Buying a franchise is an appealing first step toward financial success for many entrepreneurs. That result is not guaranteed, however; too many franchisees have found themselves unhappy or bankrupt because they didn’t fully understand the situation in which they invested.
If you want to avoid that fate – and we’re sure you do – one of the key steps will be to obtain and analyze the Franchise Disclosure Document (FDD) for any franchise you are considering. The FDD contains essential information about prospective franchisors, their franchise offerings, and a long list of details that can determine the ultimate success of your franchise.
This blog will help you appreciate the full value of an FDD and will direct your attention to specific items that are critical to making a sound investment decision.
FAMILIARIZE YOURSELF WITH THE FORMAT
The FTC requires that an FDD is provided to a potential franchisee but also mandates a standard format. Every FDD must cover 23 different sections covering a wide variety of important information. This is information the government deemed critical for new franchisees, presumably based on long experience with deficient or fraudulent franchise offerings. We won’t cover all 23 here, but you should familiarize yourself with the entire list before you sit down for an FDD.
READ THE ENTIRE DOCUMENT
At the outset, your inclination may be to focus on your potential return on investment, but every aspect of the FDD is essential. You’ll want to read through the entire document first to ensure you don’t miss anything and see if any red flags pop up in areas you haven’t considered. Once you’ve read it cover-to-cover, you can start zooming in on some key things.
ANALYZE THE FINANCIAL PERFORMANCE REPRESENTATIONS (FPRs)
Franchisors are not required to detail individual franchise units’ past, present, and potential future financial outcomes. Still, since it is possible the information new franchisees are most interested in, they are likely to do so, and the designated section for that information is item 19 of the FDD. The data provided will vary from franchise to franchise, but it may include things like average sales per unit, operating expenses for existing units, break-even analysis, and average time to reach profitability.
As always, past performance is no guarantee of future results, but with this data in hand, you will be better equipped to decide if the numbers make sense in your situation. Keep in mind that franchisors will usually seek to present their results in the best light, so you should always consider hiring an attorney or franchise consultant to help determine the reliability of any data and any projections based on it.
FOCUS ON THE FEES
Fees are a key part of how franchisors make their money; sometimes, the list is quite long. There are usually “initial” fees, including a one-time franchise fee, training fees, legal fees, and equipment fees. And there are typically “ongoing” fees as well, like royalty fees, advertising fees, insurance fees, and ongoing training fees.
You will almost certainly encounter both types of fees, and you will want to ensure that you can pay those fees while still growing your franchise and maintaining an acceptable profit margin.
UNDERSTAND YOUR RESTRICTIONS AND OBLIGATIONS
Buying into a franchise program often means that there are limits on your freedom to make certain decisions about your own business. Common restrictions include a designated territory limitation, restrictions on what products and services you can sell, and from whom you can buy the products that you ultimately sell. Common obligations may include advertising participation requirements, insurance requirements, and specific outside and indoor appearance rules to keep franchise units “standardized.”
You will want to consider those limitations carefully and whether you can live with them, both in terms of making a profit and satisfying your entrepreneurial spirit.
BE AWARE OF ANY LITIGATION OR BANKRUPTCY ISSUES
The FTC requires franchisors to disclose any past or current lawsuits or bankruptcies involving the franchisor or franchise system. It is not uncommon to find franchisors that have been sued by franchisees, suppliers, customers, or the government. It is likewise not uncommon for the franchisor to have sued franchisees, competitors, or other parties. There can also be patent or similar disputes that can ultimately affect individual franchisees.
It is up to you to assess the importance of those issues and whether they might impact your individual franchise and investment.
WHAT KIND OF SUPPORT AND TRAINING WILL YOU RECEIVE?
One key factor that often attracts new franchisees is the promise of training and support at the outset of their new business venture versus trying to start a new business from scratch. The FTC requires disclosure of these “benefits” in the FDD, and you will want to get the complete picture of what to expect if you make an investment. Will you get comprehensive initial training or just the basics? What about technical support, marketing support, or operations support? You will find this information in the FDD and want to assess it carefully.
WHO CAN TERMINATE THE RELATIONSHIP, AND WHEN?
If you do decide to invest in a franchise, the final agreement may detail the termination rights of both yourself and the franchisor. In some cases, “cause” will be required by one or both parties to terminate the relationship, while in other cases, termination is allowed without cause, usually with a defined period of notice.
If you decide to invest with a franchisor, you’ll want to be sure you understand who can choose to leave who and when.
CONCLUSION
Buying into a successful or growing franchise is exciting for many entrepreneurs, and the FTC-mandated financial disclosure document is the first definitive step to knowing if a specific opportunity is right. So be sure to give it a careful read in its entirety, and then focus on the key sections listed above to determine if a particular franchise is the best choice for you.