Evaluating the information in a Franchise Disclosure Document (FDD) is a critical part of investigating a franchise opportunity. It’s helpful to have a few quick ways to assess whether the franchise is one to avoid. Here are 4 ways to spot clues in a Franchise Disclosure Document that may indicate problems ahead. These tests will help you whittle down your list and find the high-quality opportunities out there without wasting your time.
1. Item 20 of the Franchise Disclosure Document: Unit Counts
Here’s the simplest test of all. Review Item 20 of the FDD to assess whether the number of operating units is growing, staying constant, or declining. You can also find this data in online publications such as the Entrepreneur 500 list, which is published each January. Consider a declining number of units a red flag, regardless of the explanation supplied. It suggests significant risk for anyone buying into that business.
2. Item 3 of the Franchise Disclosure Document: Litigation Experience
Check the FDD to see whether there has been an increase in litigation between the franchisor and franchisees in recent years. The unfortunate reality is that when franchisees are struggling and/or failing, there is frequently an increase in litigation. This happens as people look to assign responsibility or blame others when their business is not working out. If you see a pattern of significant or increasing litigation (again – regardless of any explanation offered) you may want to avoid investing in that franchise.
3. Franchise Disclosure Document Exhibits: Audited Financial Statements
Every franchise company is required to attach their last three years of audited financial statements as an exhibit to their FDD. There are two things we want to learn from these financial statements.
First, we want to assess whether the franchisor is financially stable and has the resources to survive for the long run. We would hope to see a financial statement indicating that the operation is profitable, the cash flow is positive, and capital reserves are strong.
Second, we want to look at the accounts receivable figure on their balance sheet. If that figure has been rapidly increasing, consider it a red flag. For most franchise companies, payments from their franchisees represent a large portion of accounts receivable. A rapidly increasing balance indicates that franchisees are struggling to pay their bills, which is never a good sign.
4. Trends in Same Store Sales
Because franchisors are not required to disclose same store sales in the FDD, you’ll likely have to request this information from the franchisor. The question to ask is: during the past few years, have same store sales increased, decreased, or remained level? As you can imagine, most systems make every effort to increase the average performance of their units year over year. If the sales trend for their units is flat or decreasing despite these efforts, their business volume is clearly vulnerable to economic downturns. While a flat or decreasing trend might not be reason alone to disqualify the franchise, consider it an issue to carefully investigate prior to moving forward.
To receive a franchise company’s FDD, you’ll usually need to complete a short online questionnaire. Reviewing the 4 items above can be done in about an hour. This process will greatly improve your chances of avoiding mistakes and reaching a successful outcome in your search for a franchise opportunity that suits your interests and goals.