When considering the purchase of a franchise business, the Franchise Disclosure Document (FDD) is one of the key documents you should review before making a decision. FDDs contain essential information about the franchise business that will give clues about whether it is a good (or bad) investment. But you need to know what to look for and how to interpret the information you find. Let’s take a look at how to read a Franchise Disclosure Document.
A Franchise Disclosure Document is broken into 23 sections with information that will give you insights into the most important aspects of the investment worthiness of a franchise. In this guide, we will cover the most important information and where you will find it in the FDD.
If you want to know the future of a franchise, you must look at the history and ownership. Sections 1 (franchisor and any parents, predecessors, and affiliates) and Section 2 (business experience) will let you know how many times a franchise has been sold, who really owns it, and the business experience of key people. This is especially important if you’re buying a franchise that is new or that has had a turbulent history. These first two sections of the FDD will allow you to dig deeper and see the details behind the business’ past and present.
Before purchasing a franchise you need to make sure that there is a track record of franchise outlets opening, staying open, and thriving in the system. You will need to look at the number of outlets and their financial health. Go to Section 20 (outlets and franchisee information) where you will find how many outlets opened and closed over the past three years as well as how many were terminated or didn’t renew their contracts. Obviously, if you notice that the majority of outlets fail to renew their lease after a year or two, it’s a red flag that the system may not work for the majority of people.
Litigation and Bankruptcy
While it is true that even the best and healthiest franchises will eventually have litigation issues, too much litigation especially for a small system is usually a red flag. All franchisors are required to disclose on their FDD any litigation that happened in the past five years. You can find that information in Section 3 (litigation). Of course, you should always get the story behind the numbers as there are situations where litigation is just a natural part of a franchise’s recovery from hard times. Once you have the litigation story sorted, you should go directly to Section 4 (bankruptcy) to find out if a franchise or one of its key owners has needed to restructure their debts. If the bankruptcy is more than 10 years old, it’s probably nothing to worry about. But if President of the franchise has filed personal bankruptcy in the past few years, it is probably worth having a discussion about why. Even if the business is financially healthy, the personal financial problems of key people in the business could bleed over if not managed correctly.
In Section 21 (financial statements) of the FDD, you will find the franchisor’s financial statements. Healthy franchises will make a good percentage of their income from ongoing royalties and a smaller percentage from the sale of new franchises. The exception to this rule is when a franchise is fairly young. Any established franchise that makes the bulk of their money from selling new franchises not royalties is probably not in a healthy financial state. And while you’re reviewing the franchisor’s financial health, take a look at Section 19 where you should find financial performance representations that will give you a good idea of what you can expect in terms of sales and profits if you decide to buy a franchise. Be forewarned that Section 19 is not required by law but if you buy a franchise without this information you are going in at least partially blind about past sales and profit performance.
Estimated Initial Investment
In Section 7 of the FDD you will find information on the estimated costs you will need to take on to become a franchisee. This estimate will not include the initial franchise fee but will include other costs such as equipment, real estate, signage and marketing. This is really important because it will help you determine if you have enough capital to invest or if you will need to raise additional capital to move forward.
Fees and Expenses
Royalties paid to the franchisor will be one of the biggest ongoing expenses you will have as a franchisee. This is why Section 6 of the FDD is critical so review this section carefully. How much are the royalties and other fees and expenses? And how close are these fees and expenses to the industry standard? How much profit will you take home AFER you’ve paid the franchisor their due? These are critical questions to answer carefully and honestly as this will help determine just how profitable your business is after all expenses are paid.
Restrictions On Products and Services
In Section 8 of the FDD, you will find any kind of operating standards and restrictions you will be required to follow. Read this section carefully because there may be restrictions on what vendors you can do business with or other controls that impact how you do business in unexpected ways.
Renewals, Termination, and Disputes
Section 17 of you FDD will let you know under what circumstances a franchisor can terminate your contract and how disputes are resolved. Does the franchisor require arbitration? What is process for appealing a decision? Just how fair are the dispute resolution terms? How a franchisor handles problems with a franchisee is a good sign of whether or not they will play fair with you overall so take a good look at this section.