We love the restaurant business. One of the easiest ways to get started in the industry is to buy in to an established franchise. To understand an investment in a potential franchise, the best way to start is to dig in to the franchise disclosure document (FDD).
Table of Contents
What is a Franchise Disclosure Document (FDD)
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The FDD is a legal document that is supplied by the franchisor. It is a very lengthy document that is often hundreds to thousands of pages long. Under an FTC rule, you must receive a copy of this document at least 14 days before you are asked to sign any contracts or pay any money to the franchisor or any of their affiliates.
The items in an FDD have been standardized, so if you pick up an FDD it should look similar to the last one you picked up. This is an attempt from the FTC to make sure you are getting accurate and reasonable information about a potential investment. There are 23 standard numbered “items” to review. It is always important to ask questions if you need more info.
For most people that pick up an FDD for the first time, they usually have two questions:
- How much does the franchise cost?
- How much money can I make with this franchise?
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This information is contained in FDD Items 5-7 (Initial and Ongoing Costs) and FDD Item 19 (Financial Performance Representation)
If you are familiar with the FDD and are ready to jump in to some well known brands, feel free to jump over to our Restaurant FDD reviews that we have available.
Estimated Initial Investment
Sometimes there can be a very wide range for a particular concept. At the low-end, this typically is for owning and building out the inside of the restaurant. At the high-end, often this includes owning the building and land as well. Click in to each restaurant to learn more about the breakdown (from company FDDs).
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- Initial Franchise fee: The fee for “buying in” to the concept
- Building / tenet improvement costs: Getting your restaurant space ready
- Equipment and Signage costs
- Opening Inventory
- Training and other opening expenses
- Insurance and permit fees
- Funds for operating the first few months (while people are finding out about your new franchise)
You will also see other ongoing fees. The most common items include:
- Royalty fees: The percentage of sales that you send back to the franchisor for the right to use their brand
- Marketing/Advertising Fee: Percentage of sales that must be sent on advertising. Sometimes companies will break out what you send to the franchisor or spend on local marketing activities.
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Financial Performance Representations
Probably more important than what a franchise is expected to cost is how much money can be expected as a return on the investment.
tem 19 includes any claims that the franchisor wants to make about sales or potential earnings for which there is a reasonable and factual basis. The franchise rule doesn’t require a franchior to report potential sales or earnings. Many restaurants choose to publish this info, but there can be a lot of variability in what is reported.
If the franchisor decides to include this info, it must be contained in Item 19. Here are some things to think about if you are evaluating sales and earnings data:
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Is the Earnings Claim Typical for a Franchise in this System?
Let’s pretend franchisor claims that franchisees in its system earned $50,000 last year. This claim may be deceptive if it doesn’t represent the typical earnings of franchisees. The FDD should tell you how many franchises the franchisor has, how many it surveyed to get that figure, and the number and percentage of franchisees who reported earnings at the level claimed.
If a franchisor claims that its franchisees earn an average income of $75,000 a year, that tells you very little about how individual franchises performed. Using an average figure may make a franchise system look more successful than it really is, because the high incomes of just a few very successful franchises can inflate the average for all franchisees.
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Some franchisors provide figures for their franchisees’ gross sales. These figures don’t really tell about the franchisees’ actual costs or profits. An outlet with high gross sales on paper might be losing money because of high overhead, rent and other expenses.
Franchisors often don’t have data about their franchisees’ net profits. If you get profit information, ask if it’s based on information from company-owned outlets. Company-owned outlets often have lower costs because they can buy equipment, inventory and other items in larger quantities at lower prices or may own, rather than lease, their property.
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Earnings may vary with geography. If a franchisor provides franchisee sales or income figures, ask if any of the supporting data came from franchisees in your area. The FDD should state whether there are geographic differences between the franchisees whose earnings are reported and your likely location.
Keep in mind that franchisees have different skill sets and educational backgrounds. The success of some franchisees doesn’t guarantee success for all.
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Reliance on Earnings Claims
Franchisors may ask you to sign a statement — sometimes presented as a written interview or questionnaire — that asks whether you received any earnings or financial performance representations during the course of buying a franchise. If they told or gave you any information about how much your franchise may earn, report it fully on the questionnaire or other statement. If you don’t, you may be waiving any right to contest the earnings representations that were made to you and that you used to make your decision to buy.
We will now cover some of the less covered topics of an FDD. Even though they are covered less, there is still some important information contained in the FDD
Background and Legal History
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Items in the franchisor background may answer some questions like:
- How long has the franchise been in operations?
- Who is the likely competition?
- Are there any legal requirements unique to the franchise like a required permit or license
Item 2 identifies the executives in the business and their business backgrounds. You can pay attention to things like how long they have been involved in the franchise business as well as their experience with this particular franchise.
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Litigation history can introduce some interesting but also important information. First, it will list information about prior litigation such as:
- Has the franchisor or any of its executive officers been convicted of felonies? Pay attention to if these included things like: fraud, violations of franchise law, or other deceptive behavior.
- Has the franchisor or its executives been held liable (or settled civil actions) regarding a franchise relationship?
These items could show that there is some unrest in past relationships with franchisees.
Item 3 should also say whether or not the franchior has sued any franchisees in the last year. This type of disclosure could help shed light on common problems within the franchise system. In example, this could show that a franchisor has sued a franchisee for failing to pay royalties. This could be a clue that some franchisee health may not be in great shape.
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Item 4 discloses recent bankruptcy of either the franchisor or their predecessor or any executives or affiliates. If you find anything here, you will also want to look into Item 21 (Franchisor financial statements) to see if there are any ongoing expenses associated with prior issues. You may even want to bring an accountant in on this one to help you evaluate the situation.
Supplier, Territory and Customer Restrictions
The franchisor can put limits on things like here you sell your products or where you buy inventory. Sometimes the franchisor has controlled these things for quality reasons or to get bulk discounts. It is also possible that the franchisor makes additional profits from selling you products.
A good list of things that the franchsor may limit include:
- suppliers from whom you purchase goods
- the goods or services you may offer for sale
- where an to whom you can sell goods and services
- your use to use the internet to sell goods or services inside and outside of your territory
- the rights of the franchisor to sell goods or services using the internet to customers inside your territory
If the franchisor doesn’t limit where franchisees are able to sell, franchisees could potentially compete with each other for the same customers.
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Franchisor’s Advertising and Training
Many franchisees are required to contribute a certain percentage of their sales to advertising. This may be national, regional or local. Often times there are requirements at multiple levels for advertising funding.
It is good to dig in to find what percentage of the advertising is spent on various items. You can also reach out to other franchisees to get more info:
- administrative costs
- national advertising
- advertising in your area
- selling more franchises
- other expenses
You can also dig in to see if you are allowed to develop and buy your own advertising and whether you can get a credit for these ad buys.
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Part of buying in to an established restaurant concept is to not have to come up with your own policies and procedures for conducting business. Therefore, as a new franchisee, look for the training to get you started and on the path to a successful venture. Examples of what to expect or look for in item 11 include some of the following:
- Who are the trainers, and what are their qualifications?
- What is the cost of the training new employees and who pays for the training
- Who is eligible for training?
- What is the length of training sessions?
- What amount of time is spent on technical training vs. general business training?
- Is there ongoing training, and what is the cost?
- Will franchisor staff be available for troubleshooting?
- What is the cost of additional on site training, and who bears the cost?
Renewal, Termination, Transfer and Dispute Resolution
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Let’s suppose that your initial term of your franchise is a success! In that case, you will want to understand the process for franchise renewal. You will want to understand things like:
- What you have to do to qualify to renew?
- Are there fees or terms to contract renewal?
If you choose not to renew, there may also be some information for you in item 17 like:
- Are there restrictions preventing you from competing with the franchisor after termination?
- Do you need franchisor approval if you want to sell your franchise?
Franchisee and Franchise System Information
This is where you can get information on other franchisee operations. You can tell if there has been franchisee turnover or the growth in new outlets. You should also see a list of franchisee contacts. It can be useful to contact franchisees, especially those that have opened new outlets within the last year. You may want to ask them things like:
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- What was their initial investment and if there was anything unique to their location?
- Is there good franchisor support for opening?
- Did the outlet open on schedule and within the budget?
- Is the advertising program satisfactory?
It may also be helpful to track down former franchisees. They may be able to answer questions like:
- Did their outlets experience problems, and what were those problems?
- What did their profitability look like?
- How long were they a franchisee?
- Why did they leave the franchise business?
You may also find information on franchisee associations. With the associations, you may be able to track down useful information like:
- What types of problems do they discuss?
- Are there any current problems that the association has with the franchisor?
- Does the franchisor engage with the association frequently?
- Is there a good relationship between the franchisor and the association?
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Item 21 includes the most recent three years of audited financial statements for the franchisor. Financial acumen will help you read this section. You may want to get the aid of an accountant to help understand the financial statements. Understanding acquired from the financial statements may include:
- If the franchisor devotes sufficient funds to support a healthy franchise
- The growth of the franchise
- Where the majority of the franchise income comes from: selling new franchises or royalty payments?
We hope that this overview helps you understand a financial disclosure document in case you ever get your hands on one.
Like any investment, investing in a franchise comes with risk. If you are serious about investing in a franchise, you should not use this as legal or financial advice, but you should seek out qualified legal and financial advice.