The Most Important Items in an FDD: Item 7 - Initial Costs

Even if a franchise concept seems like the perfect fit for a candidate’s skills, interests and lifestyle, there are still financial questions to be answered. For example, how much will it cost to open and how does that estimate fit within the prospective franchisee’s financial considerations?

Item 7 of the Franchise Disclosure Document (FDD) is what a prospective franchisee should look to in determining and evaluating how much it will cost to develop and open the franchised business. This section is a great resource for the franchisee, as it includes everything from training and grand opening fees, to furniture and real estate development costs.

“This is the section in the FDD that's all about estimated startup expenses,” said Charles N. Internicola of The Internicola Law* Firm. “Item 7 is broken down into different categories of expenses that detail the estimated costs to construct, equip, and open the franchised business in order to reserve the capital required for the first three months of operation. If prepared properly, Item 7 should reflect all of the start-up costs it will take to develop and open the franchised business.”

Item 7 provides a summary section for the franchisor to lay out a detailed explanation of all costs involved in the initial investment. The section is routinely presented as a chart that includes cost ranges for various expenses. In addition, this section typically includes a minimum recommendation of set-aside cash flow needed to start up the business and incidental, business-related costs. 

Many franchisors will specify a minimum of three months of living expenses be set aside as capital for the initial investment, and quite often more. Franchisees have the option to invest the minimum value in the range to keep initial costs down or investing at a higher level upfront in order to increase their ROI in the long-term.

“There are a few misconceptions when it comes to Item 7,” said Internicola. “For one, the estimates are not always 100% accurate. Sometimes, franchisors, especially emerging franchisors, get their cost estimates wrong and so it is important that franchisees independently evaluate their estimated start-up expenses.” 

As with most of the FDD, Item 7 is an area in which it is important to seek out additional information. Prospective franchisees should ask existing franchisees to disclose more detail during the validation stage of a candidate’s franchise investigation.

“Prospective franchisees should certainly take the time to validate that existing partners have stayed within the parameters laid out by Item 7,” said Brian Knuth, VP of Development at Raintree*. “If a current franchise partner is paying way more in marketing costs than the FDD estimates, that is an important factor to note when evaluating the opportunity.” 

Internicola points out that the estimated start-up expenses laid out in Item 7 do not always represent all of the capital that a franchisee will need. “Many times, franchisors are only required to include a reserve capital estimate for the first three months of operation. For many franchisees, building a cash-flow positive business takes more than three months and so, a three-month reserve capital estimate will not be enough.”

While it may seem simple on the surface, Item 7 can give the prospective franchisee much more than a cost estimate—it can provide a clearer insight into the viability of the entire franchise opportunity. 

“If an FDD’s Item 7 does not include detailed information and appears to be generic, it may be a sign that the franchisor has not put enough planning and thought into its cost estimates,” said Internicola. “Overall, an incorrect cost estimate can be a red flag that the franchisor's whole FDD may be off-track and unreliable.”