A Franchise Disclosure Document (FDD) serves as the foundation of the franchisor-franchisee relationship. Not only is it a critical sales tool for the franchisor, but it also gives a prospective franchisee vital insight into the franchise opportunity and help them make an informed decision to invest. While the FDD is a comprehensive document, certain key sections demand careful scrutiny during an annual review. This article explores some considerations for updating three key sections of your FDD this season and why franchisors should focus on them.
Item 19: Financial Performance Representations
Item 19 provides a snapshot of the financial performance of the franchise system for the prior fiscal year. While a financial performance representation is not mandatory under the Federal Trade Commission (FTC) Franchise Rule, many franchisors include some form of representation to show prospective franchisees their historical sales volumes and other relevant financial data. A franchisor is prohibited from making any financial representations other than what information, if any, is published in their Item 19 – so often franchisors view this as a critical data point in the sales process.
Where franchisors can miss an important opportunity is in the presentation of the financial information. Of course, the information must always be truthful and not misleading. But the data also tells a story to prospective franchisees about how well the brand is performing over time. Franchisors should carefully evaluate both the data being disclosed for the upcoming year and the format in which it is presented, asking questions like:
- How many years’ worth of data is relevant for the prospective franchisee? Are there years included that had specific challenges that are no longer relevant? Or is there just too much data generally such that readers are overwhelmed?
- What presentation of the data is easiest for a prospective candidate to understand and tells the story of the brand’s achievements?
For example, if a brand has experienced consistent increases in annual sales volumes by year, it may want to present this information in a bar chart to visually show the upward climb. Brands with fluctuating annual sales volumes by year may want to present this information in a different chart or include different data altogether.
- What data is not being included in the current format that is important for prospective franchisees to know before deciding to invest?
Franchisors who previously did not include a financial performance representation may want to carefully review their financial data and re-evaluate whether including one in the upcoming year would be beneficial to the brand’s growth strategies and goals.
It is important to conduct this type of analysis every review season since the data often looks different from year to year and may require adjustments over time to maintain an accurate and transparent picture of the brand’s financial health and performance. Above all, an annual review of Item 19 should focus the completeness and accuracy of all data disclosed– even if it was in the prior year’s disclosure – to catch and correct any clerical errors that may have occurred.
Item 7: Estimated Initial Investment
Item 7 outlines the range of estimated costs associated with opening a franchise. Many of the categories disclosed in an Item 7 can change over time based on a number of factors, such as negotiated system pricing with required or preferred vendors, additional fees imposed by the franchisor, updated construction requirements (square footage, design/décor, materials, etc.), and external factors such as market rent rates, local labor rates, inflation, shipping/freight costs, interest rates, and other general economic changes.
Franchisors are required to have a reasonable basis for each amount listed in their Item 7 and to disclose generally the factors, basis, and experience they are relying for each estimate. This will require franchisors to conduct sufficient due diligence to ensure they are accurately capturing a reasonable estimate of the costs a prospective franchisee would incur to open a franchise in the upcoming year.
The past year has made it even more critical to carefully evaluate the cost estimates included in a brand’s Item 7. Historic inflation, global supply chain challenges, and rising minimum wage costs have caused significant increases to costs across the board. When making changes this year, franchisors should consider not just the prior year’s historical experiences, but also any foreseen increases for the upcoming year.
It can be difficult to strike the proper balance with these estimates. Any ranges that are too low or not determined on a reasonable basis could expose the franchisor to liability for misrepresentation. On the other hand, ranges that are too high or too broad may deter prospective franchisees from investing in the brand.
Item 12: Territory
Item 12 is an often-overlooked section of the FDD because it is not subject to significant fluctuation each year like the financial and cost disclosures. However, it contains a critical delineation of territory rights between the franchisor and the prospective franchisee that will determine when, where, and how their businesses will expand – or be restricted from expansion.
Franchisors with rapidly expanding brands should be particularly attentive to its Item 12 disclosure and consider any necessary strategic changes. For example, a franchisor may want to reduce the size of new franchisees’ protected trade areas so that it can establish more unit locations within a smaller geographic area going forward.
There may also be value in updating the franchisor’s policies for how franchisees handle overlapping marketing efforts, customer service, and other territorial aspects of the franchise business operations. Doing so can set clear boundaries for franchisees, which reduces disputes that the franchisor must resolve, and increase their mutual cooperation to further the entire brand’s image instead of focusing solely on franchise-to-franchise competition with each other.
In short, certain sections of the Franchise Disclosure Document deserve special attention from the franchisor in its annual review. Doing so can present opportunities for the franchisor to optimize its sales and growth opportunities, while also providing prospective franchisees with the most accurate picture of its franchise offering and fostering a healthy and sustainable franchisor-franchisee relationship.