If you are going to buy a franchise, federal law requires the franchisor to make certain information available to help you evaluate what you are getting into. This information is provided in a “franchise disclosure document” or FDD.These documents are drafted by the franchisor’s attorneys. Often hundreds of pages long, they can be both intimidating and clear as mud. As with any legal document, the business owner should be able to read and understand the business terms, and call in the experts to evaluate the legal terms. Here is a summary of each section and some suggestions on how to best evaluate the information provided in an FDD:
If you are going to buy a franchise, federal law requires the franchisor to make certain information available to help you evaluate what you are getting into. This information is provided in a “franchise disclosure document” or FDD.
These documents are They are supposed to be consumer protection documents, but they are drafted by the franchisor’s attorneys. Often hundreds of pages long, they can be both intimidating and clear as mud. As with any legal document, the business owner should be able to read and understand the business terms, and call in the experts to evaluate the legal terms. Here is a summary of each section and some suggestions on how to best evaluate the information provided in an FDD:
Overall, the document has 23 sections that are supposed to disclose key information to the prospective franchisee to help evaluate the investment. Here is an overview of Section 1-10:
-
Overview. If you don’t understand the summary of what the company does, this may be a red flag. The franchise model is supposed to give you the systems and tools for successfully operating a business. Before you invest, make sure the system is good.
-
Business experience of the franchisors. Look for a management team with experience and a proven track record. The best case is success in franchised businesses or similar industries.
-
Litigation involving the franchise/franchisor. The best situation is no pending litigation, and the worst case is a class action or multiple suits alleging fraud or misrepresentation.
-
Bankruptcy of the franchisor or any principal. Carefully evaluate the circumstances of previous bankruptcies of any principals. Is this history material to this venture? Obviously the best case is no previous or current bankruptcy but any situation must be carefully analyzed.
-
Initial fees. Sometimes this is negotiable, especially if the franchise is young and would rather build its number of franchisees than obtain franchise fees.
-
Royalty and advertising fees. Many franchises require monthly payments based on sales and payment of a percentage of revenues into a joint advertising fee to benefit all franchisees.
-
Initial expenses. This section lists the estimated costs for the first three months of operation. Check with existing franchisees to evaluate how realistic the estimates are. Undercapitalized businesses often fail. Find out how long it takes existing franchisees to break even.
-
Restrictions on vendors, products. Some franchises require the franchisees to purchase supplies or products from approved vendors. This can cut both ways: It can standardize quality across the franchise and provide bulk buying discounts, but the franchisor might also have an economic interest in the purchases (own part of a supplier or get rebates). Make sure the prices are fair.
-
Description of franchisee obligations. This section will give you the best roadmap of financial and other requirements. Make sure the rest of the document is consistent with this section. Ask existing franchisees how the system actually works, and how accurate this summary is.
-
Financing. If the lender offers financing through itself or an outside lender, the general terms will be disclosed here. For example, a franchise or franchise broker may have a relationship with an SBA lender. Remember if you default on the loan from a franchisor, the franchisor can terminate your franchise agreement.
