How to Review a Franchise Disclosure Document in Less Than 10 Minutes Determine if a franchise brand aligns with your goals by using this guide to quickly review critical sections of a franchise disclosure document in 10 minutes or less.
By Ryan Zink Edited by Carl Stoffers
Key Takeaways
- The profitability and sales section of the FDD provides crucial financial performance indicators from franchised and company-owned locations.
- The initial investment estimation item offers a ballpark figure of the initial investment needed to launch the franchise.
- Potential franchisees must decide if they intend to manage the business themselves or hire someone.
- Understanding and evaluating the fees going directly to the franchisor and what kind of support the franchisor offers in return is essential.
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As the founder and CEO of Franchise Sidekick, I've had the pleasure of partnering with hundreds of entrepreneurs destined for franchise ownership. One of their most common concerns is understanding the Franchise Disclosure Document (FDD).
Legal documents can be overwhelming, but they're crucial during the franchise ownership journey. Don't stress, because by the end of this article, you'll understand how to fly through an FDD in 10 minutes or less.
While I strongly recommend you hire a franchise attorney to review before you sign, you won't need a full-blown attorney review until you're 90% certain you want to move forward with the brand.
Now, let's dive into the important items in an FDD, plus my formula to evaluate a franchise's value:
Item 19: Profitability and top-line sales
This is where the franchisor lays out all the cards, including profits, sales and important performance indicators from franchised and company-owned locations. Understanding these numbers is crucial, so write them down to refer back to later.
P&L statement
Many franchisors include a Profit and Loss (P&L) statement. Take note of any important expenses that have not been included, such as royalties, for example (typically a standard expense).
Think about your desired management style: Are you hiring a manager to run business operations, and does the P&L statement reflect an estimate for their salary?
Related: The 19 Covenants of a Standard Franchise Agreement
If a franchise doesn't have an Item 19, be prepared for extra time during validation, which includes talking to current franchisees regarding their profitability, sales and key expenses.
Your next step is to identify the total locations disclosed, often found in footnotes or headers. Determine how many locations have operated over a year and are included in the numbers. For instance, if only 70 out of 100 locations are disclosed, ask the franchisor and franchisees why 30 are excluded.
Anything less, and you're essentially creating another job, not owning a business.
Item 7: Initial investment
Item 7 offers a ballpark of your initial investment for launching the franchise, ranging from the low to high estimate. One factor that might influence the estimates is retail space. Rent or buildout may vary widely, reflecting cost differences between locations. Also, remember to factor in buildout costs, as contractor fees can greatly affect the investment range.
Next, determine if equipment can be leased or purchased. The leasing option, usually the cheaper route, will require a small down payment and subsequent monthly fees. The high-end estimate will factor in purchasing the equipment.
Then it's time to think through your estimated startup costs, like a future lease, buildout and inventory. Get an estimate together based on these factors and circle back to Item 19. It's time to do some deep thinking about your return and whether you're comfortable with the figures staring back at you. Aim for franchises with an ROI in five years or less and a net profit of at least 15% (after paying your manager's salary). Anything less, and you're essentially creating another job, not owning a business.
Related: The 23 Items Your Franchise Disclosure Document Must Include
Item 15: Business management
In determining a business management plan, you must first grapple with several pivotal questions. Primarily, they must decide whether they intend to oversee the business operations personally or if they're considering bringing a manager on board. Additionally, assessing your own availability — full-time or part-time — plays a crucial role in this decision-making process.
For those contemplating a "manage-the-manager" approach, it is essential to delve deeper. Questions, such as whether the managerial role demands any specific licenses or training, need to be addressed. Additionally, brands might need to consider if they mandate an ownership stake requirement for managers. Before proceeding with a brand, it's vital to ensure the management plan is consistent with the stipulations in Item 15.
Item 6 & 11: Fees and franchisor responsibilities
Remember, fees are not the villain, they're your ally. Fees equate to collective buying power, access to trusted vendors and tapping into the franchisor's wealth of experience. They're a shortcut to your success and help you scale up faster.
Related: A Simple Guide to Understanding Your P&L Statement
Item 20 + Franchisor agreement
Let's dive into the total number of locations and royalty growth. Growth isn't just about new locations. Pay attention to terminations and non-renewals. If the franchisor is ending franchise rights or franchisees are not renewing, that's a red flag. Another interesting point is the number of locations sold but not yet open. You want to ensure the franchisor has the experience, team and resources to support this anticipated growth.
One sneaky section is the franchisor's financial statements, usually found in Exhibit D or E of the franchise agreement. Check out the royalty revenues for the past three years. Royalty growth is a much more reliable indicator of system health than just adding new locations. If the royalty revenues from established locations are growing, meaning business systems are improving, it's a sign of a high-quality franchise.
Use This Formula
Go to Item 6 and jot down the fees that go directly to the franchisor. We're not considering any third-party payments here, so ignore fees to marketing agencies, accountants, insurance providers, etc. Focus on fees paid to the franchisor for support services like royalties, technology fees, brand funds, etc. Skip over flat fees like franchise fees, training and initial store design (we covered those in Item 7).
Write down the average sales from Item 19, and write your total variable percentage below, assuming 12% for this example. Calculate how much that would be in fees by multiplying your sales by your variable percentage, (or $50,000 X 12% in our example), which equates to $6,000 a month in potential franchisor fees.
Next, go to Item 11, and list out all franchisor support offered on your page. Now you have your potential monthly expense and franchisor support side by side. Comparing the two, could you get the same value for less if you were running an independent business? If you think you could get the same support for less, you might want to explore other franchise opportunities.
Sure, it seemed daunting, but you made it. Remember, a well-structured FDD protects both you and the franchisor. Dig in, embrace the process and take a step toward living life on your terms through franchise ownership.
