Franchise attorney John Gotaskie from Fox Rothschild LLP and two franchising executives give insight on how prospective franchisees should approach reading and understanding the FDD.
For anyone thinking about buying a franchise, it can be an incredibly stressful to understand all of the factors that go into the decision to give up the security of a full-time job, clear out a savings account, and in some cases, 401(k) accounts, to take a risk on getting into business. Some prospects inquire into buying a franchise, but never move forward beyond that initial step.
For those that do, they are eventually presented with the brand’s franchise disclosure document (FDD), which is a legal document broken up into 23 Items ranging from information about required investments to outstanding litigation to biographies on the brand’s executive team, and more. Because of the length of the document and the language used therein, reading an FDD can be overwhelming for potential franchisees.
John Gotaskie, partner at Fox Rothschild LLP, works with franchise brands of all sizes and knows his way around an FDD. He advises franchisees to read through the entire document, but to focus on a few key areas that could make or break their decision to buy.
“At the end of the day, Item 19, financial performance, is probably the most important piece to review, but every brand approaches Item 19 differently,” he said. “[Potential franchisees] need to ask questions behind the financial performance to make sure they understand how it was put together.”
John Twist, VP of Franchise Development for Batteries Plus Bulbs, agreed with Gotaskie, adding that the brand “shows a chart with the sales growth trajectory for years one through 10, along with a chart on corporate store performance.” By sharing not only the system’s average unit volume, but also a potential growth forecast, franchisees can glean more about the opportunity.
In addition to Item 19, Gotaske pointed out Items 1 through 4 as areas of interest for prospective franchisees.
“Item 1 gives an overview of who the franchisor is — who is the parent company and its affiliates,” said Gotaskie. “But don’t take that information at face value. Do some Googling. Do some research. Find out all you can about the company. Does it have a good track record? If there were problems in the past, were they related to things beyond control?”
Item 2 covers business experience, and again, Gotaskie said he encourages prospective franchisees to do their homework, cautioning that brand executives may be selling themselves as one thing, but may be very different in reality.
Regarding Items 3 and 4 (which cover litigation and bankruptcy, respectively), Gotaskie noted, “Every system is going to have litigation, it’s a fact of life. It’s more important to figure out whether a brand has a lot of litigation, and what the character of it is. Is it disgruntled people who joined the system 30 years ago and are unhappy now that there's more structure and less autonomy? Or does it suggest fundamental differences in the system?”
Another important section of the FDD is Item 9, which covers franchisee obligation. Gotaskie noted it will tell prospective franchisees “an awful lot about what [they] are expected to do” once they become a franchisee.
“Items 13 and 14 are also important because they relate to trademarks,” he continued. “If you want to take the step of buying a franchise, it’s important to know how well their assets are protected. Does the brand license a trademark from someone else? In most franchise operations, [the trademark] is one of the most valuable things you’re going to be licensing. You want to make sure that is rock solid, so you don’t get dragged into a third-party lawsuit.”
Rodney Ballance, founder of Patriot Broadband, an internet service provider franchise, encouraged prospective franchisees to review Item 7.
“The summary of start-up costs is a good way to assess the capital requirements for launching your own franchise, while also assessing the minimum level of cash reserves needed for the first few months of operations,” said Ballance.
Gotaskie agreed, suggesting that prospective franchisees also look at financial statements and get a copy of the franchise agreement and compare it, line by line, to what the FDD says.
He added, “Outside of the franchise agreement itself, there are a lot of other contracts that franchisees have to sign, like a POS operator, product supply company, or non-compete agreements. Compare those contracts with the FDD itself to make sure it's in line. You might have to sign a POS operator or make a personal guaranty in regard to financial issues, or maybe you and your spouse and senior managers have to sign non-compete agreements. All of those are disclosed in the FDD, so make sure you understand those and that they match with what is outlined in the FDD.”
Gotaskie explained that while the FDD contains a lot of information, the language used is not overly technical. He suggests that prospective franchisees read through it very carefully, and if they have questions, they should ask them.
“It never ceases to amaze me when I hear someone saying ‘I never knew that,’” he said. “If you have questions, you should ask them. If you don't have questions, you probably should not buy the business.”
When going through the franchise buying process, prospective franchisees need all the help they can get to make sure that the franchise is a fit on both sides. By understanding what items are most important in the FDD, franchisees are better equipped to make a sound decision.