Breaking Down an FDD
Once you've found a franchise (or multiple franchises) that you are interested, the real research and diligence process begins. You need to figure out whether the franchise you are looking at really makes sense for you from a financial and lifestyle perspective. Your best source of information for all of this is the Franchise Disclosure Document, or FDD.
Every franchisor is required by law to provide an FDD to a prospective franchisee at least 14 days before the signing of a franchise agreement. This requirement is to ensure that anyone opening a franchise has all of the necessary information at hand to make a fully informed decision. Even still, understanding an FDD can be a tricky process. They tend to be over 100 pages long and finding the exact information you need to understand can be frustrating. Below we break down the major sections of an FDD to help you figure out what sections you should pay close attention to while doing your research.
The Franchisor History - Sections 1-4
The first four sections break down the history of the franchisor from past business names to bankruptcy and litigation history. The main thing you should keep an eye out in this section are any potential red flags in the franchises history.
Item 1: The Franchisor and Any Parents, Predecessors and Affiliates
The main purpose of this section is to give a breakdown of the business structure of the franchise and to give the perspective franchisees information about past or alternative names the franchise may operate under. Section 1 also often includes useful information about the franchising history of the business including when they first began offering franchised units and the number of franchised units in operation. We've take a look at the Sbarro FDD and provided screenshots of some of the main sections of each item for you to take a look at. As you can see below the Sbarro Item 1 lists 8 major marks that Sbarro does business under, something important to consider and research as a prospective franchise owner.
Item 2: Business Experience
Item 2 is fairly straightforward. It lists the business experience of key figures in the franchise organization including their directors.
Item 3: Litigation
Item 3 is one you should pay close attention to. It breaks down pending and past lawsuits between the franchisor, their parent company, their predecessors, or their directors. A franchisor involved in litigation is not necessarily a deal breaker, but it is something that you should fully investigate before signing an agreement. From the Sbarro FDD we are breaking down you can see that they are not involved in any litigation that is necessary to be disclosed.
Item 4: Bankruptcy
Item 4 lists all of the bankruptcy filings within the past decade by the franchise, its predecessors, or key executives. Bankruptcy filings can happen with franchises and it isn't necessarily a bad sign for prospective franchisees, but as with litigation cases you should look into them and understand why the bankruptcy was filed. In some cases it can be a sign of broader issues. In Sbarro's case they have 2 bankruptcies disclosed, however both cases resulted in successful reorganizations and were before franchising began.
Costs - Sections 5-7
The second major section of the FDD gets more into the details of individual unit operation. It breaks down the typical franchise costs ranging from franchise fees, to ongoing costs, to estimated initial investment. When trying to construct a business model around your franchise these sections are crucial as they will allow you to understand the total costs associated with becoming a franchise owner.
Item 5: Initial Costs
Although its name might suggest that this section primarily covers the disclosure of the initial franchise fee, there is often more information contained here. For franchises such as Sbarro, the franchise charges a non- refundable application fee that covers their background checks on you as a potential franchise owner. This fee typically then covers part of your franchise fee if you are approved, but it still is substantial. Additionally this section breaks down the overall initial fee, as well as any variable aspects involved in it. In Sbarro's case the initial fee can vary substantially based on the location you suggest. While this section is important from a planning perspective, it is relatively straightforward to understand.
Item 6: Other Costs
Item 6 is one of the most important sections of the FDD to consider when you are trying to figure out how much it is going to cost you to run your franchise. It breaks down not only the traditional royalties that the franchise charges, but also a number of other ongoing costs you as a franchise owner may not have considered. For Sbarro these costs include advertising and marketing fees, web site hosting fees, as well as potential transfer fees if you look to sell your franchise before the end of your agreement. Overall a Sbarro owner may be responsible for paying 11% of their gross revenues annually in fees.
Item 7: Estimated Initial Investment
One thing potential franchise owners sometimes forget is that the initial franchise fee is only a small percentage of the initial investment you need to make to open a franchise. Item 7 of the FDD breaks down an estimate of these costs to give you a better idea of how much you would likely need to spend on property, equipment, technology, legal fees and more. Although the Sbarro initial fee can be around $20,000 the total initial investment for a new franchisee can range from $350,000 to over $700,000. A major factor to consider here is what real estate purchases will need to be made or what property improvements you will have to make. Those costs can add up very quickly.
Items 8-12 are a bit more unique than the first 7 items we've looked at, so there isn't a great way to group them together. However, they are very important items to understand as they cover things from purchasing requirements to franchisor financing opportunities.
Item 8: Restrictions on Sources of Products and Services
In Item 8 the franchisor can set limits on where a franchisee can buy or source certain goods and services from. This is important to the franchisor because it allows them to maintain consistency and quality across their locations, ensuring protection of their brand. As a prospective franchisee you will want to understand these restrictions because they may impact how you would like to run your business. For example in the Sbarro FDD outlines a specific buyer you are required to buy a certain percentage of your products from and lays out specific requirements for other potential suppliers you must buy ingredients from
Item 9: Franchisee's Obligations
Item 9 almost acts as a table of contents for the FDD from the franchisees perspective. It lays out a list of necessary obligations for the franchisee and where in the FDD the franchisee can find this information.
Item 10: Financing
Not every franchisor provides financing options for prospective franchisees. But, for those that do the options are laid out in Item 10. These can range from loans, to installment plans, to leasing arrangements. More details such as the interest rates and payback periods are laid out in this item, but these details can also be negotiated on an individual basis by the franchisee. In Sbarro's case you can see in Item 10 that they do not provide direct financing of any form, but they will help franchisees by offering subleases.
Item 11: Franchisor's Assistance, Advertising, Computer Systems, andTraining
Training can be vital for new franchisees, especially in industries they are unfamiliar with. Item 11 of the FDD breaks down exactly what assistance and training the franchisor will provide when a new franchisee gets started. It also gives information about the extent to which the franchisor will help you advertise when you get started. It is important to understand not only how much training you will receive, but also what areas of the business you will be trained in. From Sbarro's FDD you can see that they not only do classroom training, but also help bring you up to speed by training you in a current location.
Item 12: Territory
Item 12 sets out the requirements for franchise territories. While this might seem straightforward, it is a critical part of the franchise agreement. This section lays out what is a valid territory and states whether or not your territory has exclusivity. For non-exclusive territories you need to compete not only with other business but potentially with other franchisees from the same business! For Sbarro Item 12 says that the franchisor retains the right to select the territory based on factors that might impact its success. This restricts where you could open your business, but is probably beneficial for you as a franchisee, as they have an idea of what a good territory looks like. However, the FDD also states that there are no exclusivity rights, and in fact you may be granted the same territory as franchisees operating under one of their other brands.
Item 13: Trademarks
Item 13 is the first of two items focused primarily on intellectual property considerations for the franchising process. This section focuses on which trademarks you will gain the right to use under the franchise agreement, where/when they are registered (if they are with the US patent office), and what terms you agree to use them under. This isn't a critical part of the agreement, although you should make sure you understand the terms by which you are granted use of the trademarks. For Sbarro the FDD lists a number of potential trademarks you would gain the rights to use by becoming a franchisee.
Item 14: Patents, Copyrights, & Proprietary Information
Similar to Item 13, Item 14 simply lays out what patents & copyrights you gain access to use by becoming a franchisee. Once again the most important aspect is understanding what restrictions there are to using the patents. For many franchises, like Sbarro, this section will simply say there are no relevant patents.
Item 15: Obligation to Participate in the Actual Operation of the Franchise Business
Many franchisees are looking for a more passive business that they can invest in while others handle the day to day operations. This is fine for some franchises, however others will require the franchisee to actually be present and handling the day to day operations of the business. Item 15 lays out the specifics as to how much, if at all, you would need to work as a franchise owner.
In Sbarro's case you can be a remote owner, but you need to have someone in charge of the restaurant who has undergone the operational training program the franchisees undergo and they must sign a confidentiality agreement. This makes sense for the franchisor and franchisee, as you don't want someone without the necessary training trying to run the whole business.
Item 16: Restrictions on What the Franchisee May Sell
Item 16 sets limits on what you as a franchisee are allowed to sell at your business. While this may seem restrictive it makes sense. The franchisor is looking to keep their locations operating consistently and they don't want there to be too much variation across franchisees. The main thing to look out for here is any overly aggressive restrictions you would not expect. The other thing to check for is whether the franchise retains the right to change these restrictions in the future.
Item 17: Renewal, Termination, Transfer, and Dispute Resolution
This is a critical section for any potential franchisee. You should pay close attention to your rights as a franchisee to either maintain your relationship at the end of the initial agreement or get out of it. There are going to be cases, even with the best franchises, where you might need to sell your business. In that case you want to know who you can sell to and what it will cost you. Item 17 deals with all of these issues. If you look at Sbarro's FDD you can see that their franchise agreement lasts for 10 years and you have the ability to renew for an additional 10 years afterwards.
Item 18: Public Figures
This item shouldn't have a major impact on your franchising decision, but it can be an interesting section to look at. It discloses whether the franchisor has any relationship with public figures.
Item 19: Financial Performance Representations
Item 19 might be the single most important section of the FDD for you to consider before investing in a franchise because it can give an indication of how much money you can potentially make as a franchisee. We break down the Item 19 in much more detail in another article.
The exact form of the Item 19 can range from franchise to franchise, and the amount of info you can gather from it depends on the form it takes. Sbarro breaks down its locations into quartiles and gives broad, aggregate information. This can give you a good estimate of the good (more than $1 million in average annual sales) and bad (under $500,00 in annual average sales) cases for revenue and give you a relatively good idea of where your major costs lie. However, it doesn't give a more complete projection like some franchises give.
Item 20: Outlets and Franchisee Information
The best indicator of the health of a franchise might be the unit growth of its franchise locations. Item 20 gives you a breakdown of how the number of franchise units, and in some cases corporate owned locations, have changed year over year. Generally you want to see the number going up, and if it's not you would want to understand why. In Sbarro's case 2014 saw a major decrease in the number of corporate owned locations operating. That might seem like a major red flag at first to perspective franchisees, but after doing some research we can find that this is part of their plan to recover from their 2011 bankruptcy that was mentioned in Item 4. You want to not only understand which direction the franchise is trending, but understand why as well.
Item 20 also contains a list of current franchisees (although this is often listed as an attached document). This can be an invaluable resource during your search, as it allows you to reach out and talk to current franchisees who know more details about what it's actually like to own that franchise.
Item 21: Financial Statements
While not as useful as Item 19 when it comes to understanding the financial prospects of a franchisee, the Item 21 can give vital information about the financial health of the franchisor. Good financials suggest that the franchisor is profitable and that their franchisees are probably successful. Poor financial statements may indicate that there are some major risks to becoming a franchisee. As with the other sections of the FDD Item 21 shouldn't be a deciding factor on its own, but should be used as an indicator that helps lead you to do additional research.
Item 22: Contracts
Section 22 lists all of the contracts you may need to sign if you choose to open a franchise. These should each be read in depth on their own, as they contain critical information regarding your relationship with the franchisor
Item 23: Receipts
It is required by law that a prospective franchisee read and review the FDD at least 14 days prior to signing a franchise agreement so the last section is a receipt acknowledging when the franchisee received the document. The franchisor must also sign a copy and keep both receipts on file.
The FDD can be one of the most useful tools to dig into when you're trying to decide what franchise to open. From financial information to contractual obligations it will start to give you a picture of what life as a franchisee would be like.
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One key aspect of Item 12 is establishing how franchisees’ territories will be defined. This may be by zip code, population, population with certain demographics, or geographic or political markers (i.e. streets or county lines). For franchises with population-based territories, a franchisee in a busy downtown urban area may have a territory of only a few blocks, while a rural franchisee’s territory could reach for miles.