Franchise Fundamentals: Taking a deep dive into the Franchise Disclosure Document

Franchise Fundamentals: Taking a deep dive into the Franchise Disclosure Document

Love at first sight may (or may not) be a real thing, but when it comes to investing your money, it’s unwise to fall for a franchise without first subjecting it to tough-minded scrutiny. The third in the FTC’s Franchise Fundamentals blog series walks through an essential part of that evaluation: an in-depth review of the Financial Disclosure Document (FDD) required by the FTC’s Franchise Rule.

You must receive the Franchise Disclosure Document at least 14 days before you’re asked to sign any contract or pay any money to the franchisor or one of its affiliates. In fact, you have the right to the FDD once the franchisor has received your application and agrees to consider it. So speak up if you don’t receive it and ask questions – lots of them – as you review the FDD and any attached documents.

Indeed, the franchisor’s conduct regarding the FDD may raise some red flags about how they do business. Providing the FDD doesn’t establish that a franchisor is reputable – it’s required by law, after all – but if a franchisor doesn’t promptly provide this mandatory document, gives you an incomplete FDD, evades your probing questions, or tries to rush you through the process, it doesn’t speak well of their approach to legal compliance. 

Assuming you have the FDD in hand, let’s consider some of the 23 required items line by line. Here are things to look for as you review the FDD.

Franchisor’s Background (FDD Item 1)

Item 1 provides background information about the franchisor and any parent companies, predecessors, and affiliates, including how long the franchise has been in business. It also lets you know if there are any legal requirements unique to the franchised business, like the need to get a special license or permit. This can help you understand the costs and risks you would be taking on.

Business Background (FDD Item 2)

Remember the old adage “People are known by the company they keep”? Well, companies are known by the people they keep, which is why Item 2 identifies directors, principal officers, and other key executives. Pay attention to their business backgrounds, their experience in managing a franchise system, and how long they’ve been with the franchisor.

Litigation History (FDD Item 3)

Item 3 lists information about prior litigation, including whether the franchisor or any of its executive officers have been convicted of certain crimes or have been found liable – or settled lawsuits – related to the franchise relationship. Lawsuits against the franchisor could mean it hasn’t honored its agreements or that franchisees are dissatisfied with its performance. Item 3 also says whether the franchisor has sued any of its franchisees in the past year. That information could suggest problems in the franchise system. For example, if a franchisor sued franchisees for failing to pay royalties, was it because franchisees weren’t successful and couldn’t make their royalty payments?

Bankruptcy (FDD Item 4)

Have the franchisor, its affiliates, or any of its executives filed for bankruptcy? Item 4 discloses that information and could give you insights into the financial condition of the business. 

Initial and Other Fees (FDD Items 5-7)

Items 5-7 go over some of the costs involved in starting and operating a franchise. That could include things like deposits or franchise fees (some of which may be non-refundable); what you’ll have to pay for initial inventory, signs, equipment, leases, or rentals; and ongoing costs, like royalties and advertising fees. A Consumer’s Guide to Buying a Franchise suggests more than a dozen other areas of financial inquiry, which should give you an indication about the importance of both getting in touch with your inner bean counter and consulting with independent accounting and legal professionals. Consider your living expenses in light of the reality that it takes time to start a business and often much longer just to break even – and some franchisees never break even.

Supplier, Territory and Customer Restrictions (FDD Items 8 and 12)

Item 8 and Item 12 explain restrictions the franchisor may place on your business – for example, what you must buy, where you must buy it, what you can sell, and where and how you can sell it. Does the franchisor limit what goods and services you can offer? Does it restrict where you can buy supplies? Must you buy from particular suppliers designated by the franchisor? Are you allowed to negotiate with those suppliers directly? Ask if goods and services may cost more than if you bought them elsewhere. Ask why. And does the franchisor get a financial benefit by requiring that you use their selected supplier?

Also, a franchisor may limit your business to a specific location or sales territory. If you have an “exclusive” or “protected” territory, it may prevent the franchisor and other franchisees from opening competing outlets or serving customers in your territory, but it may not protect you from all competition by the franchisor. For example, the franchisor may have the right to offer the same goods or services in your sales area through its website, in catalogs, through other retailers, or at competing outlets of a different company-owned franchise.

The FDD also discloses important information about e-commerce – for example, whether you can use the internet to sell goods or services to people within and outside your territory and whether the franchisor or other franchisees may use the internet to sell in your territory. Are you OK with restrictions that may limit your ability to exercise your own business judgment? Are you willing to face competition from the franchisor or other franchisees?

Advertising and Training (FDD Item 11)

Advertising and training can have a significant impact on a franchisee’s bottom line. Franchisors often require franchisees to contribute a portion of sales to advertising funds. In addition to determining how much you’ll have to pay, ask whether franchisees have a say in how those ad dollars are spent. How much goes toward national advertising vs. local or regional? Will your contribution be used to advertise for additional franchisees? What are the administrative costs of the program? In addition, investigate if you can buy your own ads and if you’ll need the franchisor’s consent.

Item 11 also includes information about training. Ask the franchisor about trainers’ qualifications, who pays for training new employees, whether on-site assistance is available and how much it costs, and the amount of time spent on technical training, business management, and marketing.

Talk to recent franchisees to get their take on the quality of the training. (Item 20 has more on the importance of interviewing franchisees.) If you still have questions, ask the franchisor to let you review the training materials. If the franchisor balks – even if you offer to sign a confidentiality agreement – that could signal a concern.

Renewal, Termination, Transfer, and Dispute Resolution (FDD Item 17)

At the very beginning of a business, it’s hard to think too far in advance, but Item 17 reminds prospective franchisees that they need to consider “what if?” contingencies. Find out about the renewal process – what do you have to do to qualify for renewal and will fees or other contract terms change? What if you want to sell your franchise? What are the grounds for termination and does the franchisor impose limits on your future activities? Many contracts include provisions that could stop you from operating a competing business for a number of years. If you have a dispute with the franchisor, can you go to court or must you use arbitration instead?

Financial Performance Representations (FDD Item 19) 

Item 19 contains claims the franchisor chooses to make about sales or earnings. The Franchise Rule doesn’t require a franchisor to provide that information, but most do. But here’s the important thing: Any claims of that nature must be in Item 19. And if the claims aren’t in Item 19, the franchisor – as well as brokers, dealers, or other sellers – can’t make any spoken or written financial performance claims. So if a franchisor or other seller makes financial claims that aren’t included in Item 19, that should set off your baloney detector.

There are two narrow exceptions. We’ll discuss them in the next Franchise Fundamentals post, which will offer tips on how to evaluate potential earnings.

Franchisee and Franchise System Information (FDD Item 20)

Item 20 provides charts showing growth and owner turnover in the franchisor’s system. If any franchised outlets in your area have closed, investigate the reasons. Was it due to problems with the franchisor’s support or because franchises weren’t profitable?

Item 20 also unlocks a key source of highly relevant data: contact information for current and former franchisees. Talking to them may be the most reliable way to get the straight story about the franchisor’s claims. Reach out to as many of them as possible. Some franchisors may give you a separate list of franchisees to contact. To ensure you get the full picture, you may want to contact franchisees in the FDD and some on the separate list.

Relatively new franchisees may be able to give you insights into their total investment, whether they were able to open on time, whether they’re satisfied with the franchisor’s training and advertising, whether they’re OK with the cost and quality of goods or services they have to buy from the franchisor or from mandatory suppliers, and whether they’ve been able to break even. Franchisees who have been in business for five years or more can answer similar questions from a long-term perspective. 

It’s also worth tracking down former franchisees listed in Item 20. Although some may have signed confidentiality agreements, if they’re willing to talk, ask if they had problems with their outlet, if they made a profit, and why they left the franchise system.

Some franchisors may buy back failed outlets and list them for sale. If you’re thinking of buying an outlet in that category, insist on seeing the financials showing the outlet’s actual operating results. If a franchise has had several owners in a short time, maybe the location isn’t a moneymaker or perhaps the franchisor hasn’t lived up to its promises of support. Again, talk to as many former owners as possible to find out what happened.

Item 20 also lists the franchisee associations sponsored by the franchisor. Independent associations may ask to be listed, too. Whether sponsored or independent, associations can offer insights into the kinds of challenges they’ve encountered and the relationship between franchisees and the franchisor

Financial Statements (FDD Item 21)

Item 21 provides the franchisor’s three most recent audited annual financial statements. Even if you’re comfortable reading financial statements, it’s a good idea to hire an accountant to go over them with you. An independent eye can offer a second opinion about whether the franchisor has experienced steady growth and devotes sufficient funds to support its franchise system. Another key piece of information may lie just below the surface: Does the franchisor makes more of its income from royalty payments from successful existing franchisees – or from the sale of franchises to other prospective franchisees?

A new franchise may not have three years of audited annual financial statements. Until they do, the Rule has special requirements for what the franchise needs to provide. But also consider the risks of investing in a company that hasn’t been around long enough to establish a verifiable track record for financial stability.

Contracts (FDD Item 22)

Item 22 requires franchisors to attach a copy of all proposed agreements relating to the franchise offering. These include leases, options, financing agreements, purchase agreements, etc., as well as a critically important document: the Franchise Agreement itself. More about that in the fourth Franchise Fundamentals post, along with a discussion of another key item that merits your careful review: the Operating Manual.

Next in the Franchise Fundamentals series: Evaluating potential earnings, comparing prospective franchises, and consulting professionals before making a final franchise decision

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