Top10 FDD Items to Review Before Buying a Franchise
When investigating franchise opportunities, it is important to do your due diligence before signing on the dotted line. It is essential to do your research before making a smart business purchase. The most essential item to review during your due diligence is the Franchise Disclosure Document (FDD).
In 1978, the Federal Trade Commission (FTC) created consumer protection guidelines that required a franchisor to share information with a potential franchisee before allowing the new franchisee to invest in their system. Originally the FTC called the guidelines “Uniform Franchise Offering Circular (UFOC)”. In 2008, the FTC updated the rules and it became known as the Franchise Disclosure Document (FDD).
The FTC requires all franchisors to provide candidates with their current Franchise Disclosure Document at least 14 days prior to signing an agreement. The information contained in the FDD is vital for all franchise candidates to make an informed and educated decision on their investment.
The FDD contains 23 items that provide information on a variety of areas such as franchise history and background, costs, fees, legal issues and obligations for both parties. While it is extremely important to analyze each section of the FDD, there are ten items in particular that I believe are the most informative when reviewing a franchise system. Here are some of the key items from the FDD that require special attention: Item 1: The Franchisor And Any Parents, Predecessors
This section contains general business information and the history of the franchise. Importantly, it will let you know if the franchise previously operated under a different name. This history can lead to an interesting process of discovery. Overall, Item 1 serves as the foundation for understanding the details of the franchise throughout the remainder of the FDD. Item 2: Business Experience
When you are building your future, you want to make sure it’s on a solid foundation. During your discovery process, you will meet the franchise development director, operations executive and either the founder or the CEO. Smaller franchise organizations may have a smaller executive team. The FDD will include a listing of the top executives and their management responsibilities within the company.
It is important to know the backgrounds of your potential business partners and how they may be able to assist you in the future. Companies with executive experience in business, management and franchise operations often have stronger, more successful franchise systems. Item 3: Litigation
This section contains a list of the litigation the company is currently involved in or has been convicted of over the past 10 years. While a certain amount of litigation may be expected with larger businesses, you will want to pay close attention to the volume and nature of these cases. The first red flag may be raised if you see a pattern of excessive litigation or situations in which the franchisees are regularly suing the franchisor for non-performance. Also, be aware of third-party suits claiming trademark or intellectual property infringements. Any warning signs in this area should be investigated before proceeding with an agreement. Items 5,6,7: Estimated Initial Investment
This provides a detailed look at the reasonable expenses you should expect to incur and should give you an idea if you can afford to purchase and operate the franchise. While items 5 and 6 provide the initial franchisee fee and other ongoing fees, item 7 includes a comprehensive list of expenses one should expect when opening the business and operating it for the first several months. Item 12: Know Your Territory
Territory refers to the exclusive area or radius granted to a franchisee to operate their business. This is an important designation because you don’t want to be in competition with a fellow franchisee for the same customers in a given market. Make sure you have a clear understanding of the territory, boundaries, and how they gather their population data. It can be beneficial to learn if any neighboring territories are available and what would your cost be if you wanted to expand your business.
Every franchise has different territories and industry can also play a role in determining the size. Convenience stores may be located more close together than home repair companies. However, one sub shop franchisor may grant smaller territories allowing multiple locations within a 10 mile radius. A mobile ice cream truck franchisor may grant you a territory with 3 zip codes for a population size of about 500K people. Plus, they may allow you to operate that truck at large public events in a different territory. Item 19: Financial Performance Representations
Many prospective franchisees will want to skip to this section in an attempt to get an understanding of how much money can be made through ownership. The problem with that is only about half of the franchisors make limited financial performance representations in the FDD. In order to understand the financial performance of a franchise system, you will likely want to reach out to existing franchisees to discuss finances. This is the best way to build an accurate profit and loss statement. Item 20: Outlets And Franchisee Information
This information ranges from the status of franchise- and company-owned units to franchise transfers and projections of growth. Pay close attention to system-wide trends, such as a high level of terminations and abandonments. This section provides three years of data on a state-by-state basis. If you see any potential data that concerns you, please discuss it with your business broker and the franchisor. There may have been a problem and it was remedied. Item 21: Financial Statements
It’s important to make sure the franchisor has the financial reserves to create a stable growth environment and solid franchisee support services. This section includes balance sheets for the past two years and income statements for the previous three years. If your net worth is greater than the franchisor’s annual gross revenue, you might want to find another franchise to investigate.
While FDDs do not provide information on why or how a franchise system is successful. They do provide a transparent view into many aspects of a company’s operations and documented track record. It should be used as an important tool for due diligence. Read Between the Lines
When you are going through discovery and due diligence, you will also gain an idea how transparent a franchisor is, willingness to discuss your concerns, and your access to leadership. It’s important to choose a franchisor that is truly committed to your success by providing training, support, and resources to operate and help grow your business. You can also talk to your trusted advisors (franchise broker) certified public accountant and legal counsel) before making a decision.