Item 7 in the FDD: Breaking Down the Costs Needed to Buy a Franchise
Before signing your new franchise agreement, it’s important to know how much it will cost. Without this critical information, you could find yourself in a financial bind before you even open for business.
The good news is that franchisors are required to include a breakdown of the estimated costs associated with setting up a franchised business in Item 7 of the Franchise Disclosure Document (FDD).
This article will break down the information franchisors must include in Item 7 of the FDD and briefly explain each.
What Is the Required Information for Item 7 of the FDD?
Before signing your new franchise agreement, it’s important to know how much it will cost. Without this critical information, you could find yourself in a financial bind before you even open for business.
The good news is that franchisors are required to include a breakdown of the estimated costs associated with setting up a franchised business in Item 7 of the Franchise Disclosure Document (FDD).
This article will break down the information franchisors must include in Item 7 of the FDD and briefly explain each.
What Is the Required Information for Item 7 of the FDD?
Under the amended Franchise Rule of the Federal Trade Commission (FTC), franchisors are required to provide prospective franchisees with the estimated initial investment necessary to start and operate a franchise.
Although these costs are estimates, they help ensure you are prepared to cover living expenses and other pre-opening expenses until your franchise is operational. Each category in Item 7 of the FDD should include a low to high range of costs to give you a realistic idea of the initial fees required.
Item 7 of the FDD may include the following:
Initial franchise fee: This is the fee paid by the franchisee to the franchisor for the right to use the franchise systems, brand, and support. It's often a fixed amount and varies widely among franchises.
Real estate/lease costs: If the franchise requires a physical location, this will cover the costs associated with leasing or purchasing a space. It may include security deposits, the first month's rent, and any leasehold improvements required to fit the franchisor’s specifications.
Utilities: Estimated costs needed to operate the business until it becomes cash-flow positive.
Build-out costs: The expenses involved in customizing the leased space to meet the franchise's operating requirements, including construction, signage, furniture, and equipment.
Equipment and supplies: Costs for purchasing the initial inventory, equipment, and supplies necessary to commence operations.
Insurance: Costs for insurance coverage may include liability, property, and casualty insurance.
Additional training expenses: Many franchisors require franchisees and/or their managers to complete a training program. This section outlines the costs of attending this training, including travel, lodging, and meals.
Professional fees: Expenses for legal and accounting services, including franchise agreement review, business registration, and compliance with local regulations.
Marketing and advertising: Initial marketing and advertising fees may include contributions to a national or regional advertising fund and costs associated with grand opening promotions.
Working capital: An estimate of the operating expenses needed to cover the franchise's first few months, including employee salaries, utilities, and other day-to-day expenses. It is critical for maintaining the business until it generates sufficient revenue.
Additional funds: An estimate of extra funds needed to cover unforeseen expenses, ensuring the franchisee isn't caught off-guard by unexpected costs.
Keep in mind, while Item 7 provides a comprehensive estimate of initial costs, actual expenses can vary based on:
- Location
- Size of the franchise
- Market conditions
- Your business experience
Do your due diligence and consider these estimates as a starting point in your financial planning.
What Is the Required Format for Item 7?
Like Item 6 of the FDD, Item 7 is presented in a tabular five-column format with the heading, “YOUR ESTIMATED INITIAL INVESTMENT” in all uppercase letters.
And each column should be labeled as follows:
- Type of Expenditure
- Amount
- Method of Payment
- When Payment is Due
- To Whom Payment is Made
These column headers make it easier to read and understand the various categories of expenses and their estimated ranges. The FTC governs FDDs under the Franchise Rule to ensure they follow the same format.
A tabular format also helps organize the information concisely with a clear overview of the financial commitments involved.
The table ends with a total estimated initial investment—the sum of the low and high estimates for all categories listed. This provides a ballpark figure for the minimum and maximum amounts needed to operate the franchise until it becomes cash-flow positive.
Franchisors might also include notes clarifying how these estimates were determined and suggestions on adjusting some of them, if needed.
Lastly, footnotes provide additional information on individual items. For example, if the initial inventory costs vary significantly depending on the location or size of the franchise, a footnote might explain the basis for the range provided.
Additional Funds in Item 7
The additional funds section of Item 7 is as it sounds. It lists all the extra expenses you might encounter during the initial period of operation.
Item 7 should list all the additional funds a new franchisee might run into above the initial investment expenses. It often covers extra costs that didn’t fall under Item 5 (pre-opening fees) or Item 6 (recurring fees).
These additional funds could fall under:
- Working capital like payroll, rent, or ongoing supplies not covered under the initial investment
- An emergency fund to cover unforeseen costs or lower-than-expected revenues
- Additional marketing to help build the business
- Royalties or ongoing fees required by the franchise system
The franchise system typically projects the additional funds to cover a period ranging from the first three to six months of operation, although this can vary. However, depending on the nature of the business and how long it generally takes for a franchise unit to break even or become profitable, this period can be longer.
Interpreting Costs of Each Type of Expenditure in FDD Item 7
Franchisors are required to detail the expenses associated with opening and operating a franchise. They should specify the amounts or provide an estimate based on industry experience.
If exact amounts aren’t available, then the franchisor should include the low and high ranges in the total sum column and explain the numbers provided through footnotes.
For example, real estate costs may be too variable for a simple range, so the franchisor can describe the property's expected size, type, and location.
Additionally, if a franchisor sells its company-owned outlets, the investment required for such a purchase may be excluded from Item 7. This is only the case if the sale price from the previous fiscal year surpasses the highest initial investment estimated for franchise outlets.
If this happens, the discrepancy must be noted in a footnote and the sale price of company-owned outlets must be included to show how much the initial investment for franchised outlets exceeds the highest initial investment. This ensures transparency and helps you better understand the financial scope of your investment.
What to Look for as a Potential Franchisee
Investing in a franchise is a big deal and should never be taken lightly. Item 7 of the FDD serves as an essential resource in this process, providing a detailed breakdown of the estimated costs.
Purchasing a franchise can be complex. Consider assembling a team of advisors, from franchise brokers and consultants to accountants and attorneys, who can provide personalized advice and help you pick the right franchise that aligns with your business goals.
Whether you’re considering a brand new franchise or a well-established one, the franchise relationship can significantly impact your business success. Search franchises for sale on BizBuySell to find a franchise that is transparent and willing to work with you to ensure your success.