The 5 Sections to Pay Close Attention to in a Franchise Disclosure Document
As you learned in my last column, How Do You Size up a Potential Franchise, it is important to put in your due diligence when it comes to buying a franchise. A great deal of your time and money is on the line, so you need to know everything there is to know about the franchise you want to purchase.
Contacting other franchise owners before making any big decisions is a necessary step because it allows you to get a feel for the business you may some day join. Now that you've heard what the other franchisees have to say, it's time to dig a little deeper and take a look at the Franchise Disclosure Document, or FDD.
The FDD is not a legally binding document. It is simply a disclosure that every franchisor must provide to all prospective franchisees at least 14 calendar days prior to the signing of a franchise agreement. Its purpose is to protect franchisees by disclosing to them everything they need to know before they make their investment decision.
You, as the prospective franchisee, have the right to request the FDD from the franchisor once the franchisor has received and accepted your application. The FDD may be given to you in print, online or digital format. If you ever want to access an FDD online, use the FDD Exchange to find the FDD from the company you're looking into.
While examining the FDD for the franchise you are interested in, you will notice there are 23 categories the franchisor must disclose. While it is important to carefully read through each category, there are a few that deserve some extra attention. Below are the top five things to look out for as you read through the document:
1. The franchisor, its predecessors and affiliates
It's important to read carefully through item one because it provides a background on the business, outlines the business model and talks about all the affiliated businesses. In addition, item one also discusses the competition and regulations in the industry -- incredibly important information for any potential franchisee to note.
This section discloses any prior or ongoing litigation against the franchisor, which may include convictions of fraud, franchise-law violations, unfair or deceptive practices or other related misconduct. It also discloses any instances in which the franchisor has taken civil action against a franchisee within the past year or vice versa.
If there is a lot of litigation in either direction, this can be a red flag that there are problems in the system. This could indicate that the franchisor has failed to uphold agreements or, on the other end, that the franchisees are unable to make their payments. If you see any of these warning signs, make sure to explore them further as this may mean that this a franchise you should avoid.
3. Initial franchise fee and other fees
Item five provides a disclosure of the fees that must be paid to enter into the franchise. This includes any franchise fees or deposits that must be paid to obtain ownership of the franchise. Item six outlines the fees that will be paid to the franchisor on an ongoing basis, such as royalties and advertising. It is crucial to have a full understanding of what to expect financially before any big decisions are made.
4. Initial investment
Item seven provides information about the cost to open the business and operate it for the first few months, including a chart of estimated expenses. Most businesses do not begin to make a profit until at least a few months after opening. In many cases, it may be a full year before a new franchisee is out of the red. Pay close attention to this section to find out whether you will be able to afford to go into business with this particular franchise.
5. List of franchise outlets
This section gives a list of all the franchisees who are or have been in the system, as well as their contact information. Pay close attention to the numbers as a lot of franchisees leaving the system may be a sign that this is not a good franchise investment.
The franchisees' contact information may be your best resource in determining if this franchise is right for you. Call as many current and past franchisees as possible and ask them questions. If you are finding that many of the franchisees are dissatisfied with their experiences, it might be time to look at other options.
6. Financial performance representation
Most prospective franchisees think Item 19 is the most important part of the FDD and immediately skip to it. I would argue, and many attorneys would agree, that it is far less important than you think. The information in this section is rarely complete. Most Item 19's give you a peek at some of the information, but not enough to allow you to properly understand the earnings potential, norms and averages across the entire franchise system.
If you want to understand the true earnings potential, the best way to do this is to interview existing franchises and build the profits and losses from the top down.
The FDD may seem long and confusing at first, but once you delve in, you will find it is a straightforward document intended to protect you as the franchisee. Pay close attention while reading over the first five sections listed above, but don't neglect to read the other sections as well. If there is anything you are unsure about, be sure to consult a lawyer for help before signing any legal contracts.
This can be an exciting time. Entering into a franchise is a big, and potentially very rewarding, decision. Staying careful, informed and diligent will help keep the process as stress-free and enjoyable as possible.
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