FDD Review: What Every Franchise Buyer Must Know
The Franchise Disclosure Document (FDD) is the most important document you'll review when buying a franchise. It contains critical information about the franchise system, costs, obligations, and risks. Here's what you need to know.
What is an FDD?
The FDD is a legal document that franchisors must provide to prospective franchisees at least 14 days before signing any agreement or paying any money. It's required by the Federal Trade Commission (FTC) and contains 23 specific items of information about the franchise. The FDD can be 100-300+ pages long and filled with legal jargon. Most prospective franchisees don't read it thoroughly—and that's a costly mistake.
The 23 Items of the FDD
Let's break down each section and what to look for:
Item 1: The Franchisor and Any Parents, Predecessors, and Affiliates
This covers background information about the franchisor, including business history, predecessors, and affiliated companies. Look for how long the franchisor has been in business, how long they've been franchising, any name changes or restructuring, and related companies that might affect your franchise. Red flags include very new franchisors (less than 2 years), frequent name changes, or complex corporate structures that obscure ownership.
Item 2: Business Experience
This covers the background of the franchisor's directors and key executives. Check if executives have relevant industry experience, how long they've been with the company, and if there are any concerning gaps in employment. Red flags are high turnover in leadership, lack of industry experience, or executives with questionable backgrounds.
Item 3: Litigation
This covers lawsuits involving the franchisor, its officers, or key personnel. Examine the number and types of lawsuits, especially any from franchisees (particularly multiple similar claims), and the outcomes of past litigation. Ongoing litigation is also important. Red flags are multiple lawsuits from franchisees alleging fraud, misrepresentation, or breach of contract, indicating a pattern of similar complaints.
Item 4: Bankruptcy
This covers the bankruptcy history of the franchisor and key personnel. Look for any bankruptcies in the past 10 years and understand the context. Red flags are recent or multiple bankruptcies, especially those involving fraud.
Item 5: Initial Fees
This covers the initial franchise fee and other upfront costs. The typical range is $20,000-$50,000, but can be higher. Understand what the fee covers and if it's refundable (usually not). Also, note any additional initial fees.
Item 6: Other Fees
This covers ongoing fees you'll pay to the franchisor, including royalty fees (typically 4-8% of gross sales), marketing/advertising fees (1-3%), technology fees, training fees, renewal fees, and transfer fees. Calculate the total ongoing fees; if they exceed 10-12% of gross sales, your profit margins may be too thin.
Item 7: Estimated Initial Investment
This provides the total estimated cost to open and operate your franchise until it becomes profitable. Look at the low and high estimates for real estate, construction, equipment, inventory, working capital, insurance, licenses, and permits. Always plan for the HIGH end of the estimate, not the low end.
Item 8: Restrictions on Sources of Products and Services
This outlines requirements to purchase from the franchisor or approved suppliers. Check what you must buy from the franchisor, what must come from approved suppliers, whether you can suggest alternative suppliers, and if the franchisor receives rebates from suppliers. Excessive restrictions or undisclosed rebates are red flags.
Item 9: Franchisee's Obligations
This is a table listing your obligations and where they're detailed in the franchise agreement, covering site selection, training, operating standards, advertising, and insurance.
Item 10: Financing
This section details whether the franchisor offers financing, including terms, interest rates, and consequences of default.
Item 11: Franchisor's Assistance, Advertising, Computer Systems, and Training
This covers the support the franchisor will provide, including pre-opening assistance, ongoing support, training programs, advertising, and technology systems. Ask if the support is adequate and if existing franchisees feel well-supported.
Item 12: Territory
This defines your exclusive territory (if any). Key questions: Do you get exclusivity? How is it defined? Can the franchisor open competing locations nearby or sell online in your territory? Red flags include no exclusive territory or franchisor reserving the right to compete with you.
Item 13: Trademarks
This covers the trademarks you'll use and their legal status. Check if they are registered with the USPTO and if there are any disputes or challenges.
Item 14: Patents, Copyrights, and Proprietary Information
This details other intellectual property you'll use. Inquire about what proprietary systems or methods you'll use and if they are legally protected.
Item 15: Obligation to Participate in the Actual Operation of the Franchise Business
This clarifies whether you must personally operate the franchise or if you can hire a manager, and what the requirements are for managers.
Item 16: Restrictions on What the Franchisee May Sell
This outlines restrictions on products and services you can offer. Consider what you're required to offer, what you're prohibited from offering, and if you can add products/services with franchisor approval.
Item 17: Renewal, Termination, Transfer, and Dispute Resolution
This covers terms for renewing, ending, or selling your franchise. Pay close attention to termination provisions—can the franchisor terminate for minor violations? Key aspects include term length, renewal conditions and costs, circumstances for termination, restrictions and fees for transfer, and how disputes are resolved (arbitration, mediation, litigation).
Item 18: Public Figures
This addresses the use of public figures in advertising and their actual role, whether they are paid endorsers.
Item 19: Financial Performance Representations
This presents actual financial performance of existing franchisees. Note average gross sales and net income (if provided), the percentage of franchisees achieving these results, and how results are calculated. If not included, talk to existing franchisees. Unrealistic projections or refusal to provide financial data are red flags.
Item 20: Outlets and Franchisee Information
This details the number and status of franchise locations, including openings and closures in the past 3 years. Calculate the closure rate; more than 5-10% annually is a red flag.
Item 21: Financial Statements
This provides audited financial statements of the franchisor. Assess profitability, cash reserves, debt levels, and financial trends. Losses, declining revenue, high debt, or inadequate working capital are red flags.
Item 22: Contracts
This includes copies of all contracts you'll sign, such as the franchise agreement, lease agreements, equipment leases, and financing agreements.
Item 23: Receipts
This is your acknowledgment of receiving the FDD. Sign and return one copy, keeping one for your records.
Critical Questions to Ask
After reviewing the FDD, ask about total cost, ongoing fees, time to profitability, closure rate, franchisor support, territory exclusivity, transfer rights, and common reasons for franchise failure.
Talk to Existing Franchisees
Call at least 10-15 current and former franchisees listed in Item 20. Ask about their actual revenues, profits, startup costs, franchisor support, what they wish they'd known, and if they'd buy again.
Get Professional FDD Review
The FDD is complex. A professional review can identify red flags and help you understand the agreement. Traditional law firms charge $2,000-5,000 for this service, while Paralex offers comprehensive FDD reviews for just $750. This investment could save you from a $100,000+ mistake.
Red Flags to Watch For
Be wary of high closure rates, multiple lawsuits from franchisees, recent bankruptcy, very new franchisors, no Item 19 financial data, excessive ongoing fees, no exclusive territory, difficult termination or transfer terms, poor franchisor financials, and negative feedback from existing franchisees.
Get Your FDD Reviewed
Don't sign a franchise agreement without a thorough FDD review. Paralex's $750 FDD Review includes detailed analysis, red flag identification, financial analysis, a written report, and a consultation. Protect your investment—get your FDD reviewed before you sign.
