All franchisors face one common business growth challenge: how do I sell my franchise to quality prospective franchisees? If you’ve forayed into the franchise industry to any extent, you know that a franchisor’s Franchise Disclosure Document (FDD) is a cornerstone of any franchise sales program, and – for better or for worse – every prospective franchisee will eventually receive this document and information regarding their prospective franchisor. Some industry professionals may brush off the document as being ‘too legal’ or not helpful in doing true due diligence about a franchise system – however, we advise our clients that there are nuggets of information that can really shed some light about a franchised brand. Whether you’re a prospective franchisee going through the due diligence process, or a franchisor that needs to be prepared to answer questions regarding its disclosures, it is important to note these items in order to dig deeper into the presentation of a franchised network.
Item 19 – Obviously!
Most prospects will flip directly to the Item 19 financial performance representation section of the FDD, which franchisors can use to present a financial picture of units in its system. Outside of limited exceptions, this is the only place that financial performance information should be presented. We won’t spend too much time here on this item as analyzing this section is an article in and of itself, however, it goes without saying that prospects will want to understand whether and how a franchisor presents unit financial information.
Skip Right to Franchisor Financials
After paging to Item 19, the next thing many prospects review are the franchisor financials, which are required to be included as an exhibit, and except in some specific circumstances, are required to be audited. Here, prospects can glean some key information – such as, whether the franchisor has enough capital to be able to meet its ongoing obligations, and invest in infrastructure, support, and other investments needed to grow and evolve a brand. Franchisees can also find other important information such as alternative revenue sources to the franchisor, like supplier or vendor rebates, conference or training revenue, and amounts for the purchase of equipment or other supplies directly from the franchisor. The footnotes to the financials also often contain interesting nuggets of information – including whether third party financing or debt exists, which may include obligations that the franchisor has to third parties.
A Story of Openings and Closures
Item 20 of an FDD requires a franchisor to present state by state information on unit openings and closures over the most recent three fiscal years, plus a list of franchise agreements that have been signed, but for which the unit is not yet open, as of the end of the last fiscal year. Reviewing this information in detail can be the most important way to understand the evolution of a franchised brand. Openings or closure rates alone only tell one part of a story, and can be used to create a list of questions based on the information presented. For example, a franchisor might display a year or multiple year period of significant openings, which can lead to questions as to how the franchisor has capitalized itself and what systems have been created to support such fast growth. The same can be said about a significant number of franchise units which have yet to be opened. As another example, closures can sometimes be limited to a time period or particular geographic region – which may indicate an obstacle that a franchisor faced or results of one particular troubled franchisee – from which the franchisor has strengthened its systems accordingly.
After reviewing Item 20 charts, we also advise reviewing the associated information about franchisees that have left the system or otherwise not communicated with the franchisor within 10 weeks of the issuance date of the disclosure document. This list will display contact information for franchised locations that were bought, but never opened, which invites its own list of questions as to what led to these occurrences.
It’s All About the Ad Fund
The franchisor’s use and management of a system advertising fund can be one of the most contentious points in a franchise system on an ongoing basis. How a franchisor collects and utilizes this money is often of significant importance to franchisees who contribute a percentage or portion of their revenues into the advertising fund, and hope for a return on this investment.
Item 11 of the FDD requires a franchisor to break down how it made expenditures from its ad fund in its last fiscal year. Smart prospective franchisees will review this information to determine whether the ad fund was spent on true marketing initiatives, how much was spent on administrative amounts (i.e., internal salaries and costs), and to determine if funds have been kept in reserves rather than being spent in a particular year.
Supplies and Rebate Revenues
Item 8 of the FDD is designed to present information regarding suppliers to the franchise system, which is often another hotly debated and relevant part of any network. Franchisors commonly either sell items and/or services directly to franchisees, or designate mandatory or preferred suppliers to provide items and services to franchisees. A close reading of this section should help to paint a picture as to under what circumstances a required supplier is used (i.e., a mandatory software vendor), and under what circumstances the franchisor itself is the direct vendor. One key sentence in this section is often the starting point for many conversations: the required disclosure that a franchisor must make regarding the amount of revenue it receives as a result of franchisee purchases in its last fiscal year, displayed also as a percentage of its total revenues. Reading this disclosure carefully in conjunction with the franchisor financial statements can create an important picture in the minds of prospects.
Obviously, up-front initial franchise and other fees (Item 5) and ongoing fees (Item 6) are going to be carefully reviewed by any prospect. However, outside of the list of current fees, franchisors are also required to disclose information about initial fees that they charged in their last fiscal year. This information can be scrutinized to determine if the franchisor offered any discounts or reductions to its standard fees, and can many times be a negotiating point for new prospects entering into the system. This disclosure should be carefully reviewed and understood prior to negotiating any particular discounts, as it can have a real effect on ongoing disclosures and negotiations.
As lawyers, we feel that the entire FDD is important and riveting information, but this list is a starting point on where we direct our franchisor clients to pay attention to their ongoing operational decision-making that may have an effect on these disclosures. We also direct our franchisee clients to these sections to help them evaluate the franchise opportunity presented. Most importantly, we encourage all prospects to truly read and understand the information presented in the disclosure document itself prior to making an investment, as many times purchasing a franchise can be a life changing decision for all parties involved.