document that outlines the history of the business, all the franchisees in a franchise’s system, turnover rates, terminations, fees, rules, restrictions, and numerous other things pertaining to that particular franchise. A FDD encompasses 23 Items with additional Exhibits following the Items. Franchisors are required by the Federal Trade Commission (FTC) to present potential franchisees a FDD at least 14 days before a contract is signed.
It is strongly recommended that prospective franchisees go over the FDD with a franchise attorney. Though a franchise attorney will go over the whole FDD with you, it’s a good idea to review the FDD ahead of time for yourself so the issues that you personally need more clarification on are already noted. This article, breaks up the FDD into sections based upon some of the most frequently asked questions by prospective franchisees, and explains not only what the items are, but why they are important to the franchisee.
Before you get too far into the process, you want to verify that you’re doing business with the company you want and within the industry that you desire. This information begins the FDD.
Item 1 gives you an overview of the franchise operation stating the background of the franchisor, including their address and when the company was formed. This section also describes the franchise business being offered, and tells of the franchisor’s history, any predecessor entities and how long the franchisor has offered the franchised business. If applicable, any other companies the franchisor governs or is affiliated with are listed in this section. Some FDDs also disclose industry competition, if the industry is under special regulations, and if any special permits or licenses are needed to conduct business.
The principal executives of the franchise are listed in Item 2 along with a description of what role they play in the managing of the franchise and the more recent highlights of their professional backgrounds.
Item 3 details legal action taken by franchisees against the franchisor and vice versa. Although a large number of lawsuits can be a red flag, especially if the franchise is comparably small in scale of operation, the number of suits listed isn’t of utmost importance. Rather, it is important to mote the nature of the complaint and how it was resolved. Item 4 also deals in legal matters, making note of if the franchisor or any of the principal executives listed in Item 2 has filed for bankruptcy protection. However, in some cases the franchisor will not be required to divulge information pertaining to these two Items.
Your potential future peers make up Item 20, a listing of the number and location of franchisees currently in the franchisor’s system. Names and contact information for these franchisees are also provided to the prospective franchisee, usually as an Exhibit following the Items of the FDD. It is recommended prospective franchisees contact several of these franchise owners and inquire about their experiences with the franchisor to gain a better understanding on if they will fit into the franchisor’s system. Another thing to note from this Item is how many outlets the franchisor already has in your area. You want to avoid investing in a franchise that is edging towards oversaturation in your area.
In addition, Item 18 is reserved for public figures for the franchise (i.e. a celebrity endorsement). In many cases, franchisors will not divulge, or use public figures to “promote” their franchise. Item 18 disclosure isn’t necessary if the public figure is only used to promote franchisees’ products and services. However, disclosure must be made if the public figure is used to sell franchises, or if the public figure has an investment stake in the franchisor.
How much will I make? (Items 19, 21)
The Items addressing the finances of the franchise are often vague. This is commonly the case because making any statement that could be interpreted as a prediction about the future financial performance of franchisees could come back to hurt the franchisor. As a result, this leaves prospective franchisees to do their due diligence in gathering information and inferring what business could potentially look like from a financial standpoint for them personally.
Legally, franchisors are only allowed to discuss financial performance information if it’s already published in the FDD. The Item reserved for financial performance information is Item 19. However, because it is not a required section, franchisors in many instances will not make any statements about a franchisee's potential future financial performance or about the past or current financial performance outlets within the FDD.
Item 21 makes mention of which Exhibit the franchisor has compiled their audited financial statements for the franchisee’s reference. These statements typically cover the most recent three years of business for a franchise. If the franchise is part of a larger entity the financial statements will most likely be representative of all the businesses together, and more research will have to be done into finding the financials for that franchise alone.
How much do I have to invest? (Items 5-7, 10)
Investing in a franchise involves much more than just the initial franchise fee. There are building costs, equipment purchases and many other expenditures that must be covered before the doors of a franchise business can open. Items 5 and 7 lay out the investment necessary to purchase the franchise in paragraph and tabular form respectively. Fees for additional franchises purchased after the first are usually detailed in Item 5, if applicable. In addition, if the franchisor offers different types of franchise models to franchisees, multiple tables will be shown in Item 7.
After the franchise business is operational, there are ongoing fees necessary for the running of the franchise, which are detailed in Item 6. These fees include royalty fees, advertising and marketing contributions, software fees, costs of potential audits, additional training costs if needed, etc. The due dates of these fees will also be disclosed.
Some franchisors offer financial assistance or payment plans to prospective and/or current franchisees. Check Item 10 to see what kind of direct or indirect financing options the franchisor offers, if any.