Many people are turning to buying a franchise as an alternative to the standard corporate job. They are attracted by the numerous franchise opportunities and the prospect of gaining control over their destiny. The numbers paint a pretty picture as well: according to recent reports, the local franchise industry continues to grow and accounts for more than 3% of the annual GDP.
But, regardless of the business niche you are interested in, if you contemplate the prospect of buying a franchise, you need to first familiarize yourself with the Franchise Disclosure Document (FDD).
What is an FDD?
The FDD is a legal document that every franchise for sale must provide to prospective buyers. The FDD is usually sent by the franchisors a few days before signing the contract or agreeing on any financial transactions.
Most FDDs include the following information:
- An overview of the company’s history
- Initial franchise fees
- Legal obligations for both parties
- Proprietary information and patents
- Termination, transfer, and renewal
Some franchise agreements can also include financial performance representations.
How to Read a Franchise Disclosure Document
A Franchise Disclosure Document runs in hundreds of pages, and it’s usually written in an intimidating language. If you are not familiar with the jargon, it can be hard to comprehend all the important pieces of information. To help you make sense of it and ensure that you won’t be missing any franchise opportunities, we’ll walk you through some of the most important items in an FDD.
Pay Attention to the Franchise Company
Most FDDs begin with a brief history of the franchise for sale and and often include detailed information about the business model, profits, and so on. Although pretty basic, this section can provide valuable insights into the franchise’s past, especially if it has been sold and purchased many times over the years.
Make Sure You Understand the Litigation
Franchisors are required to disclose all litigation they’ve been involved in during the last few years. Don’t get worried if you notice a few claims – even the most successful businesses are bound to have a few cases listed. However, be wary if the franchise has multiple lawsuits or class actions pending that could bankrupt the company.
Carefully Analyze the Estimated Initial Investment
This section details the various costs that you’ll have to pay to become a franchisee. To make sense of the numbers, you need to know what the average initial fees for a similar business are as well as the costs for marketing, equipment, real estate, and so on.
Don’t Neglect the Fees and Expenses
Do yourself a favor and carefully analyze the fees section. Royalties are a regular ongoing fee, but they are not the only ones. Depending on the industry, look for software licensing fees, advertising fees, and so on.
The Financing section of the FDD tells you whether the franchise for sale offers a lending program or if the company has deals with outside lenders. Make sure you understand the financing plan and stipulations. Keep in mind that borrowing from your franchisor is similar to lending money from a bank. Ensure that you follow and respect the credit terms. Otherwise, the franchisor might choose to terminate the agreement.
Trademarks, Patents, and Proprietary Information
This section of the Franchise Disclosure Document is pretty straightforward, and it lists the patents, copyrights, and trademarks that the franchisor has obtained. A trademark that isn’t registered is a red flag, so keep your eyes opened for any potential problems.
Review the Terms of Termination and Renewal
One of the most important things when reading a franchise agreement is ensuring that you understand the relationship between the franchisee and the franchisor. Carefully review the terms of termination and renewal and make sure you understand how disputes will be resolved. As a rule of thumb, try to include as many financial conditions into the renewal as possible.
Analyze the Financial Statements
One key question to ask yourself is whether the franchisor is making the bulk of its revenue from ongoing royalties (a sign of a profitable business) or from selling new franchises (a potential red flag).
Financial Performance Representation
Some FDD can include details about what the franchisees may expect in terms of sales and profits. This critical information can help you determine whether you should invest or keep looking for other franchise opportunities. Unfortunately, this information is voluntary, and about 70% of franchisors choose not to include it in the document.
In some regards, and FDD is similar to a prenuptial agreement: not very romantic, but you’d better read it carefully before you sign it. Keep these tips in mind when selecting your next franchise opportunity.