If you’re contemplating franchise ownership, understanding the Franchise Disclosure Document (FDD) is an essential step that cannot be taken lightly. The FDD is often perceived as being overwhelming due to its sheer volume alone, with many tallying in excess of 200 pages. Dense passages filled with legal jargon and financial data only serve to make the FDD even more intimidating. Yikes! Nothing sounds worse than reading pages of words that barely make sense.
At Franchise Solutions, we’re here to help you develop a basic understanding of the FDD and assuage any concerns you might have about performing an insightful inspection of its contents. The FDD is a document developed and maintained by the United States Federal Trade Commission and is required to be made available to prospective franchisees before signing any agreements with a franchisor. It produces an accurate, up-to-date, and detailed disclosure of all essential facts related to the franchisor. These include details about start-up investments, operations, and ongoing fees. With so many franchise opportunities from which to choose, prospective owners must learn to carefully compare the details and data shared by the franchise system – despite the fact that the presentation of the information might vary greatly from franchisor to franchisor.
Some critical elements, characterized as “Items” (basically, sections), of an FDD include a sample agreement, information about the franchisor and its history, a list of existing and previous franchisees, financial performance representations, an itemized list of initial investment fees, and a renewed disclosure of any material changes (such as change in corporate ownership) in a timely manner. Armed with this information, prospective franchisees are better-positioned to determine whether a franchise meets their criteria – not only financially, but also in terms of the franchise system’s ethos and culture
Perhaps the most crucial section of the FDD is the Financial Performance Representations, otherwise known as Item 19. This section of the document, also referred to as “Earnings Claims,” helps you answer the critical question: “How much money can I make?”. Exactly what information the franchisor shares can vary greatly. For example, some franchise systems will report gross sales, while others will provide a detailed breakout of an average Profit & Loss statement. Some franchise systems will instead group the highest-performing, lowest-performing and average-performing franchisees together. Believe it or not, some franchise systems – in many cases the most nascent ones – won’t disclose any information whatsoever regarding financial performance. Prospective franchisees are required, by law, to have the opportunity to review, analyze all of the financial information provided in the FDD before making a decision to enter into a franchise agreement.
You shouldn’t rely on the financial performance disclosures alone. Thankfully, a list of existing franchisees in the system is included in Item 20. Contacting several (at least 5-7) of these franchisees, who have firsthand knowledge of owning and operating the franchise, will help you develop a deeper understanding of the financial characteristics and answer other pressing questions (e.g. how much support and training is provided), enabling you to lock in on the best opportunity. These interviews will also help you identify the franchise systems you want to avoid at all costs. This process of interviewing current franchisees is known as “Validation” in the franchising industry.
While reported or obtained (via Validation) information can’t guarantee success or failure, it can give you a strong sense of how profitable your business can be. If there are existing locations in cities of a similar size, population, and demographics to your desired location, focusing on their performance may bring you an even clearer picture of what to expect in terms of financial performance. And understanding the potential financial performance of your location will help you build a more comprehensive and polished business plan, one which will contain your required operating capital, an expected break-even date, and a growth strategy. Not only will a sound plan benefit your business, but it will also increase your odds of receiving the startup funding you need.
In summary, understanding the FDD and its contents is a vital step in ensuring you buy into the right franchise system. The FDD provides information about the franchisor, its history, any start-up costs and fees you’ll incur, and key insights on the financial performance of existing franchisees, so that prospective owners are able to feel informed and confident before signing a franchise agreement. If anything about the document is unclear to you, it’s highly recommended that you find a franchise attorney who can ensure you are investing safely.