Franchise Basics: A Deep Dive into Franchise Disclosure Documents

Love at first sight may (or may not) be real, but when it comes to investing, it’s unwise to fall in love with a franchise without rigorous scrutiny. The FTC’s third Franchise Basics This blog series covers an important part of that evaluation: an in-depth review of the Financial Disclosure Documents (FDDs) required by the Federal Trade Commission’s Franchise Rules.

You must receive the Franchise Disclosure Document at least 14 days before you are asked to sign any contract or make any payment to the franchisor or one of its affiliates. In fact, you are entitled to an FDD once the franchisor receives your application and agrees to consider it. So if you don’t receive one, please ask questions (lots of questions) when reviewing the FDD and any attached documents.

In fact, a franchisor’s behavior with respect to FDD may raise some red flags in the way it conducts business. Providing an FDD does not prove that the franchisor is in good standing—it is required by law, after all—but if the franchisor fails to provide this mandatory document in a timely manner, provides you with an incomplete FDD, evades your probing questions, or attempts to rush You’re in the whole process, which doesn’t say a lot about their approach to complying with the law.

Assuming you have the FDD handy, let’s consider some of the 23 required items line by line. Here are some things to note when checking FDD.

Franchisor’s Background (FDD Item 1)

Item 1 provides background information about the franchisor and any parent, predecessor and affiliated companies, including how long the franchise has been in operation. It can also let you know if your franchise business has any unique legal requirements, such as needing to obtain special licenses or permits. This can help you understand the costs and risks you will be taking on.

Business Background (FDD Item 2)

Remember the old adage “You are known by the people you are by”? Well, companies are known for the people they retain, which is why Article 2 lists directors, principal officers and other key management personnel. Pay attention to their business background, experience managing a franchise system and how long they have worked with the franchisor.

Litigation History (FDD Item 3)

Item 3 lists information regarding prior litigation, including whether the franchisor or any of its executive officers have been convicted or held liable for certain crimes related to the franchise relationship or have had litigation resolved. A lawsuit against a franchisor may mean that the franchisor is not living up to its agreement, or that the franchisee is dissatisfied with its performance. Item 3 also states whether the franchisor has sued any of its franchisees in the past year. These messages may indicate problems with the franchise system. For example, if a franchisor sues a franchisee for nonpayment of royalties, is it because the franchisee was unsuccessful and unable to pay the royalties?

Bankruptcy (Article 4 FDD)

Has the franchisor, its affiliates or any of its officers filed for bankruptcy? Item 4 discloses this information and can provide insight into the financial health of the business.

initial and other expenses (FDD Project 5-7)

Items 5-7 discuss some of the costs involved in starting and operating a franchise. This may include fees such as a deposit or franchise fee (some of which may be non-refundable); fees you need to pay for initial inventory, signage, equipment, leases or rentals; and ongoing costs such as royalties and advertising. The Consumer’s Guide to Buying a Franchise suggests a dozen other areas of financial advice, which should give you an idea of ​​the importance of connecting with your inner actuarial and consulting independent accounting and legal professionals. Consider your living expenses because starting a business takes time and often takes longer to break even, and some franchises never break even.

Supplier, Territory and Customer Restrictions (FDD Articles 8 and 12)

Clauses 8 and 12 explain the restrictions the franchisor may impose on your business – for example, what you must buy, where you must buy, what you can sell, and where and how you can sell. Does the franchisor limit the goods and services you can provide? Does it limit where you can buy supplies? Do you have to buy from a specific supplier designated by the franchisor? Can you negotiate directly with these suppliers? Ask if goods and services might be more expensive than if purchased elsewhere. Ask why. Does the franchisor gain a financial benefit by requiring you to use a supplier of their choice?

Additionally, the franchisor may limit your business to specific locations or sales territories. If you own an “exclusive” or “protected” territory, it may prevent franchisors and other franchisees from opening competing stores or serving customers in your territory, but it may not protect you from the franchisor’s All competition. For example, the franchisor may have the right to offer the same goods or services in your sales territory through its website, catalog, other retailers, or competing stores owned by franchises owned by different companies.

The FDD also discloses important information about e-commerce, such as whether you can use the Internet to sell goods or services to people inside or outside your area, and whether the franchisor or other franchisees can use the Internet to sell in your area. Do you agree to restrictions that may limit your ability to use your business judgment? Are you willing to face competition from franchisors or other franchisees?

Advertising and training (FDD Article 11)

Advertising and training can have a significant impact on a franchisee’s bottom line. Franchisors often require franchisees to contribute a portion of their sales to an advertising fund. In addition to determining how much you’ll have to pay, ask the franchisee if they have a say in how those advertising dollars are spent. How much does national advertising cost compared to local or regional advertising? Will your donation be used to advertise other franchisees? What are the administrative fees for the program? Additionally, investigate whether you can purchase your own advertising and whether the franchisor’s consent is required.

Item 11 also includes information on training. Ask the franchisor about the qualifications of the trainers, who pays to train new employees, whether on-site assistance is provided and how much it costs, and how much time is spent on technical training, business management and marketing.

Talk to recent franchisees to find out what they think of the quality of training. (Item 20 details the importance of interviewing the franchisee.) If you still have questions, ask the franchisee to let you review the training materials. If the franchisor is hesitant—even if you offer to sign a nondisclosure agreement—that may be a sign of concern.

Renewal, Termination, Transfer and Dispute Resolution (FDD Article 17)

In the early days of a business, it’s difficult to think too much ahead, but No. 17 reminds potential franchisees that they need to think about the “what if?” contingencies. Understand the renewal process – What do you need to do to qualify for renewal, and will fees or other contract terms change? What if you want to sell your franchise? What is the reason for termination? Does the franchisor impose restrictions on your future activities? Many contracts contain provisions that may prevent you from operating a competing business for several years. If you have a dispute with your franchisor, can you go to court or must you use arbitration?

Financial Performance Statement (FDD Item 19)

Item 19 contains statements regarding sales or earnings that the franchisor elects to make. Franchise rules do not require franchisors to provide this information, but most franchisors do. But importantly: any claim of this nature must be covered by Article 19. If the claim is not covered by Article 19, the franchisor and the broker, dealer or other seller cannot make any oral or written claim for financial performance statements. Therefore, if the franchisor or other seller makes a financial claim that is not included in item 19, your BS detector will be triggered.

There are two very small exceptions.watte‘two discuss them inside Next Franchise Basics posts, which will provide Tips on how to evaluate potential income.

Franchisee and Franchise System Information (FDD Item 20)

Item 20 provides a graph showing growth and owner turnover rates in the franchisor system. If any franchises in your area have closed, investigate why. Is it because there is a problem with franchisor support or because the franchise is not profitable?

Article 20 also unlocks a key source of highly relevant data: current and former franchisee contact information. Talking to them is probably the surest way to find out what’s going on with your franchisor’s claim. Reach out to as many of them as possible. Some franchisees may provide you with a separate list of franchisees to contact. To make sure you get the full picture, you may want to contact the franchisees in the FDD as well as some of the franchisees on the separate list.

Relatively new franchisees may be able to give you insight into their total investment, whether they were able to open on time, whether they were satisfied with the franchisor’s training and advertising, whether they were satisfied with the cost and quality of the goods or services they had to obtain from the franchise people or forced suppliers to buy products from, and whether they are able to break even. Franchisees who have been in business for more than five years can answer similar questions from a long-term perspective.

It’s also worth tracking down the former franchisees listed in item 20. While some may have signed non-disclosure agreements, if they are willing to talk, ask if their locations are having problems, if they are profitable and why they are leaving the franchise system.

Some franchisees may buy back failed locations and put them up for sale. If you’re considering purchasing a store in this category, insist on looking at financial data that shows the store’s actual operating performance. If a franchise has had multiple owners in a short period of time, the location may not be a profitable place, or the franchisee may not be living up to its support commitments. Again, talk to as many former owners as possible to find out what happened.

Item 20 also lists the franchisor associations sponsored by the franchisor. Independent associations may also request inclusion on the list.Whether a sponsoring association or an independent association, associations can gain insight into the various challenges they encounter and the relationship between franchisees and franchisors

Financial Statements (FDD Item 21)

Item 21 provides the franchisor’s three most recent audited annual financial statements. Even if you can easily read your financial statements, it’s a good idea to hire an accountant to review them with you. An independent set of eyes can provide a second opinion on whether the franchisor is growing steadily and investing enough capital to support its franchise system. Another key message may be hiding just beneath the surface: Does the franchisor’s income come more from royalties from successful existing franchisees or from selling franchises to other potential franchisees?

New franchises may not have three years of audited annual financial statements. UUntil they do, rightule has special requirements for franchise needss supply.but also consider Investment Risks a company It has not been around long enough to establish a verifiable record of financial stability.

Contract (FDD Item 22)

Item 22 requires the franchisor to attach copies of all proposed agreements relating to the franchised product. These include leases, options, financing agreements, purchase agreements, etc., as well as that all-important document: the franchise agreement itself.More on Part 4 Franchise Basics post, and a discussion of another key item that deserves your careful review: the operations manual.

Other posts in Franchise Basics series: