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What is the Franchise Disclosure Document

What is the Franchise Disclosure Document

The Franchise Disclosure Document (“FDD”) is a legal document that the franchisor presents to prospective franchisees in the franchise pre-sale process. Every U.S. franchise must register their Franchise Disclosure Document in order to sell the franchise opportunity. It is a very extensive document that discloses detailed information about the franchisor and the franchise. Its purpose is to give the potential franchisee enough information on the organization to plan and decide their investment. The document is divided into 23 categories which are labeled as “Items.” Typically, the most important Items to be analyzed are Items 3, 4, 6, 7, 19, and 20, all of which we will cover in detail. Below is a quick summary about each item:

  • Item 3 discloses any recent litigation the company or any of its executives has been involved in
  • Item 4 discloses any bankruptcies related to the franchisor or of its executives
  • Item 6 discloses all the fees related to the franchise, either one-time or ongoing fees
  • Item 7 discloses the estimated initial investment
  • Item 19 discloses financial performance representations
  • Item 20 discloses a list of franchise outlets

Major Items in the Franchise Disclosure Document

Item 3 – Litigation

When analyzing Item 3 of the Franchise Disclosure Document, the potential franchisee should focus on looking at not only what is disclosed on the document, recent litigation, but also conduct an extensive online research. The online research should include reviewing the management team and franchisor, the brand in general, and it is also important to consider the reviews on websites such as Yelp, Google, Facebook, and articles posted. Having a number of claims against the franchisor may imply that franchisees are dissatisfied or that they are not performing according to its agreements. It is very important to understand whether the litigation items have merit, have already been settled, or have the potential to completely impact the ability to conduct business.

Item 4 – Bankruptcy Disclosures

When analyzing the Franchise Disclosure Document’s Item 4, it is important to read through the claims, if any are disclosed, since this is a way for potential franchisees to evaluate the franchisor’s capability of delivering the support and service it is proposing in addition to serving as a potential indicator of the franchise’s financial stability. Additionally, it will list recent relevant bankruptcies that any of the individuals on the management team might have had in the past. This is important to note as prior bankruptcies could indicate that the executive or executives are having financial trouble.

Item 6 – Other Fee Disclosures

On Item 6, the Franchise Disclosure Document discloses fees associated with the franchise. It includes ongoing royalty and advertisement fees and fees related to transfer and renewal of the franchise agreement. Franchisees are typically required to contribute a percentage of their income to royalties and the advertising fund every month. It also includes fines and fees if the franchisee fails to pay. This item is important as sometimes a franchisor might require a franchisee to pay certain ongoing fees for licenses, technology, support, or other miscellaneous items that could increase the ongoing costs. Knowing up front exactly what fees need to be paid can help a franchisee plan for those costs.

Item 7 – Estimated Initial Investment Breakdown

Item 7 discloses the estimated initial investment amount, basically meaning what a franchisee would have to invest to open that franchise, inclusive of working capital. This item may include only one type of buildout or several types of buildouts. In case of a retail concept it could be an inline or stand-alone buildout and for a food concept it can be a store front or kiosk. Therefore, it can vary from concept to concept. The investment amount is also shown as a range. This means that the investment amount will vary depending on a variety of factors. The factor that tends to affect the franchise investment amount the most is the location of the franchise, not only by state but what also what exact neighborhood or city block it will be located.

Item 19 – Financial Performance Representations

All items mentioned above are required by government laws to be disclosed by the franchisor. Item 19 is not required to be disclosed, however it can be a good way for potential franchisees to become comfortable with the investment and have a better idea of the financials before speaking to franchisees. If this item is disclosed, the law requires the franchisor to have a basis for the information and evidence for the numbers presented. Franchisors typically do not have data of their franchisees’ net profits, for example, so what is normally disclosed are averages related to revenues and gross sales. An important point here is to read the fine print as the franchisor will have many disclosures regarding the data they use.

Note that a franchisor has a big incentive to present the financials in the best possible light, so it is recommended to not just rely on the Item 19 financials but to also speak to at least three current franchisees regarding their financial performance. At the end of the day, the goal is to lower the investment risk as much as possible by having the best possible insights regarding the potential financial performance of a franchise before deciding to invest.

Item 20 – Outlets and Franchisee Information

Item 20 shows information on number of units. It is possible to see how many units they currently have open and a net change over the past three years. There is also a list by state of where they have franchise units open, number of projected openings, and transfers to new franchisees or to the corporate. It is interesting to see how the franchise grew or reduced over the past three years. In particular, when reviewing any franchise, the potential franchisee should focus on not just the number of closures but also the number of transfers that a franchise has had in recent years. Sometimes franchises try to transfer franchises between franchisees in order to avoid having to disclose that franchise units have closed. A high number of closures / transfers relative to the overall total unit count can indicate that the franchise is not doing well. Therefore, it is important to pay close attention to this section in order to have a better idea for how current franchisees are performing.

Included in Franchise Disclosure Document: Franchise Agreement

Towards the end of the document, the Franchise Agreement is also included. This enables potential franchisees to already have access to the document that they will potentially sign with the franchisor. Keep in mind that the FDD must be at least 14 days in the possession of the potential franchisee or investor before they can sign and buy a franchise. This cool down period, a key component of franchise law, helps potential franchise investors make a more educated decision. Also, included in the end of the document, more information on the franchise company can be found. The FDD discloses audited Balance Sheets, Profit & Loss statements and Cash Flow statements. These documents can help the potential franchisee to determine if the franchise has sustainable growth or at least a path to sustained growth and if it has strong enough financials to support franchisees over the long-term.

Importance of Hiring a Franchise Attorney

Vetted Biz recommends all potential franchisees to hire a franchise attorney in order to have the entire document reviewed before signing the franchise agreement. The importance of hiring a franchise attorney is not only to understand all the documents that will be required to be signed, but also to advise you and protect you as a potential franchisee. Franchise attorneys most likely have already written an FDD themselves, so they are very familiar with the wording and what is negotiable or not in the document. Most franchisors say that the FDD is non-negotiable. However, each franchisor is open to different sorts of negotiation, though normally they only accept minor changes. The franchise attorney also knows the sort of changes a franchisor would accept or not.  In other words, it is essential to have an expert by your side to not only comprehend the FDD but to be legally protected before signing the franchise agreement.

Summary

In summary, this due diligence is very important when deciding to invest in a franchise. With the FDD, it is possible to not only learn more about the franchisor but also understand more about requirements, risks, fees, and the level of investment that the potential franchisee will have to commit. It is always recommended during the franchise evaluation process to hire a reputable franchise attorney in order to have the items reviewed by a professional attorney who truly understands the nuances of franchise law. Franchise laws in the U.S. are quite unique so it is essential to have a specialized professional’s guidance before deciding to invest.

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Overview of Vetted Biz

Vetted Biz is the leading platform for individuals thinking of becoming franchisees and business owners in the U.S. Our platform contains accessible and analytical data on franchises and businesses located throughout the U.S. Our goal is to enable potential franchisees to navigate and find more information on franchises and businesses they are interested in in order to save them the time and hassle of speaking to a large number of franchises that might not be the best fit for them.

Our research team behind the platform has analyzed over 1600 franchises and is quite familiar with the key factors that indicate a successful franchise system. Vetted Biz converts complex materials and data into easy-to-understand information that can help individuals that are looking for business opportunities. Our goal is to constantly update the franchises on our website in order to provide individuals looking to speak with franchisors the latest information possible.

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