Before you make the decision to buy into a franchise, you have to do your research. Careful due diligence can help you make the right choice, and avoid buying into the wrong system. The FDD, or financial disclosure document, offers a lot of detailed information, if you know how to read it. It is a dense document, but with guidance it will reveal a great deal of useful information that you can use to make the right franchise investment decision.
There are 23 items in the FDD. In this blog, the fifth in a five-part series, I will explain briefly what information you can find in items 19-23.
- Financial Performance Representation: This section of the FDD tells a potential franchisee what financial returns they could expect from their investment. It answers the question, to some degree: How much money can I make?
A franchisor’s decision to input financial performance information is voluntary not required. However, roughly 60 percent of franchisors do offer this information. If a franchisor only has company owned units, for example, they can include those units, and any other information offered is at their discretion.
Some companies include information on gross sales, some put in a full P&L, others put gross sales less cost of goods. It really depends on the company. But if the franchisor has franchisees, they have to include both company and franchise unit data. They cannot only offer company information.
Franchisors also have to include information on top and low performing units. They can do averages and medians, but they cannot just offer information on top performing stores. Some companies do not bother to put in a profit because that varies from region to region and franchisee to franchisee. It really depends on what the company wants to disclose.
Further, not having this information does not necessarily signal a red flag because submitting information for this item is voluntary. Some franchisors are brand new and only have one company store that has been in business for less than a year. The store has to be in business for 12 months, four full seasons, otherwise no state will allow the information in the FDD.
- Outlets and Franchise Information: Item 20 gives a buyer an idea of what a franchise system has done successfully and not successfully over the past three years. This item will detail how many units were terminated, sold or transferred during that time period.
For example, if the franchisor lost 30 franchisees in one year, as a potential franchisee you will want to query why? Item 20 is particularly useful for a mature company. For a startup, the data is mostly zeros, so it is almost irrelevant.
- Financial Statements: This item details the franchisor’s financial statements. It has nothing to do with individual store earnings. For a new franchisor, all that is required is an opening balance sheet with some cash on it. This can be provided in a compilation statement. However, some states, like New York and Maryland, require the opening balance sheet to be audited. For a mature franchisor, one operating for two years or more, there is a two or three-year financial audit requirement, depending on how long they have been selling franchises.
When evaluating the financial statements in an FDD, you will want to make sure the franchise is profitable. If the system is losing money, find out why. It likely will depend on the size of the company. Many of the larger franchise systems make money, but some small ones may not, at least not during the first few years.
- Contracts: The franchisor has to exhibit all of the material contracts that franchisees have to sign, such as the franchise agreement or a multi-unit operator agreement. Some exhibits will list all agreements. For instance, if there is a general release that must be signed when a franchisee sells or transfers, a sample of that general release must appear here. If there is a multi-unit component, that agreement has to be listed here as well as a table of contents for the operations manual.
As a separate exhibit, the franchisor must also list the franchisees’ names, addresses and phone numbers. For larger systems like Subway, with hundreds of thousands of franchisees, the first 100 is sufficient. There is also an exhibit for the agents who service and process contracts for the franchise system. There is also an exhibit for franchisees who Left the System during the prior fiscal year.
- Receipts: This item is very important. It must be signed and dated when the franchisee gets the FDD. Keep this on file for seven years in case there is a lawsuit. For instance, in the event of trouble, a franchisor will be able to show that a franchisee received the franchise disclosure document on a specific date and signed for it. When you do electronic disclosure, there has to be a hard copy as well.
Well, that is it. We have gone through all 23 items in the franchise disclosure document. If you made it to the end of this blog series, thank you. If you missed any of the previous blogs on the items in an FDD, that content is just a mouse click away.
If you need a franchise attorney, or you have more questions about a franchise disclosure document, please click here. I am here to help.