What to Look for in a Franchise Disclosure Document (FDD)
If you're an entrepreneur considering purchasing a franchise, one of the essential documents you'll receive is the Franchise Disclosure Document (FDD). The FDD contains 23 sections, also known as "Items," which require franchisors to disclose specific information. This information is intended to arm prospective franchisees to make an informed decision before investing in the franchise business.
Each item covers different aspects of the franchise, including the franchisor's background, fees, and expenses, litigation history, and the terms and conditions of the franchise agreement. Although the document is obligatory, some of the FDD's constituent elements noted below are up to the franchisor's discretion.
In this guide, we'll break down what you should look for in an FDD to make an informed decision about your franchise investment.
Legal Requirements for an FDD
Before we delve into the details of an FDD, let's talk about why it exists. The Federal Trade Commission (FTC) has set legal requirements for franchisors. One of these requirements is to provide a copy of the FDD to potential franchisees at least 14 days before signing a contract or paying any initial fees.
As a result, the FDD serves as a comprehensive guide that gives potential franchisees all the information they need to make an informed decision about whether to invest in a particular franchise system. It typically covers a wide range of topics, such as the franchisor's history, financial performance, legal matters, and fees.
The FTC's main goal by providing franchisee information is to safeguard consumers from fraudulent practices in the franchising industry. The FDD is one way to achieve this goal. By mandating franchisors to provide potential franchisees with the FDD, the FTC ensures that people have access to essential information about the franchisor and the franchise system before making a decision.
This way, potential franchisees can understand the potential risks and rewards associated with investing in a particular franchise system and decide accordingly.
Key Components of an FDD
There are 23 components to an FDD, all of which can be found in FTC documentation. That said, some high-level FDD item components are critical to note:
- Franchise fees: This section will outline the initial franchise fee you'll be required to pay to become a franchisee. It may also outline ongoing royalty and marketing/advertising fees that you'll be required to pay.
- Franchisor support: This section will detail the help the franchisor will give you as a franchisee; this may include initial training, ongoing support, and marketing assistance.
- Unit financials: This section will provide information about the revenue and profit expectations for a typical unit in the franchise system as a financial performance representation. While sharing unit performance is not a requirement, it is relatively standard. Additionally, large franchisors with a large number of franchises are typically readily able to provide financial statements, including any income statements and balance sheets.
- Litigation: This section will outline any past or ongoing legal disputes involving the franchisor or other franchisees in the system.
Evaluating an FDD
As prospective franchisees, it's important to read the document carefully and ask questions if anything is unclear. The FDD contains a wealth of information about the franchisor and the franchise system, including details on the franchise fees, royalties, restrictions, and the franchise’s financial performance. This information is crucial in evaluating whether a particular franchise opportunity is a good fit for you.
In addition to reviewing the FDD, it's important to research the franchise opportunity itself. This might involve talking to current and former franchisees to get a sense of their business experiences, researching the industry, franchise sales, and competition to understand market trends and challenges, and evaluating the franchisor's reputation and track record.
By carrying out the due diligence process and taking the time to evaluate the franchise opportunity carefully, you can make an informed decision about whether it's the right investment for you. Remember, investing in a franchise is a significant financial commitment, so it's essential to do your homework and gather as much franchisee information as possible before making a decision.
Potential Red Flags in an FDD
As you review an FDD, look for potential red flags that may indicate problems with the franchise system. Here are a few things to look out for:
Unreasonably High Fees
If the franchise fees, royalties, and marketing/advertising or initial investment fees are significantly higher than those of other franchises in the same industry, it may be a red flag. This section should include information about the initial franchise fee, ongoing royalty fees, and any marketing or advertising fees that you must pay.
It's important to review these fees carefully and make sure they're reasonable compared to other franchises in the same industry. Keep in mind that while a higher initial franchise fee may indicate a higher level of support from the franchise owner, it may also make it more difficult to achieve profitability in the early stages of your franchise.
Lack of Support
If the FDD does not provide detailed information about the support that the franchisor will provide to you as a franchisee, it may indicate that the franchisor is not committed to helping franchisees succeed. Various forms of support include initial training, ongoing support, and marketing assistance. It's important to review this section carefully and ensure the franchisor is committed to helping franchisees succeed.
If the FDD does not provide detailed information about the support that the franchisor will provide to new franchisees, it may be a red flag.
Unrealistic Financial Projections
If the FDD includes revenue and profit projections that seem too good to be true, it may be a sign that the franchise owner is dishonest about the potential for success. Reviewing this information carefully and ensuring realistic projections based on the industry and the franchisor's track record is important.
Look for financial performance benchmarks from other franchisors to make a better assessment. Remember that your revenue and profit may vary based on several factors, including the location of your franchise and your ability to manage your business effectively.
Litigation
The section of the FDD detailing litigation is important to review carefully. This section will outline any past or ongoing legal disputes involving the franchisor or other franchisees in the system.
If there are a significant number of legal disputes involving the franchisor, it may be a red flag indicating potential problems with the franchise system. Therefore, it's important to review this section carefully and ask questions if anything is unclear.
Conclusion
In summary, taking the time to review the Franchise Disclosure Document (FDD) thoroughly is crucial for anyone considering investing in a franchise. By familiarizing yourself with the essential elements of an FDD and being aware of warning signs, you can make a well-informed decision about whether a franchise opportunity is suitable for you.
Remember to read the FDD carefully, ask any questions, and conduct proper research before signing any contracts. Your due diligence will pay off in the long run by helping you to avoid costly mistakes and find the right franchise for your needs and goals.