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As you learned in my last column, How to assess a potential franchise, it is important to exercise due diligence when it comes to buying a franchise. Much of your time and money is at stake, so you need to know everything about the franchise you want to buy.
Contacting other franchise owners before making big decisions is a necessary step as it gives you an idea of the business you may one day join. Now that you’ve heard what other franchisees have to say, it’s time to dig a little deeper and take a look at the franchise disclosure document, or FDD.
The FDD is not a legally binding document. It is simply a disclosure that each franchisor must provide to all potential franchisees at least 14 calendar days before the signing of a franchise agreement. Its goal is to protect franchisees by revealing everything they need to know before making their investment decision.
Related: Do Franchise Owners Have Sales Quotas? The king of the franchise explains.
You, as a potential franchisee, have the right to request the FDD from the franchisor once the franchisor has received and accepted your request. The FDD can be given to you in print, online or digital form. If you want to access an FDD online, use FDD Exchange to find the FDD of the company you are looking for.
By examining the FDD for the franchise that interests you, you will notice that there are 23 categories that the franchisor must disclose. While it is important to read each category carefully, some deserve special attention. Here are the top five things to watch out for when reading the document:
1. The franchisor, its predecessors and its affiliates
It is important to read the first point carefully, as it provides a history of the business, describes the business model and talks about all of the affiliated businesses. In addition, the first point also deals with competition and industry regulations – extremely important information to note for any potential franchisee.
This section discloses any previous or ongoing litigation against the franchisor, which may include convictions for fraud, violation of the franchise law, unfair or deceptive practices or any other related fault. It also discloses all cases in which the franchisor has brought civil action against a franchisee in the past year or vice versa.
If there are a lot of two-way disputes, this can be an alarm signal that there are problems in the system. This could indicate that the franchisor has not respected the agreements or, on the other hand, that the franchisees are unable to make their payments. If you see any of these warning signs, be sure to explore them further as this may mean that it is a deductible that you should avoid.
3. Initial franchise fee and other fees
Item five provides a disclosure of the fees that must be paid to enter the franchise. This includes franchise fees or deposits that must be paid to obtain franchise ownership. Point six describes the fees that will be paid to the franchisor on an ongoing basis, such as royalties and advertising. It is essential to understand what to expect financially before making big decisions.
Related: franchises that did not exist three years ago
4. Initial investment
Point seven provides information on the cost of opening the business and operating it for the first few months, including a table of estimated expenses. Most businesses do not start making a profit until a few months after they open. In many cases, it can take a full year for a new franchisee to emerge from the red. Pay close attention to this section to find out if you can afford to go into business with this particular franchise.
5. List of franchised outlets
This section provides a list of all franchisees who are or have been in the system, along with their contact information. Pay close attention to the numbers, as many franchisees leaving the system may be a sign that it is not a good franchise investment.
Franchisee contact information can be your best resource for determining if this franchise is right for you. Call as many current and past franchisees as possible and ask them questions. If you find that many franchisees are not happy with their experiences, it may be time to explore other options.
6. Representation of financial performance
Most potential franchisees believe that section 19 is the most important part of the FDD and move on immediately. I would say, and many lawyers would agree, that it is much less important than you think. The information in this section is rarely complete. Most articles 19 give you an overview of some information, but not enough to allow you to fully understand the revenue potential, standards and averages across the entire franchise system.
If you want to understand the real income potential, the best way to do this is to interview existing franchises and generate profits and losses from top to bottom.
The FDD may seem long and confusing at first, but once you delve into it, you will find that it is a simple document intended to protect you as a franchisee. Pay special attention when reading the first five sections listed above, but be sure to read the other sections as well. If you are unsure of anything, be sure to consult a lawyer for help before signing any legal contracts.
It can be an exciting time. Going into a franchise is an important and potentially very rewarding decision. Staying careful, informed and diligent will help keep the process as stress-free and as pleasant as possible.
Related: 5 Things You Should Know About Franchising – But Won’t Find Online