Before you invest in any franchise, get a copy of the franchisor's Franchise Disclosure Document (FDD). Under the Franchise Rule enforced by the FTC, you must receive the document at least 14 days before you are asked to sign any contract or pay any money to the franchisor or an affiliate of the franchisor. You have the right to ask for - and get - a copy of the FDD once the franchisor has received your application and agreed to consider it. Indeed, you may want to get a copy of the franchisor's FDD before you spend any money to investigate the franchise offering.
The franchisor may give you a copy of its FDD on paper, via email, through a web page or on a disc. The cover of the FDD must provide information about the available formats. Make sure you have a copy of the FDD in a format that is convenient for you, and keep a copy for reference. Read each of the 23 numbered Items in the FDD. Don't be shy about asking for explanations, clarifications and answers to your questions before you invest. Here are some key sections of the FDD:
Franchisor's Background (FDD Item 1)
Item 1 tells you how long the franchisor has been in business and its likely competition. It also lets you know if there any legal requirements unique to the franchised business, like a requirement that you get a special license or permit. This will help you understand the costs and risks you will take on if you purchase and operate the franchise.
Business Background (FDD Item 2)
Item 2 identifies the executives of the franchise system and describes their experience. Pay attention to their general business backgrounds, their experience in managing a franchise system and how long they've been with the franchisor.
Litigation History (FDD Item 3)
Item 3 lists important information about prior litigation - whether the franchisor or any of its executive officers have been convicted of felonies involving fraud, violations of franchise law, or unfair or deceptive practices law, or are subject to any state or federal injunctions involving similar misconduct. This item will tell you whether the franchisor or any of its executives have been held liable for - or settled civil actions involving - the franchise relationship. If there have been many claims against the franchisor, it may mean the franchisor has not performed according to its agreements. Or it could show that franchisees are dissatisfied with its performance.
Item 3 also should say whether the franchisor has sued any of its franchisees during the last year. That disclosure may indicate common types of problems in the franchise system. For example, if a franchisor sued franchisees for failing to pay royalties, it could be because franchisees weren't successful, and weren't willing or able to make their royalty payments.
Bankruptcy (FDD Item 4)
Item 4 discloses whether the franchisor or its predecessor, affiliates or any of its executives have been involved in a recent bankruptcy. If the franchisor or its predecessor or affiliate has declared bankruptcy, carefully review the franchisor's financial statements in Item 21 of the FDD to see if the franchisor is financially capable of delivering the support services it promises. Consider having an accountant review the required financial statements too.
Initial and Ongoing Costs (FDD Items 5-7)
These items describe some of the costs involved in starting and operating a franchise, including deposits or franchise fees that may be non-refundable, and costs for initial inventory, signs, equipment, leases or rentals. It also explains ongoing costs, like royalties and advertising fees. In addition, ask or find out about:
- grand opening or other initial business promotions
- business and operating licenses
- product or service supply costs
- real estate and leasehold improvements
- required equipment, such as a computer system or a security system
- business insurance
- compliance with local ordinances, such as zoning, waste removal, and fire and other safety codes
- employee salaries
You'll need to investigate other initial and ongoing costs that aren't described in Items 5-7, such as the cost of accounting and legal help. It may take several months to start your business, and it may take more than a year to break even. Some franchises never break even. Estimate your operating expenses for the first year and your personal living expenses for up to two years. Compare your cost estimates for the franchise with what other franchisees in this system and competing systems have paid. An accountant can help you evaluate this information. You may be able to do better with another franchisor.
Supplier, Territory and Customer Restrictions (FDD Items 8 and 12)
These items tell you whether the franchisor limits:
- suppliers from whom you may purchase goods
- the goods or services you may offer for sale
- where and to whom you can sell goods or services
- your use of the internet to sell goods or services to customers within and outside your territory
- the right of the franchisor (or other franchisees) to use the internet to solicit customers or to sell in your territory
These kinds of restrictions may limit your ability to exercise your own business judgment in operating your outlet. If the franchisor does not limit the territory where each franchisee can sell, the franchisor and other franchisees may compete with you for the same customers by establishing their own outlets or selling through the internet, catalogs or telemarketing.
Franchisor's Advertising and Training (FDD Item 11)
The FDD includes important summaries of the franchise system's advertising programs and the initial and ongoing training the franchisor will provide . Talk to the franchisor and current franchisees to get answers to your questions.
Franchisees are often required to contribute a percentage of their sales to one or more national, regional or local advertising funds. Ask the franchisor what advertising it has done and what is being planned.
Ask whether franchisees have any control over how advertising dollars are spent, and if all franchisees and company outlets contribute equally to the advertising funds. Find out if the franchisor gets a commission or rebate when it places ads. If there is a rebate, who benefits - you or the franchisor?
See what percentage of the fund is spent on:
- administrative costs
- national advertising
- advertising in your area
- selling more franchises
- other expenses
Read Item 11 to learn whether franchisees need the franchisor's consent to develop and buy their own advertising. If they buy their own advertising, do they get a rebate or discount on their advertising contribution?
New franchisees typically count on the franchisor to provide all the business and operational training needed to run a successful franchise. The training you need depends on your business experience and knowledge of the franchisor's goods and services. Check Item 11 for information about:
- the trainers and their qualifications
- who is eligible for training
- the cost of training new employees and who pays
- the length of training sessions
- the amount of time spent on technical training, business management training and marketing
- whether the franchisor offers ongoing training and at what cost
- whether support staff are available for trouble-shooting in your area and how many franchisees they are responsible for
- whether on-site individual assistance is available and at what cost
- Be sure to talk with recent franchisees about the quality of training the franchisor provides. If - after you read the information in Item 11 and talk with franchisees - you still aren't sure you'll get the training you need, ask the franchisor if you can review the training materials. If the franchisor won't provide them, even if you volunteer to sign a confidentiality agreement, consider a different franchise opportunity.
Renewal, Termination, Transfer and Dispute Resolution (FDD Item 17)
Item 17 covers important topics. First, it states whether you can renew your franchise at the end of the term, and, if you can renew:
- what you must do to qualify for renewal
- whether fees and other contract terms may change
Item 17 also explains what your obligations would be to the franchisor after termination. For example, after termination, restrictions in the contract typically will stop you from operating a business that would compete with your prior franchise, if the new business is within a specified distance of your prior outlet.
The restrictions may also prevent you from operating a new business within a specified distance of any other outlets of the franchise. The restrictions may last as long as three years.
Additionally, Item 17 describes what you must do to get the franchisor's approval if you want to sell your franchise. Lastly, it states whether you have the right to go to court if you have a dispute with the franchisor, or must use arbitration instead.