Top 5 FDD Red Flags

A franchise disclosure document may seem fairly cut-and-dry, but prospective franchisees would do well to keep their eyes peeled for some very specific red flags. 1851 Franchise spoke with Tom Spadea, a founding partner of Philadelphia-based Spadea Lignana LLC to learn more about where these problem areas may pop up in the FDD review process.

For starters, Spadea noted the importance of actually reading the FDD. While it’s perfectly acceptable to want a lawyer to look it over, he strongly advises prospective franchisees to make sure they take the time to review the FDD themselves.

“If you’re not a big reader and you’re not a very process-oriented person, you will struggle and be unhappy in franchising,” he said, adding that it takes a certain personality to want to learn and follow a process. A franchisor, he noted, will follow up with information on things like how to market the business and the operations manual.

“The reading doesn’t end,” Spadea said. “So if you don’t like reading and you don’t want to study or learn what you’re getting into, then you really are going to struggle as a franchisee.”  

Here are five red flags prospective franchisees should look out for when reviewing an FDD.

Litigation

Litigation is the first thing a prospective franchisee should scour in an FDD, Spadea said. He noted that a larger system with thousands of units that’s been around for 20 to 30 years will be bound to have litigation listed in Item 3 of an FDD, but a smaller, emerging brand with litigation is another matter.

“I think there are so many steps to solve problems before the point where either side is upset enough to resort to the courts,” he said. “So I think that’s a red flag. I think it tells potentially of an underlying culture problem.”

The management team

Spadea advises prospective franchisees to look at every person in Item 3 of an FDD and use online resources such as Google and LinkedIn to research the management team and see whether they have franchising experience. A red flag, he said, would be people who have been jumping around.

“You’re essentially hiring the management team to teach you this new business,” he said. “You should view it as an interview. Their background and five-year work history is right there in the FDD. It’s a wonderful starting point to do due diligence on these people.”

Costs

Franchisees need to keep an eye out for hidden costs.

“Sometimes there are a lot of hidden costs buried in the FDD that franchisees don’t realize are there,” Spadea said. “You’ll see how much income and profit the franchisor generated from purchases that the franchisees were required to make.”

Costs, he said, speak to the culture of the franchisor, and franchisees should note, for example, whether a company has a nickel-and-dime type of culture.

“Do they look at royalties as just a profit center and then make franchisees pay for everything else?” he asked, adding that “You’re just trying to discern what it is the franchisor is all about. How do they really act?”

Weak financial statements

Spadea noted that franchisors sometimes have multiple entities. If it’s an emerging brand, they might have little cash in the company, which can be an issue.

“Does the franchisor have the financial resources to really see through all of the things that they’re promising to do?” he asked. “Weak financials are definitely a red flag and they have to be in there.”

Sold-but-not-open units

Too much growth can be just as damaging to a franchisor as too little. Brands that have sold many franchises but haven’t opened them are an enormous red flag, Spadea said.

“A prospective franchisee should look in the FDD to figure out how many sold-but-not-open stores are in the system,” he said. “Basically, these are people who have paid the franchise fee. The franchisor has some commitment to support them, so when you see 20 open stores and 50 more that are sold but haven’t opened yet, you’re going to be number 51. Are you really going to get the attention and the support from the franchisor that you expect? I think that’s an important thing to look at and discuss with the franchisor."