This is a guest blog post written by Bob Steinberger.
About two weeks prior to buying into a franchise, a prospective buyer will be given a Franchise Disclosure Document (FDD), highlighting 23 different disclosures that a franchisor is required to provide. This gives potential buyers the opportunity to check under the hood of the business, determine merit, financial stability and evaluate the value of the business as an investment.
All are very important, but several deserve extra attention, especially when initially deciding if this particular franchise fits your needs.
Although #7 in the FDD, prospective buyers should start here. This disclosure clearly defines if the business you are considering is within your financial capabilities.
Much more extensive than the franchisee fee, this disclosure gives you an entire outline of the projected expenses you can expect to incur when opening the franchise. This includes third party expenses, such as rent, equipment and inventory, as well as licensing, training and advertising.
Red Flag: Be on the lookout for an initial investment that far surpasses what it would take to open and operate a similar business on your own.
At first glance, opening a franchise will be more expensive than opening a similar business on your own. You are paying to utilize their business model, operating procedures and brand. But when initial investments go far beyond the norm, there might be mandated contracts with 3rd party vendors that line the pockets of the franchisor.
Near the end at #21, this disclosure keys you into the overall health of the franchise through presenting audited balance sheets and income statements of the franchisor for the past two years. Use these to determine the durability of the franchise, weighing if you are making a good investment.
Red Flag: Go through these with a financial advisor for indications that the franchise’s future is solid.
Renewal, Termination, Transfer, and Dispute Resolution
Listed 17th in the FDD, this disclose summarizes the requirements of both the franchisor and franchisee with respect to termination, renewal, transfer, dispute resolution and other important aspects of the franchise relationship.
Red Flag: This is a large encompassing section, so there are several things to be wary of. In the event of a termination, what liabilities will you be accountable for, such as damages.
Exorbitant transfer fees limit your ability to sell the business, which is the desired exit plan for any franchisee, cashing in on the goodwill and reputation you build in your area.
#12 in the FDD, this section outlines the territory that will be assigned to the franchisee, if one is assigned at all. A territory, ranging in size from a square block to a few mile radius, comes into play to a greater or lesser degree depending on your type of business. In a large city, there can be multiple 7-Elevens operating within a few block radius. In a small town, multiple doggy day cares within a 10-mile radius creates problematic competition.
Red Flag: Ensure your territory gives you enough padding from competition. A small territory in a small area could cause problems in developing a sustainable income. Also, review your territory in relation to marketing. Are there restrictions to the areas or channels where you are able to distribute flyers or run ads, including online?
#3 mandates that the franchise disclose any litigation that they were, or currently are, involved in, dating back ten years. A long-standing franchise will have legal disputes, most likely some good and some bad. Good types of litigation are when the franchise acts to enforce the integrity of the franchise system or if an action is labeled “ordinary routine litigation.”
Red Flag: New franchises that already have negative activity in the litigation arena typically have substantial problems in the system. Another red flag comes from franchises that default to legal action every time a disagreement with a franchisee arises, indicating a lack of a strong system to resolve issues. Litigation that threatens the future of the franchise, such as a patent dispute, or rulings that create negative long-standing financial implications, should leave you very wary.
The 4th disclosure shows if any of the key officers had any connections with and/or filed bankruptcy over the past ten years.
Evaluate the circumstances surrounding the bankruptcy, as well as the position of the person in question, to determine its impact on the officer’s ability to manage the finances of the business. Many times filing bankruptcy due to a divorce or crippling medical debt can be almost unavoidable.
Red Flag: If the CFO or other key leaders went bankrupt.
List of Franchise Outlets
Marking #20 in the FDD, this creates a roadmap of where the franchise is going. Several tables outline three years’ worth of documentation on the status and number of franchises, transfers, abandonments, and projected new franchises.
Red Flag: When the numbers of franchises are diminishing, the business is going in the wrong direction. Businesses, especially franchises, strive to expand, and if franchise numbers are shrinking, there is likely a problem in the business model or it didn’t transfer well to other areas of the country. Also, transfers or abandonments exceeding 10% indicate a problem in the business.
While designed to give you more transparency into the inner workings and history of the franchise, the FDD can be incredibly overwhelming, if for nothing else than from the sheer volume. Make sure to comb through the document with licensed professionals.
Financial Performance Representations
Item #19 provides details on earnings, expenses, and other factors likely to affect future financial performance. This can include written or visual representations stating specific or ranges of potential sales, incomes, and profits. The numbers are based off of current operators.
Red Flag: Up until recently, most franchises opted out of providing these. If they don’t provide them, make sure to reach out to current operators to learn their financial health and overall gains. To get a more accurate idea of the strength of the business model, reach out to a large number at various stages of operation, such as just opening and open for 10 years.
If they do provide financial performance representations, look for context and scope on the claims. Operators in their first year don’t see the same gains as well established operators. If you are looking at a well-established franchise with a lot of franchisees, the performance representations should be based on the large majority, if not all, of the operators. If they only use a small sample, odds are they have something to hide.
A CPA and lawyer can identify discrepancies in financial statements, evaluate the strength of the franchise, aid in understanding contracts and regulations and more, ultimately giving you a better understanding of the mechanics of the franchise.
If you are considering investing in a franchise and need help looking under the hood, contact Bob Steinberger today.