If you’re considering franchising and you’ve taken the time to pinpoint your ideal franchise opportunity, receiving the franchise disclosure document (FDD) is the next step in your journey. This is a legally mandated document (although it does not impose legal obligations) that every prospective franchisee must receive before signing the franchise agreement.
While it may be an exciting time in your life, it’s also good to approach the FDD with caution and sobriety. This is because there could be certain franchise red flags in the FDD that you’ll want to be aware of before committing yourself to a long-term partnership that could be harmful for your business aspirations.
In this article, that’s exactly what we cover, so keep reading below to discover what are some franchise red flags and how to spot them.
In this article:
What are the red flags in a franchise disclosure document (FDD)?
Red flags are any sign that the franchise opportunity you’re considering is not as stable as communicated or a signal that it is ultimately not worth pursuing.
One of the very first red flags you should be aware of is if the franchisor does not provide you with the FDD at least 14 days before signing the agreement.
You are, by law, required to receive it so if the franchisor doesn’t provide this document, gives it to you in an incomplete format, evades your questions, or tries to rush you through the process — you’ve got some careful thinking to do.
This is just the starting phase in the process. Once you do receive the FDD, it’s important to know what to look for in a franchise disclosure document.
The FDD contains 23 items as part of the standard FDD requirements and most of them can be an indicator of the franchise’s current and anticipated performance.
Ultimately, this can affect you in big ways — both in terms of time wasted and valuable resources invested. That’s why it’s important to look out for franchise disclosure document red flags, which are covered in more detail below.
Franchise disclosure document red flags
Here’s a brief breakdown of what you should be on the lookout for when you receive the FDD:
Item 1: The Franchisor, its predecessors and affiliates
This information is contextual and offers a brief history of the franchisor and a high-level overview of the business.
Item 2: Corporate officers
When looking at item 2, identify if the group of professionals at the helm of the franchise have any actual previous franchising experience.
Remember that running a franchise business is not the same as running a business. That’s why the experience of the franchisor leadership team is so important. It requires a solid understanding of the franchise system and experience is a big must.
Item 3: Litigation
Look at past and present franchisor lawsuits. This can suggest a broken business model or a franchisor that is unable to work through disagreements constructively.
While some litigation is natural, such as enforcing the brand’s integrity, other types of litigation can signal problems with the business process.
So, consider the details of each lawsuit and the average number of lawsuits per total number of franchisees.
Item 4: Bankruptcy
Bankruptcies can indicate inefficiencies and inexperience within higher-level leadership and business strategy echelons.
Item 5: Initial franchise fee
This is the amount and payment terms for the initial franchise fee and any other prepayments (including real estate and construction fees).
Make sure you have absolute certainty about the full fee you’ll be required to pay. Any ambiguities should be addressed.
Item 6: Other fees
Ensure you understand how much the royalty amount is and how it compares to other franchise brands in this market segment. This fee is usually non-negotiable.
Also, you need to get a clear explanation of how these fees have been calculated.
Item 7: Estimated initial investment
Look at the different line items such as training, construction, furniture, etc. and determine to whom you will be paying that money.
In cases of a strong franchise brand, you’ll be paying directly to third-party suppliers. Look out for cases of having to pay the franchisor directly.
Additionally, make sure you speak to current franchisees to better understand what their initial costs were as sometimes the three-months of working capital is insufficient.
Item 8: Restrictions on sources of products and services
An important red flag here is if a franchisor is attempting to profit from deals with higher-cost suppliers. Make sure that third-party vendor relationships are in your favor and best interest.
Item 9: Franchisee’s obligations
While this is quite an exhaustive section, its purpose is to cover the franchisor in the event of a franchisee going rogue.
You’ll see a table that covers all the things you’re responsible for in order to get the business started. Make sure you will get all the necessary support to be able to fulfill your duties.
Item 10: Financing options
This entails a description of any financing offerings the franchisor may be providing directly. However, this is left blank in most cases as many franchisors do not have banking or third-party financing relationships.
Item 11: Franchisor’s assistance, advertising, computer systems, and training
As a minimum, your franchisor should assist you with training, site selection, lease negotiation, construction management, permitting, advertising, website, software support, ongoing operational assistance and others.
Good brands will offer this as a basic and add on to the list. Poor brands will offer the bare minimum.
Item 12: Territory
You should carefully evaluate the territory restrictions in franchise agreements and FDDs.
Low-quality brands will often try to cram as many owners in a single geographical area as possible to maximize their franchise fee earnings or are placing too many new franchise owners too close to their territory.
Item 13: Trademarks
Look out for incomplete or missing trademarks associated with the brand name.
Item 14: Patents, copyrights and proprietary information
This is typically the copyright of brand assets. It can often be found by requesting to see the “brand standards” manual.
Item 15: Obligation to participate in the actual operation of the franchise
If you’re interested in a semi-absentee franchise model, you should make sure that this section clearly spells out that a designated manager can run the franchise.
In other cases, the franchise owner will be expected to undergo training and to participate in running the business for several months or more.
Item 16: Restrictions on what the franchise may sell
Strong brands should exercise control over this aspect and will want the exact same goods and services offered at every branded location.
Other brands may offer flexibility. However, you should make sure to what extent this is available.
Item 17: Renewal, termination, transfer and dispute resolution
If you need to exit the business, you’ll find that most brands don’t give the franchisee the power to terminate the agreement. However, it’s possible to discuss options such as selling, shutting down, or debranding a location.
Look out for the duration of the franchise agreement. The longer it is, the more certainty you’re likely to have that the franchisor won’t make overhaul changes to their franchise disclosure document and franchise agreement too quickly.
Item 18: Arrangements with public figures
Make sure the public figure’s reputation is strong, that they have a solid history, and that they are not likely to cause harm to the brand.
Item 19: Financial performance representations
Be careful of earnings claims because this is something the FTC outlaws. Also, look for underwhelming financial performance over the past year as well as franchisors who exclude financial performance representations altogether.
However, if it’s a young brand, this may not always be a cause for concern. Make sure that costs such as franchise fees and royalties are clearly spelled out in addition to expenses you will need to pay.
Also, never solely rely on the provided information. Verify the information from existing franchisees.
Item 20: Outlets and franchisee information
Look at whether there is a high franchisee turnover rate as this could signal unsuccessful relationships within the franchise system.
Item 21: Financial statements
Make sure you completely understand the franchise financial statements. Look for any long-term debt, look for risk sharing, look at whether and how much the franchisor is reinvesting back into the support infrastructure of the franchise business.
Other factors to consider include unrealistic earnings claims in franchising, the number of franchisees entering the system, the satisfaction levels of current franchise owners, growth rate of locations and success levels of multi-unit franchisees.
Item 22: Contracts
Here, consider the information that is included in the franchise agreement and check if and how it differs from the FDD. Ensure that the terms of the agreement reflect what appears in the FDD.
Item 23: Receipt
This is a short part of the FDD that states you acknowledge receiving it.
How to spot red flags in an FDD
Having identified potential red flags in an FDD, it’s time to look at how to read a franchise disclosure document. Ultimately it requires careful attention to detail.
Specific attention should be given to certain sections such as item 19 and item 20.
Also, pay close attention to the language used in the document. Evasive or unclear language can be a warning sign. In many cases, you may wish to consult a franchise attorney for guidance.
Conclusion
Despite some franchise opportunities appearing better than they actually are, most franchisors are solid options worth considering. If you’re wondering if franchising is a good investment, the answer is a clear “yes”.
However, it requires due diligence, thorough research, and professional advice before investing. We invite you to explore further resources on this topic and download our due diligence checklist.
