Decoding Franchise Disclosure Documents: A Detailed Study

A Franchise Disclosure Document (FDD) is a legally mandated document provided by franchisors to potential franchisees. It outlines the history of the business, fees, rules and restrictions, all the franchisees in a system, turnover rates, renewal terms, and other aspects of a particular franchise. 

It's crucial for franchisees to receive the FDD at least 14 days before signing any agreements or making payments, allowing them time to review, seek advice and make an informed decision. This document, comprising 23 Items, plays a vital role in ensuring transparency and informed decision-making in the franchising industry. Here’s a closer look at what to look for. 

Breaking Down the Most Important Sections of an FDD

Though the entirety of the FDD is important for franchisees to read, there are some sections that stand out more than others. Arguably the most important section of the FDD is Item 19, which includes up-to-date financial information on corporate and franchised units. 

“I think what everybody wants to know when they're getting into business is how much money they can make,” said Merri Cronk, franchise consultant at FranNet. “So, looking at Item 19, which is financial performance representation, really helps people gauge interest.”

Because franchisors are not required to disclose information about potential income or sales, some do not include this information. And if they do, the law requires they have a reasonable basis for their claims. Examine this section closely and look at figures from corporate stores, average sales and earnings, gross sales, geographic difference, and number of years the franchise has been in operation.

Cronk noted that another important part of it is the list of franchisees past and present, or Item 20. This list allows prospective franchisees to validate what the franchisor is telling them with first-hand accounts. Item 20 is also key because it discusses how many franchisees a franchise has, how many they plan to add and how many are no longer a part of it. 

“Really understanding the growth trends and security is important there,” said Cronk.

Item 7 is another key section. Here, franchisees can find the estimated startup costs associated with opening the franchise. 

Is Seeking Legal Counsel Essential?

When franchisees receive the FDD, it can be important to go through it with a legal advisor. This will give you an inside perspective on the health of the franchise and can help you determine if it is a smart business move. 

“While there are a lot of things that won't be negotiated in a franchise agreement, having a fresh set of legal eyes can help you understand what it is that you're agreeing to,” said Cronk. “[That’s] really important. An attorney with franchise industry experience can not only review the franchise agreement, but they can also take a look at that FDD. I think it's the cost of doing business — and a good one.” 

Common Pitfalls and Red Flags to Look For

Cronk believes one of the biggest mistakes franchisees can make is solely relying on a legal review. 

“When they get their FDD, I tell people that they need to read it,” she said. “As boring as it might be, they need to read it. I tell them that this document they're getting represents the past, but it also represents the future. So the FDD and the 23 items in it reflect the history of the business. But it can also reflect the future, should they agree to sign it.” 

When going through the FDD, there are also certain red flags that franchisees should look for, mainly the financial health of the business. Make sure it’s safe to take on new franchise owners. 

“If you see that a franchise is going backwards, or if there are declining unit sales, that would be a big red flag,” said Cronk. 

In the world of franchising, thorough examination of the FDD empowers franchisees to make informed decisions and start their entrepreneurial journey with confidence.