The Anatomy of an FDD

Reading the Franchise Disclosure Document, or FDD, might not be as entertaining as curling up with a good mystery novel, but it does provide most of the clues you'll need to find the best franchise for you. And you definitely don't want mysteries when you're looking at franchises--you want the most important facts presented to you in plain English so you have what you need to make a good decision.

For just that reason, the Federal Trade Commission requires that all franchise companies provide prospective buyers with an FDD organized into a common format to allow for reasonably easy comparison between franchises. Just think of this as the most valuable written tool you'll receive in your franchise research stage.

The FDD has 23 sections (referred to as "Items"), as well as exhibits that provide a ton of supplemental information. Here's a guide to understanding the FDD:

Items 1-4: History
Item 1: A general review of the company, including any predecessors or affiliates, and the opportunity being offered. This key overview of the business is one of the sections you'll want to review first.

Item 2: Background data on key officers, directors, employees and any others who have management responsibility related to the sale or operation of the franchise. It includes a summary of their work experience from the past five years and any other experience they have as officers and/or directors of other companies.

Items 3 and 4: These include disclosures of any past or current litigation or bankruptcy on the part of the company or its key people.

Items 5-7: Fees and Costs
Item 5: Any and all initial fees you have to pay as you begin the franchise business.

Item 6: Any and all other fees that may be required in the subsequent operation of the franchised business, including royalty, advertising, renewal and transfer fees.

Item 7: An outline of every component of the initial investment you'll be expected to make in the franchise operation, including an allowance for initial advertising and operating capital reserves. This section is extremely important, but the value of the information is limited by the fact that the franchise company is required to express the data in a tabular form involving ranges of potential costs. Review this section with existing franchisees and the franchisor to determine the most accurate estimate possible for your specific location and circumstances.

Items 9, 11 and 15: Contractual Obligations of Franchisee and Franchisor
Item 9: Your obligations (as a franchisee), in a tabular format. The table lists major areas of responsibility in the business (for instance, obligations in relation to finding the real estate site for your business), then provides specific references to the exact sections of both the FDD and the actual franchise agreement contract that define the legal obligations you're assuming. Even though it might seem tedious and burdensome to complete all the cross-referencing that is required by the format chosen for this section, it is essential to your investigation. You should read through the entire FDD and franchise agreement first (to develop a strong overall knowledge base) before coming back to Item 9 and carefully checking each cross reference in the table.

Item 11: The contractual support obligations of the franchisor. This is usually the longest section of the FDD and is very important because it tells you what you'll receive in exchange for the fees you're paying. The section outlines pre-opening assistance as well as ongoing assistance. It also provides extensive detail about the franchisor's training programs and any required franchise systems, such as computer point of sale or advertising programs. Keep your highlighter handy in this section to make sure you note all important information as well as any questions you may have.

Item 15: Explanation of exactly what your personal obligations are in relation to the operation of the franchise business.

Item 12: Territory
Item 12: What you will receive in terms of a protected or exclusive territory. You'll find quite a variance in this provision from franchise to franchise.

Most prospective franchisees believe intuitively that the bigger the protected territory, the better for them. To the contrary, as a general rule, the most successful and well-known franchise systems typically offer territories that are either extremely limited or sometimes no protected territories at all. Discuss this at length with the franchisor to ensure you understand and agree with whatever philosophy it adheres to on this important matter.

Item 17: Exit Strategies and Dispute Resolution Procedures
Item 17: Any restrictions related to the renewal, termination or transfer of your Franchise Agreement as well as definitions of any required methodology for resolving disputes. You should consider any and all fees and restrictions you face in selling your business long before you get to the point of wanting to sell.

Dispute resolution provisions requiring negotiation and/or mediation before proceeding with legal action are quite common in franchising. It is also fairly common to see requirements for binding arbitration rather than lawsuits in state or federal courts, though this type of provision does not seem as prevalent as it was 20 years ago.

Item 19: Financial Performance Information
Item 19: Franchisors' representations about the financial performance of their units. This is often the first Item prospective franchisees read to determine the answer to the most commonly asked question in franchising: "How much money can I make in this business?"

But Item 19 will never give you the answer to this question. In fact, the disclaimers of every Item 19 representation you'll ever see will make this point in the clearest and most emphatic language possible. Every franchisee is different, every site is different, and it's simply impossible to predict in advance what future financial performance results you might achieve. What Item 19 can provide--and it is extremely valuable--is helpful clues you can use in your own research to answer the question of how much money you might make.

The typical Item 19 disclosure consists of three types of information: 1) numerical presentations of revenue and/or expense data, 2) notes and explanations outlining the assumptions used in preparing these numerical presentations, and 3) disclaimers that carefully explain the limitations of the usefulness of the data presented.

It's essential to carefully review and analyze the clues you receive from each of the three types of information. If, for example, this Item states that all units used in calculating the numerical presentation were at least two years old at the time the data was gathered, it should be obvious that the presentation won't be relevant in determining what your performance might be like in the first year of the operation of your business.

Item 19 can be one of the most important sources of information you'll receive in the entire FDD. The secret is to be very careful to use the information only within the scope of what it's meant to convey and then to verify this data in your conversations with existing franchisees.

Item 20: Existing Unit Data
Item 20: Information, in tabular form, about the number and location of the existing units in the franchise system. By requiring franchisors to disclose numbers on the units that have transferred ownership or closed, you get information that may assist you in forming an opinion about growth and success rates for the system.

Items 21 and 22: Financial Statements and Contracts
Item 21: The franchise's audited financial statements for the previous three years. Examine these financial statements to determine the financial strength and stability of the franchisor because you won't receive any future assistance if they go out of business. If this isn't a subject you know well, get assistance from your accountant or someone else familiar with financial statement analysis to help you perform this review and form this opinion.

Item 22: All contracts you may be required to execute in conjunction with becoming a franchisee, including the actual Franchise Agreement contract and other contracts covering personal guarantees, real estate assignments, advertising, co-op rules and conditions, and territorial development schedules.

Other Rules, Restrictions and Information
Items 8, 10, 13, 14, 16, 18 and 23 all contain important information pertaining to the franchise. Some of these sections relate to rules, such as where you can buy your supplies, what products or services you can offer and what your obligations are as far as personal participation. Others contain information about any financing programs available through the franchise, any public figures involved in promoting the business and the status of all trademarks, patents and copyrights. In addition, there are standard exhibits in every FDD with required listing of state-specific information and other "housekeeping" matters.

By using a careful, systematic approach to assimilating the important information that's available to you via the FDD, you'll go a long way toward solving the riddle of whether a particular franchise is right for you.

Jeff Elgin is the "Buying a Franchise" coach at Entrepreneur.com and has more than 25 years of experience in franchising, both as a franchisee and a senior franchise company executive. He's currently the CEO of FranChoice Inc., a company that provides free consulting to consumers looking for a franchise that best matches their needs. He was assisted in the research and writing of this article by Terrie Hall of FranChoice.