Understanding the Franchise Disclosure Document and Franchise Validation
The FDD (Franchise Disclosure Agreement) contains 23 items, but some are more important than others.
One of the most important items for you is Item 20—the list of outlets—since the best way to understand any franchise operation is to interview their franchisees, who can provide you an accurate, up-to-the-minute view of what it’s like to run this business.
We’ll break down the FDD, dig into the interview process, and give some helpful questions for other franchisees in this post.
The Most Important Aspects of the Franchise Disclosure Document
The Franchisor (Item 1)
The very first page gives you the business history of the franchisor, where it is incorporated, other names under which it has operated, and a general description of the business.
Litigation (Item 3)
You’re not looking for a gotcha moment for a single lawsuit, but if you see a history of many lawsuits or arbitration cases brought by franchisees, heed the warning, stop reading, and cross this franchise off your list. Frequent lawsuit activity between the franchisor and franchisees indicates an unusually combative franchisor. If you were foolish enough to join that franchise organization, you should expect them to be just as combative with you, and that’s not what you want from the people whose support you are counting on.
Initial Fees and Investment Costs (Items 5-7)
You can learn how much this operation will cost you. How great is that! I can think of no more valuable information than learning exactly how much capital you will need to get your business up and running. By contrast, when you start your own independent business, any number you come up with is, at best, an educated guess.
The cost breakdown will include your initial fees, royalty fees, estimates of wages and other labor costs, training, lease payments, costs to furnish your office or store, inventory, signs, advertising, insurance, etc.
Don’t gloss over the numbers. This section will tell you how much money you will need to run your business for several months. Let me repeat. You need enough money to pay your bills until your business becomes profitable and this section will tell you how much that is. Without enough start-up capital, your business could founder.
The one item not included will be how much it will cost you to live until your new business starts turning a profit. Every new business has a ramp-up phase, and you have to be prepared to cover your own living expenses during that period.
Since the number-one reason businesses fail is inaccurately estimating start-up costs, getting the rundown on how much it will cost should enable you to choose a business that actually fits your budget, so you can succeed for the long haul.
Franchise Territory (Item 12)
Some franchises have what is called a protected or exclusive territory. This is a promise that they will not allow another franchisee to operate within a specified distance of your location. Franchisors have different ways of determining a territory, which is meant to protect current franchisees but may not be satisfactory to you. Protected territories are not necessarily better, but you do want to understand the parameters, so you can ensure you have a sufficient market to make a good income.
Earnings Claim (Item 19)
Only about a third of all franchises make earnings claims. Since earnings for individual franchises can vary substantially, we recommend you verify any numbers you see in this section with individual franchisees.
List of Franchise Outlets (Item 20)
This is where you will find the key that will help you open the door to a successful business future: the names, locations and phone numbers of all franchisees currently operating, as well as franchisees no longer operating. You should call as many as you can, both current and former franchisees, to learn about their businesses. Have the franchisor’s support systems been helpful? How long did it take for them to become profitable? Are they satisfied with the franchise? Would they purchase this franchise again? If not, what went wrong?
We recommend you have in-depth conversations with any owners you find who are failing. Sometimes you can learn more from someone who failed than from the biggest success stories. Tips on how best to interview franchisees are covered in the next section.
Franchise Financial Statements (Item 21)
Franchisors are required to include copies of their audited financial statements for the three most recent fiscal years. Review these to ensure the company is solvent. If you aren’t comfortable reading and interpreting the financial statement, then have an accountant look it over to ensure the financial stability of the company. It will be the best $150 you ever spent.
While less important, you should also take note of:
Restrictions (Items 16-17)
Franchisors may restrict from whom you order supplies, what you may offer for sale, and where you can sell.
Training (Item 11)
While franchisors offer training, you need to know who is eligible for training and who pays. Are new employees eligible? Are support staff available for ongoing support? Again, make sure you know all the costs.
Advertising (Item 11)
Franchisees are often asked to contribute a portion of their earnings for advertising. Get the details on what the franchisor requires. Will you need to supplement the national advertising campaign with local advertising? Usually you will, so take that expense into account. Also see Items 6-8.
Before signing any contracts, we recommend you consult a franchise attorney who has the expertise to help you review what can be a long and complex agreement. And do yourself a favor: Make sure the attorney you select specializes in franchising. Only a specialist has the expertise to know exactly what to look for in the franchise contract to protect you.
As you get closer to a decision, you should know:
A Franchisee’s Obligations
If you don’t agree with all the expectations for how you must operate, this business is not for you. Find this information in Item 9.
Renewal and Termination Procedures
The franchisor is also required to detail how a franchise can be terminated or ownership transferred or renewed. Know these details upfront, because there will come a time when you want to sell, either to retire with your hard-earned wealth, or for a tidy profit. Advice from a franchise attorney is well worth the cost.
Why Franchisees Have Left the System?
With the list of outlets in the FDD (Item 20) you also get contacts for franchisees who have left the system recently. Call them and find out why. If you learn about a pattern of neglect or, perhaps, complaints of wrongful termination of a contract, you might want to back away. Just remember, sometimes the fault lies with the franchisee, and don’t take just one person’s word for it.
What Current Franchisees Say About the Franchisor?
Your best resource—bar none—are franchisees who can tell you from experience how well the franchisor’s services match the hype. Many will even share some of their financial information, such as how long it took to start operating in the black, how much you might realistically be able to earn, etc.
Bottom line: What works for them? Are they making money? Are they happy with the program?
While your research may take some time, and expert advice may add some expense, the payoff is in the end result:
You can choose a great franchise. One that gives you the life and the living you always wished for, and that works for you in the long run.
Interviewing Your Way to Success
Once you have read through the FDD, where you can get the list of franchisees, you should start calling them. You can learn from no better source how the franchisor’s system works. Besides all the issues mentioned above, we have a list of questions in the appendix, which you should consult and use as a worksheet when calling franchisees. Keeping a good record of your interviews will allow you to compare and contrast what you hear from different people, considering their locations and specific aspects of their personal experience.
As we mentioned, you should also make a point to talk to franchisees who have not been successful. Find out what went wrong. Remember, sometimes people shortchange their research process and choose franchises that don’t suit their expertise, interests, or personality, and this can cause failure as much as problems stemming from the franchisor.
Every good interview follows the same basic steps. Ask a friend to help you practice before you begin to locate, contact and interview your way to the right franchise.
A Critical Opportunity to Verify the FDD
The FDD includes many financial estimates, and interviewing franchisees is your opportunity to verify them. You can ask the owners what their average revenues are for franchise units after one, two, or three years and what their profit margins are. You can also confirm the amount of investment the franchise requires. Pay particularly close attention to how accurate the franchisor’s claims are in the FDD.
Don’t be surprised if many franchise owners cannot answer questions about costs or profit margins. Not everyone who becomes an owner knows those figures, but you should be able to find some owners who are very familiar with their financial metrics and are willing to share their observations with you.
If you have trouble locating franchisees with this type of knowledge, ask the franchisor to direct you to someone who is able to help answer these crucial questions. And if you don’t know exactly what to ask to get the information you are seeking, ask your franchise coach for a tip.
Be Cordial and Gracious
Remember you are imposing on the franchisee’s time, so when you call, get right to the point: You are interested in the franchise and are hoping he or she might have a few minutes to talk about his or her experiences. Ask if this is a good time or when might be a good time to call back.
Often, it will work well to email the franchisees in order to schedule a specific time to talk together.
Plan Your Franchisee Interview
You might want to plan a couple of layers to your interview. First, prepare a few questions that would take no more than 15 minutes of the franchisee’s time. Then write additional questions you might get to if the franchisee does have the time. Ask questions that you want answered specifically by a franchisee—what this person knows that you cannot otherwise learn from any prepared written material. In other words, don’t waste their time on questions easily answered by the franchisor’s promotional materials.
Show Respect
You may not like everything the franchisees tell you, but you’re after their perspective. For owners who may be struggling, the most important information you want to get is whether they are following the franchisor’s system. How do you learn this? By the time you are having this conversation, you will know the components of the franchise system.
If owners of a particular franchise are directed to spend $2,000 per month on advertising, you will want to ask each owner how much they spend. If they tell you, “Everybody knows advertising doesn’t work, so I don’t advertise,” you have found the reason they aren’t successful.
Listen
The most important time during your interview is when you’re not talking. Try to draw out as much information as possible from the franchisee by asking succinct questions, and then stop talking. Sometimes people need a few moments to clarify their thoughts before responding.
Clarify
Even with the best listening skills, you may miss some of what is said. Don’t be shy about asking your source to repeat something or clarify an answer you may not have understood. As most journalism professors will tell you, there’s no such thing as a stupid question. Worse is skipping the question you wish you had asked.
Make sure you ask for specific examples, evidence, which can help you understand the story better. For example, when you ask, “Did a franchisor’s actions live up to their promises?” make sure you learn how and in what circumstances they did or didn’t. But be careful not to turn your friendly conversation into an interrogation.
Follow-Up
As you go through your notes and something important pops out that you fear you may have misunderstood or gotten wrong in your notes, call back. Most people appreciate conscientious attempts to get it right. Just remember to be respectful of the franchisee’s time. And it never hurts to drop a thank-you email after the interview. You might want to keep these lines of communication open for the future.
Specific Questions for Franchisees
Why did you choose this franchise?
Listen for: Does the franchisee have anything in common with you? Can you see yourself in his or her shoes? Do you have the skills necessary to run this business?
Have you been satisfied with the level of support and training from the franchisor?
Was it all that the franchisor promised? Do the support staff and executives of the franchisor know their stuff? Are they easy to work with?
What do you like best and least about the business?
Get a good feel for what running this business is all about. Maybe the best thing is the social interaction with customers. If you don’t want to deal with the public, that sort of need for connection could indicate this franchise won’t suit you. Choosing a business can be a lot like choosing a spouse. The match has to be particular to you.
Would you purchase this franchise again?
If the answer is no, find out why. These reasons may not be true for you.
How long should it take to reach break-even?
You need to know how much capital it would take to get this business to profitability.
Are you able to earn six figures with this business?
While you may not be able to get specifics on their earnings, press for as much information as you can to see how it aligns with the franchisor’s sales pitch. Getting information on earnings from franchisees is a critical aspect of your research. Why? They’re the only source from which you can get actual numbers because franchisor executives are prohibited from discussing detailed financial information with you.
What are the keys to success with this franchise?
In most businesses, to become successful, some features of operating the business matter more than others. For example, business success might hinge more directly on developing employees, networking in your local community or managing the advertising programs. Make sure you understand which aspects of the business matter most in the franchise you are considering.
What do you spend most of your day doing?
Learning what the owners focus their time on can help you understand if this is the right business match for you. Maybe the workdays of successful owners are largely spent on sales activities, such as networking. If that is not your skill or interest, then this franchise might not be the right one for you. As we often point out, the role of the owner should closely match your skills and interests.
Determine If a Franchise Operation Matches the Hype
The stories are legion about people who have breathed new life into their careers with a franchise or even several franchises. But there are also some pretty notable misses in the franchise business, as well. Just think Quiznos or Curves, two franchise systems which have faltered for different reasons: Quiznos, the once promising sandwich shop, fell into bankruptcy and Curves, fitness centers for women of a certain size, is a shadow of its former self.
While it’s true that nothing in life is guaranteed, you can do quite a bit to minimize your risk by thoroughly checking into a franchisor’s track record. As we discussed previously, you must always include in your research a thorough reading of the FDD. Or, if you know you’re not likely to read it, ask someone else to read it for you. Better still, have the FDD reviewed by an attorney who specializes in franchising.
Item 20 of the FDD tells you both how many people have joined the franchise as new owners and how many have left. If you see a franchise that is not growing, or more alarming, getting smaller, you will want to understand why.
How In-Depth Due Diligence Led to Success for Rachel
Rachel Tilow took her time while searching for her second franchise business, determined to spend as much time on research as it took to feel comfortable with her decision to commit to a new business. She knew from experience how good it feels to be in a business you love. Likewise, she had seen her share of struggling franchisees and knew problems often stem from leaping before looking.
Tilow enjoyed the 16 years she spent as a successful franchisee of Gymboree, a parent-child play center, that she had often visited when her son was a toddler. When she moved to Tampa, Fla., she went looking for a Gymboree and couldn’t find one. So she opened one of her own.
But not before conducting a thorough vetting of the company.
Even though she loved the whole concept, she did her due diligence, taking a full year from when she started investigating the franchise business to her opening day. During her research, she talked to many of the already existing franchisees. She knew she wanted to make money and have a flexible schedule, so she could spend time with her young son.
When she bought in, she was franchise No. 184, and when she sold the franchise 16 years later in 2005, there were more than 500 franchisees. Gymboree has evolved to include a large retail business, but back when she first bought, Gymboree was a play center that offered mom and baby classes.
As a franchisee, Tilow loved having the ability to share ideas with her network of fellow franchisees. After she sold, Tilow continued in business, first as a landlord and property manager, then the owner of a produce business. After relocating to another city, she decided to look into buying another franchise business.
This time she reviewed a couple of franchise companies to start. The first franchise on her list didn’t seem exactly forthcoming when answering her questions.
“They were awful at communicating with me,” Tilow said, and when she asked for the Franchise Disclosure Document, “I had to request it six times before they actually sent it.”
The upshot: “I didn’t trust the franchisor.” So, she moved on to investigate the next one.
This was a tax preparation business that promised franchisees would need only to work three months of the year to make enough for the entire rest of the year. After talking to 20 franchisees—incidentally, way more than most people call—she learned the sales pitch didn’t hold up to scrutiny.
When her franchise coach mentioned The Groutsmith, of Sarasota, Florida, Tilow immediately had an interest in the basic, no-frills business of grout cleaning and restoration.
Since her top goal was to make money, she called every franchise, other than those related to the owners, which was just under 35 in this small operation, and she learned “they were all making money right off the bat. They raved about the franchise. No one had anything negative to say.
Content with what she had learned, Tilow bought in and became franchise owner No. 36. This time, her entire investigation process, from start to decision, took her only five weeks.
The Groutsmith system allows franchisees to keep their overhead low, Tilow noted, and she keeps her office in her home and rents a small storage unit. She has one employee, who started part time then moved to full time as soon as the business grew enough to fill the hours, about 10 weeks after they opened. Just as the other franchisees told her, Tilow started making money pretty quickly and started paying herself a salary when she was only two weeks in.
She says the franchise company always has someone available when she calls with a question. “They are extremely supportive,” she said, plus her fellow franchisees are also a great source of support.
The key to doing well with a franchise business is to understand exactly what you’re getting into, so that when you start your business you already know this is a business model you can follow. Then you need to follow it.
“People buy franchises and they just think they have a better idea of how to run the business,” she observed, then added, “but that’s a recipe for failure.”
This blog sourced from and accredited to Dan Citrenbaum, Author of Own Success;
Permission granted by Dan Citrenbaum.