Franchise Disclosure Document: Item 21

When researching franchise concepts, arguably the most important step in this process is reading a brand’s Franchise Disclosure Document (FDD). The FDD is a document that 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. The FDD encompasses 23 Items, all of which contain essential information. 

Item 21 represents the financial audit of a franchisor’s financial statement reporting obligations. Here, candidates will find important information about the company’s financial status, including audited financial statements. In some circumstances, unaudited financial statements, or parent/affiliate financial statements may be provided. 

Item 21 gives prospective franchisees a look back (in most cases three years) at the franchisor’s financial condition. In addition to seeing whether the franchisor’s condition has improved over time, the most important element of Item 21 financial statements is simply to understand how the assets and cash flow of the franchisor correspond to the number of franchised units it projects to sell or support. For example, if the franchisor has limited resources and hundreds of franchisees, it might be a signal that franchisees will not be receiving much support. 

Franchisee candidates should also pay attention to instances where the franchisor also operates a unit-level business (i.e., a company-owned outlet), as its financial statements may effectively constitute a financial performance representation. 

These financial statements are also important to the franchisor, because it will affect the franchisor’s ability to get registered in many states — whose state examiners will review these financial statements before permitting the franchisor to sell franchises in their state. A franchisor with weak financial statements may be rejected by certain states, or only approved contingent on certain financial safeguards (such as escrowing the initial franchise fees paid by franchisees with a third-party bank until the franchisor has met its pre-opening obligations).

Overall, Item 21 is one of the most significant sections of the FDD because it gives franchisees meaningful information about the financial health and viability of the franchisor. Ideally, Item 21 should show steady growth and income from royalty payments, as opposed to strictly franchise sales. This would suggest franchisees are seeing success, and the system is growing in a healthy way.

If a franchisee candidate is overwhelmed by all of the tables and figures that can be found in this section, the two most essential resources are the profit-and-loss statement and the balance sheet. Enlisting the assistance of a franchise accountant can help candidates determine whether the current ratio of assets to liabilities is favorable and how the franchisor accounts for deferred revenue. 

Before signing a franchise agreement, each prospective franchisee needs to feel comfortable that the franchisor is financially sound and able to meet its obligations. Item 21 of the FDD can be a valuable tool in finding that information.