How to Read an FDD

Running a franchise comes with a lot of risk and responsibility. To make sure you fully understand the risks involved, franchisors are legally required to provide you with a Financial Disclosure Document (FDD) at least 14 days before you enter into a franchising agreement. These documents will include most of the information you need to know to decide whether or not buying the franchise is a good choice.

However, FDDs can often cause more confusion than they resolve. And if you’re new to franchising, you might not know which red flags to keep your eyes peeled for. In this guide, I’ll explain how to properly read an FDD. You’ll find out about the type of information included, where you’ll find it, and some common warning signs to look out for.

Key Takeaways

• Review the history and experience of the franchisor and its key executives to assess their expertise and stability.
• Examine all fees, including initial franchise fees, royalties, and estimated startup costs, to ensure they align with your financial capabilities.
• Investigate any past legal issues or bankruptcies involving the franchisor or its executives to identify potential red flags.
• If provided, scrutinize the earnings claims to gauge the potential profitability of the franchise.
• Seek advice from franchise attorneys and accountants to thoroughly understand the FDD and its implications.
• Carefully reviewing the FDD with these considerations can help you make the right decision about investing in a franchise.

Understanding the Franchise Disclosure Document

Up until a few decades ago, the lack of regulation in the franchising industry made it a hotbed for scammers. So, to prevent franchising scams from taking place on such a large scale, the Federal Trade Commission (FTC) implemented what became known as the FTC rule in 1978. This law requires franchisors to provide potential franchisees with a Financial Disclosure Document (FDD) at least two weeks before signing the Franchise Agreement or paying any fees.

The purpose of the FDD is to provide you with enough validated and vetted information about the franchisor to make an informed decision about whether the franchise is worth your investment before you enter into a franchise agreement. Before buying a new franchise, you need to review the FDD with a fine-toothed comb, ideally with an experienced franchising expert. 

How to Read and Review an FDD

Depending on the franchise, the FDD may be over a hundred pages long and will include a lot of information. Go in blind and attempt to read the FDD without any prior franchise knowledge, and you are bound to miss some things. An FDD typically contains at least 23 distinct sections (or items), each serving to provide answers to specific questions about the franchising opportunity. Below, I’ve grouped some of the most important items with the key questions they answer.

How Much Does the Franchise Cost?

One of the most crucial questions the FDD answers about a franchise is the total cost of the investment. You obviously shouldn’t purchase a franchise without thoroughly understanding how much it will cost.

In addition to the initial franchise fee, the FDD should provide details on costs such as ongoing royalty fees, renewal rates, advertising contributions, and any other costs that may arise during your tenure as a franchisee.

Here’s where you’ll find more information about franchise costs in the FDD.

Item 5

This section details the initial fees associated with becoming a franchisee, including the franchise fee, supplies and materials, and any applicable multi-unit fees.

Item 6

Here, you’ll discover information about ongoing costs such as royalty, marketing, renewal, training, and technology fees.

Item 7

Item 7 gives you a realistic estimate of how much it will cost in total to open a franchise. It combines the initial investment fees covered in Item 5 with estimates for signage, IT infrastructure, lease deposits, insurance fees, grand opening expenses, and any other fee that will contribute to the total cost of your initial investment.

Support You’ll Receive From the Franchisor

Investors are often attracted to franchising because it allows them to capitalize on the reputation of a well-known brand while utilizing a proven, successful business model. Another major benefit of franchising is that you’ll generally receive ongoing support from the franchisor to mitigate risks and maximize the chances of business success. You should expect to receive some level of support from your franchisor in return for your ongoing royalty payments. However, the amount of support you’ll get varies significantly depending on the parent company. So, carefully read through the following FDD items to find out what type of support your potential franchisor provides.

Item 8

Item 8 details your suppliers for materials and inventory, which is especially crucial if you intend to operate a franchise in the fast-food or restaurant industry.

Item 11

This section summarises the ongoing assistance you’ll receive through training and operational procedures as a franchisee.

Item 12

Here, you can discover how your franchisor defines a territory and allocates territorial rights.

Item 14

Check Item 14 to learn more about the franchisor’s intellectual property and copyrights.

Item 15

Lastly, Item 15 details franchise renewal fees, termination grounds, dispute resolution procedures, and transfer options.

Franchisee Obligations

The FDD is crucial in helping you determine your rights and roles as a franchisee, but it also details your obligations to your franchisor. In the following sections, you’ll find your dos and don’ts as a franchisee.

Item 8

As a franchisee, you’ll face limitations on where you can source products and materials, the details of which are covered in Item 8 of the FDD.

Item 9

Item 9 outlines your specific obligations to your franchisor.

Item 15

This section details your ongoing obligations in the business, specifically which aspects require your personal involvement.

Franchisor’s History and Reputation

The FDD is one of the first places to look when attempting to gain insights into a franchisor’s reputation and history. Before paying the fees and signing an agreement with the franchisor, you need to know whether the brand has previously filed for bankruptcy or has a history of litigation. You should also look into the franchisor’s experience, their history as a franchise, management team, and current operations.

Item 1

You’ll find details regarding the franchisor’s parent companies, affiliated entities, and predecessors in Item 1.

Item 2

Item 2 offers details on the experience of the franchisor’s founder or CEO and management team. You’ll also find information on the business’s operational history.

Item 3

Here, you can discover the franchisor’s history of litigation covering the previous ten years. Item 3 should also discuss whether the business is currently involved in litigation.

Item 4

Read Item 4 to find out whether the brand has ever declared bankruptcy.

Item 20

This section details the franchisor’s existing franchised outlets.

Financial Expectations

Naturally, as a prospective franchisee, you’ll want to gain insights into your potential earnings. It’s worth noting that franchisors aren’t always legally required to include details regarding their financial performance in the FDD. However, if financial information is included, you’ll find it in the following section:

Item 19

Item 19 serves as the only source of information on the financial performance of a franchisor, and its inclusion is not mandatory. The franchisor is free to include as much or as little information as they see fit.

Renewal and Contract Terms

When you start out as a franchisee, you’ll sign a Franchise Agreement for a set term, usually five or ten years. Once this term ends, you may have the option to renew your agreement. It’s important to understand how long your franchise contract is valid and how much you’ll need to pay to renew the contract down the road.

Item 17

Pay close attention to Item 17 as it details your rights as a franchisee and what you’ll lose in the event of a termination of transfer. You’ll also find details such as non-compete provisions and any obligations you’ll be left with once the franchise relationship terminates.

Tips for Properly Understanding the FDD

You can think of the 14 days (minimum) you have to review the FDD as your dating period with the franchisor before you enter a legally binding “marriage”. Make the most of your short time with this document by keeping these tips in mind:

Don’t Be Afraid to Ask the Franchisor Questions

The FDD is usually drafted by a franchising attorney and can run for hundreds of pages. It can also be packed with dense language and technical jargon that can be confusing, even for franchise experts. This is why I strongly recommend asking the franchisor as many questions as you need to feel comfortable. Don’t hold back in an attempt to remain in a favorable light.

Talk with a Franchise Expert

While it’s a good idea to ask questions, it’s also wise to remember that franchisors may provide answers based on their best interests. If you want peace of mind regarding the terms and details of the FDD before you press ahead with negotiations, I recommend enlisting the services of a franchise expert who’s perused countless FDDs and knows all the red flags and details to look for.

Read the Fine Print

It’s relatively easy for important details to get buried in the fine print of large documents like FDDs. Reading through hundreds of pages of legal jargon might not be exciting, but it’s crucial to do so when determining if a franchise is a good fit for you. Make sure you understand every tiny detail in the FDD before signing any legally binding contracts.

How to Determine If a Franchise Is a Good Fit

Now that you know what information an FDD contains and where it’s all hidden, let me shed light on some of the most common red flags to look out for.

Lack of Executive Experience

I recommend choosing a franchise run by a team of executives with plenty of experience in franchising. An executive team with minimal experience or a history of failures with other companies is a major red flag.

Litigation

Companies can become embroiled in lawsuits for all sorts of reasons, but you should steer clear of franchisors that have had multiple lawsuits filed by franchisees, especially if they allege misrepresentation or fraud.

Working Capital Estimates

Item 7 of the FDD details estimates for the working capital required to sustain the business until it becomes profitable. However, you should not assume that the figure provided in Item 7 is sufficient. Many franchisees face problems due to undercapitalization. Before entering into a franchise agreement, ask other franchisees in the organization how long it took them to break even.

Supplier Prices

Franchisees are often required to source their products and materials from designated suppliers, which typically give heavy discounts to the franchise. That said, you should ask other franchisees if they pay fair prices for materials and inventory. 

Qualifying Language

The FDD will set out your franchisor’s ongoing support and advertising obligations. However, beware of any vague language surrounding the support you’ll receive. Wording like “as needed” or “at our discretion” is unclear and can leave the door open for interpretation.

If the FDD uses qualifying language, you should keep in mind that you might have difficulty accessing certain services. Moreover, if you have no say in how your contributions to the advertising fund are spent, you can consider it a red flag.

Territory

Some franchisors provide no exclusive territorial rights to their franchisees, meaning a competing franchise for the same brand can open shop right next door to you. If you have been given exclusive rights to a territory, check what happens to those rights at the end of your franchise agreement. You may lose those rights when it comes to renewal.

Understand the Franchise Before You Commit

Knowing how to properly read an FDD is key to making a smart franchise investment. It provides the transparency needed to evaluate costs, obligations, and potential risks before committing to the legally binding franchise agreement. Whether you’re reviewing an FDD for the first time or simply want to make sure you have a thorough understanding of the document, take the time to read each section carefully to avoid any surprises down the road. If you’re looking for the right franchise opportunity, Franzy is here to help. Our platform connects you with top franchise brands, provides data-driven insights, and simplifies the research process.