How to Read a Franchise Disclosure Document
In the process of buying a franchise, one of the most important documents you can expect to receive is called the Franchise Disclosure Document, the FDD. This document will require careful interpretation in order for you to make a good decision about buying the franchise.
The FDD provides 22 important points about the franchisor and the franchise itself that are mandated by the Federal Trade Commission. Because the FDD has been drafted by franchise lawyers, it is written in daunting “legalese” and can be longer than 100 pages.
That’s why we wanted to help and break it down for you.
While it may be tempting to jump directly to the juicy bits over in item 19, 20 or 21, it is important to get a proper understanding of the entire document. Those that are looking to begin a profitable franchise should be well-versed in the history of franchise, its founders, history of litigation as well as the fees and obligations of the franchisees, etc.
To do this right, it helps to know what you are getting into. So, we have compiled the following beginner’s guide to understanding the FDD. Here you will find plenty of information on the nature of each item and some things to look out for in reach one.
Item 1 – The Franchise Company
Here you will find an overview of the franchise narrative from its founding to its current ownership and the types of franchises offered. These are the testing grounds, if everything is clear and easy to understand here, you can move on. If you are confused at this point, you must know it doesn’t get much easier from here.
Item 2 – Business Experience Of Franchise Executives
Here is where you will get an idea of the kind of people you will be working with. Strong teams who have been in operation for a long time are a good sign. You can also research the history of any executives that seem new to the franchise business.
Item 3 – Litigation
Here is where you will be informed of any legal issues or lawsuits that have been filed against the company. Here is a good place to get an idea of the types of problems you will need to watch out for when being a part of this franchise. A franchise with a long history of trademark infringement or claims against the franchisor along with pending class actions could be a warning of impending bankruptcy.
Item 4 – Bankruptcy
If you have properly researched the franchise you are interested in buying, you should know if they are in bankruptcy. But, this section will also let you know if there are officers and directors who may be in bankruptcy or were involved in bankrupt franchises in the past.
Item 5 – Fees to open the Franchise
Items 5, 6 and 7 are especially important. You will find the fees for opening your franchise listed in item 5. You may notice that your fees are listed as a range ($XX,XXX – $XXX,XXX). If so you may be able to ask if you qualify for fees at the lower end of the range.
Item 6 – Chart of Fees
In item 6 you will see an overview of the fees franchisees are required to pay regularly. This might include fees like marketing and royalty fees. You should note that there might be fees that are not listed here and you may want to ask about this.
Item 7 – Fees & Expenses for the First 3 Months of Operations
You will find a handy description of the fees and expenses that will be needed to open your franchise and begin operations here. But these figures may not be exactly on point and you will want to go over these numbers with your accountant to ensure you don’t run into financial issues before you begin raking in the cash.
Item 8 – Restrictions On Sources Of Products And Services
The franchisor needs to know that the products and services you are providing meet the standards the franchise has laid out. This may require purchasing certain products from the franchisor or only using specific suppliers. You can get a better idea of how this actually works in real life by asking other franchise members if they believe the prices and rates are fair.
Item 9 – Franchisee’s obligations
This is an especially important item as it contains the contractual obligations connected to franchise agreement. Here you will find all the obligations carefully laid out and it will be important that you learn and memorize each one.
Item 10 – Financing
Here is where you will find out about any lending programs offered by the franchisor. Your franchisor may also have agreements with certain financial institutions that allow special financial aid for franchisees. You will find out more about the nature of these agreements here as well. Don’t assume that borrowing from the franchisor will be any more beneficial than borrowing from the bank. Be sure to carefully examine and compare the credit terms before you make any deals.
Item 11 – Franchisor’s Assistance
This is where you will find information on the support service your franchisor may have in place for their franchisees. Be sure to understand all information on handling sensitive franchise data and all other disclosures here as well. Be on the lookout for stipulations that include phrases like “as needed”, this dubious qualification won’t count for much in the broad scheme of things. You should note here that not all of the fees collected from franchisees for advertising will be used in advertising.
Item 12 – Territory
Depending on the type of franchise you are owning, you may not want other franchisees too close to your operations. You may find specific limitations to how many franchises can operate in a certain area. But be careful, your franchisor can change territorial protection when they renew your contract.
Items 13 – Trademarks and Patents
A comprehensive list of trademarks and Patents. Make sure all trademarks are registered.
Item – 14 – Copyrights and Proprietary information
Self-explanatory information that will be useful to your specific franchise.
Item 15 – Obligation to Participate in Franchise Business
The franchisor will want to know that his franchisees are spending their resources in participating in business operations. This may mean that the franchisees must be personally active in managing regular operations and others may hire another manager to handle the business in their stead. Be sure you check for any restrictions for the managers you select, they may be required to hold shares of the company.
Item 16 – Restrictions On What The Franchisee May Sell
Read this point carefully. It describes what products and services are allowed to be sold by the franchise and they can be unexpectedly restrictive at times.
Item 17 – Renewal, termination, transfer and dispute resolution
This section describes the relation between the franchisee and franchise and includes references to the franchise agreement. In addition to the terms of termination this section includes points on how disputes will be worked out.
Item 18 – Public figures
This item is only relevant to those franchisees that will be buying into franchise systems that employ public endorsements from famous figures.
Item 19 – Financial Performance Representations
While this is the first item most franchisees will examine when presented with the FDD, only some investors will actually include how much profit their franchise is generating. Many will simply decline making any such claims. There are some things to look out for here. Like the earnings claims from corporate stores which will not face many of the fees and costs that you will experience. Also, those that have been in business for a while may be enjoying cheaper rents and possibly other financial benefit you will not see for a while.
Item 20 – Outlets And Franchise Information
This item will provide an overview of the franchises that were opened, transferred or shut down within the last three years. This can indicate whether the franchise is growing or shrinking in their market. The list of current and former franchises is one of the most important things to look over and it would be smart to call up a few of the franchisees that closed their business and find out what happened.
Item 21 – Financial statements
Item 21 contains a list of all the important financial statements that will let you know if the franchisor has a secure business. You can look over the profit and loss margins to see how the numbers add up, but it might not be so simple. Here is where the input of a qualified accountant will give you an idea of how favorable this company is. A franchisor that makes the majority of their revenue from royalties is a good sign, beware of those that capitalize primarily of franchise sales.
Items 22 and 23 – Contracts and Receipts
Items 22 and 23 include the contracts and receipts that must be signed after carefully reading the FDD in its entirety. You will also want to carefully read the contracts section and keep copies of all the documents you give and receive in this transaction.
Final Notes for Reading the FDD
While it can seem daunting, the FDD is an important document that will help franchisees escape common problems around owning a franchise business. It may be a good idea to set up a Free Consultation and have the document examined by a Certified Franchise Expert (CFE) if you feel you lack the business experience to fully understand the details listed within. This can help give you a clearer idea of what the franchise will actually cost you and what it will require to be profitable in the long run.