UNDERSTANDING THE FRANCHISE DISCLOSURE DOCUMENT – PART II

Tue, Jun 15, 2010

UNDERSTANDING THE FRANCHISE DISCLOSURE DOCUMENT

In a recent survey of our readers, many requested that we provide deeper insight into the Franchise Offering Circular that must be provided to each buyer. This document is developed by each franchise system and includes several important sections that help a prospect gain a great deal of knowledge about the franchising company. The major portion of the document is a plain-English description of the company offering franchise licenses, the business that will be created, the costs involved and the restrictions placed on the franchisee. In addition, the franchisor’s promises to the licensee are enumerated. The company’s latest Profit & Loss Statements and Balance Sheets are included for the buyer’s review, as is a copy of the actual license agreement that will be signed if the parties agree to join forces. Reviewing this article should help you choose between franchisors, avoid misunderstandings and protect your investment.

Section 7. Franchisee’s Initial Investment This section help you focus on opening costs.

The FTC asks that each Franchisor disclose to prospective franchisees all the costs that could be encountered when opening a store, restaurant or office within their system. For the sake of discussion, we have provided a typical chart as might be found in a small retail business with minimal investments for remodeling and inventory.
Type of Expenditure Amount Method of Payment When Due To Whom Payment is to be Made
Initial Franchise Fee $24,500 Lump Sum or $10,000 down payment At signing of Franchise Agreement or monthly payments Franchisor
Travel & Living Expenses while Training $1,000 to $2,000 As Incurred During Training Airlines, Hotels, & Restaurants
Leasehold Improvements $2,500 to $4,000 As Incurred Before Opening Contractors, Landlord or Franchisor
Inventory $10,000 Lump Sum Before Opening Franchisor or other Vendors
Furniture, Store Equipment & Signage $6,500 to $7,500 As Incurred Before Opening Vendors
Grand Opening Advertising $1,000 As Incurred Within 30 days after Opening Franchisor or other Vendors
Miscellaneous Opening Costs $1,000 to $1,500 As Incurred Before Opening Vendors
Security and Lease Deposits $1,500 to $2,000 Before Opening Before Opening Franchisor or other Landlord
Additional Funds (Working Capital) $2,000 to $5,000 As Incurred During the initial 6-month period Vendors
TOTALS $50,000 to $57,500
The Initial Franchise Fee for franchisees is usually a set amount and is paid in full at the time you sign your license. Sometimes, a new system will discount the first few licenses to encourage entrants into their young system. Some systems will finance all, or part of their license fees. While this shows their confidence in their system, be sure you don’t get loaded down with so much debt that you can’t draw any money out of your new business for many months. You are responsible for your travel, motel, food and incidental costs while attending training at the company’s training school. Often in a small venture, you and your spouse will be the only ones trained. In systems where you will have many employees and two or three managers, you may have to pay your new employees and cover their travel expenses weeks before you start generating revenues.

Leasehold Improvements:

Your opening equipment costs will vary depending on the space you choose for your business. Space of 750 to 1,500 square feet should be enough. A suitable location should be found for $8 to $15 per square foot per year. Remember, you should be easy to find, and have plenty of parking. A location near public transportation may be a plus.

Inventory:

This represents the amount paid for the “widgets” that you will carry in your store for sale to customers.

Furniture, Store Equipment & Signage:

Most prospects will have at least one desk, chairs, phones, and other incidentals to get started. You’ll need to do an inventory and determine the amount of new purchases you’ll need to make to open your unit. Also discuss with the Franchisor any special needs within their system. Sometimes the family PC will not be powerful enough to manage your new franchise. You may desks, chairs, phones, file cabinets for each of your employees. You may need computers for each, as well, depending on their function.

Grand Opening Advertising:

Getting your business off to a fast start is important. Ask the franchisor if you will be spending these funds or if they will handle it for you.

Miscellaneous Opening Costs:

These items include your prepayment on a liability insurance policy, office supplies, the installation of your phone lines, obtaining business licenses and incorporating.

Lease Deposits:

Assume you will rent space and be required to give deposits to your landlord and the utility companies.

Working Capital:

Working capital is the toughest number to predict. To keep this at a minimum, you must not make any draws during the first few months of the business. Therefore, you must be prepared to meet your living expenses with cash from other sources, your spouse’s income, savings, etc. Be sure you are very clear in your understanding of how your revenues will be generated and when they will be collected. In food services and retailers, your funds should begin coming in on opening day. In a service business, it may take several days (or weeks) before you gain a client and begin generating revenues. Do you collect payment in full up front, obtain progress payments or wait until the job is completed to receive your income? Each of these scenarios will have a dramatic impact on your need for working capital.

8. Restriction on Sources of Products and Services

Sample Company does not significantly restrict your purchases of products or services. In order to maintain their image of professionalism, you are required to utilize business cards, letterhead and envelopes printed on a quality paper. They will provide your initial letterhead and business cards and the training manual describes the minimum standards. You may place reorders with their local printer and have them shipped and billed directly to you. So that the franchisor may properly support you, you may have to utilize specific software programs for managing your business.

9. Franchisee’s Obligations

This table provides cross-references for you to review the promises you’re making when you join the Franchisor. Typically, your franchisor will approve your site and give you guidance in remodeling and opening your unit. How much assistance you can expect and the costs involved should be considered. Are there undue restrictions on the products or services you may offer and the geographic area that you may provide your products to? Do these seem fair or too tight? Are the required insurance policies in line with industry standards? Expect to have all your advertising materials review by the home office before submitting it for publication. Are you required to operate the business personally or can you hire a manager? What kinds of reports will the franchisor require? Typical are royalty reports which recap sales plus year-end balance sheets, profit and loss reports and tax returns. What inspection or audit rights does the franchisor retain? How do you affect a transfer? Usually, you must obtain franchisor approval and the buyer must have skills similar to new franchise owners. How long is the license agreement and what are the terms for renewal? What are your obligations after the ending of your relationship with the franchisor? Are you restricted from competing in the same marketplace? How will disputes be resolved? Mediation and arbitration are usually preferable to litigation. While reviewing all these restrictions in one sitting may make them seem onerous, we see them as the backbone of the system. If someone violates the rules and regulations imposed for the good of the system, they should be brought into line. If not, the system will soon disintegrate. Anyone who is interested in joining a successful system should be glad that there are rules in place to protect the chain’s integrity from “renegades.”

10. Financing

Franchisors may finance the initial license fee, inventory, equipment, remodeling or even loan funds to a franchisee for working capital purposes. Interest rates and terms of repayment are usually negotiated at the time of application. In most instances, collateral will include the assets of the business, the franchise license and additional personal assets of the principals. While many view franchisor financing as a good sign (it does prove they believe in their system) too much debt must be avoided. In the early months of most franchises, profits are slim (often non-existent). Making monthly payments will exacerbate losses and delay the time when the franchisee can draw out a salary commensurate with that available if he (she) was employed elsewhere. Just as with any debt, you should carefully weigh the pros and cons–being especially cognizant of the fact that your future income is only projected-not yet proven.

Section 11. Discusses the Franchisor’s Obligations

Before you open, you must attend the franchisor’s training for new franchisees. The Table of Contents for their Operations Manual are included for your review. Other typical promises from Franchisors include: loaning you a copy of their Operations Manual; forwarding any leads for work in your area; maintaining a telephone advisory service to help you address unique situations; and holding annual conferences for franchisees to meet and discuss industry changes. Most franchisors regularly conduct research and development into their systems to try and find better ways to serve customers that will bring increased profits and ease of operations to the network.

Section 12. Territory

In most systems, each franchisee is granted a specific territory within which you must locate your store, restaurant or office. In some service businesses, you’ll operate from your residence but generally you’ll have a unique territory to service. You should focus your direct marketing efforts within this area and you are usually restricted from mass marketing within an area owned by another franchisee. Determining how large an area is reasonable is a challenge for both the franchisee and the franchisor. Some food operations now promise only to restrict others from opening “within the walls” of your restaurant! They may co-brand with a nearby convenience store and they may even sell the branded product in a grocery store within sight of your unit. If these policies will help or hurt the success of your venture may be hard to determine.

13. Trademarks

This section outlines the franchisor’s registered trademarks, how you should use them, and how to notify the franchisor if someone challenges their use in your market.

14. Patents & Copyrights, and Proprietary Information

The franchisor typically has copyrights on products or services that you will sell or deliver to clients, they also claim such rights on their Proprietary Software, their Operations Manual and Employee Manuals.

15. Obligation to Participate in the Actual Operation of the Franchise Business

Your franchise must be operated on a day-to-day basis by someone who has taken headquarters training. This insures the quality and integrity of the network. Should you die or be incapacitated, most franchisors will work with your estate to help keep the business solvent as they help find a new owner who is qualified to run the company.

16. Restrictions of What the Franchisee May Sell

So that the business community is not confused as to who they are and what they do, franchisors ask that each franchise offer, at a minimum, the products, menu or services listed.

17. Renewal, Termination, Transfer and Dispute Resolution

This table guides you to the sections in the Franchise License Agreement that control the relationship in these areas. Remember, they want you to succeed. They should have low renewal fees in order to keep the maximum number of franchisees involved. Their goal should be to build a strong network and only take actions against franchisees who don’t maintain high standards, infringe on the rights of other franchisees or refuse to pay fees outlined in their agreements.

18. Public Figures

Some franchise chains use national spokespersons to endorse the quality of their products or services or to recommend their franchise opportunity. If you feel this is a significant cause of the public’s perception, you should determine how long the relationship is guaranteed to exist. If the relationship ends, will it have a negative effect on your unit?

19. Earnings Claims

The government has set very tight limits on how franchisors can predict future earnings. Unfortunately, without sufficient records of other franchisees, most are unable to provide any predictions. You know your ability to motivate yourself. You know your willingness to implement a proven business plan. You recognize how profitable the industry can be if you deliver enough quality products or services! You must evaluate how much better their assistance will help you compete than if you were working alone. Recognize that most franchise units generate at least 25% to 35% more revenues than independents in the same industry. This, plus the cost savings involved in franchising almost always yield greater profits for the franchise owners.

20. List of Franchise Outlets

Here you’ll find a list of existing franchisees including those that may have closed within the last three years. A statement is also made suggesting how many new units the franchisor expects to open within the 12 months after the completion of the offering circular. We’d encourage you to call them and ask them if they still believe in the system as much as they did the day they signed the license. The Franchise Doctor has an extensive list of questions in an article on our web site “How Should You Evaluate a Franchise Opportunity?”

21. Financial Statements

Please take the time to review the financial statements of the franchisor. Are they sound financially or struggling? Remember that they have been in business several years, so you should not expect to replicate their units’ sales numbers in your early years.

22. Contracts

The full Franchise Agreement is also presented for your review. You may want to have these documents reviewed by an Attorney or CPA. Please make sure that they are specialists in franchising so that they will be able to give you advice based on contracts that are relevant to the franchising arena. The Franchise Doctor welcomes your comments: Click Here to Send us an Email or Call: 800-220-8256