Buying a restaurant franchise? While the restaurant brokers focus only on open and operating restaurant franchises for sale, this article addresses the FDD points that anyone buying a franchise should learn from the FDD. The first requirement you will be exposed to in the FDD is the receipt. Not only are you required to receive the FDD but you are required to acknowledge receipt of this lengthy manuscript. With FDD’s average well over 100 pages, this document is not intentionally designed to overwhelm and intimidate but it certainly has that effect on the average buyer.
In this article, the restaurants brokers are going to break down a standard FDD and give you the “Cliff Notes” version of the 5 key items you should focus on as a restaurant buyer.
First of all, what is the FDD? The FDD is the Franchise Disclosure Document mandated by federal law and the Federal Trade Commission or FTC. In plain English – the FDD is what the government requires the franchise to tell you before you go into business with them. Face it, you are signing up (in most cases) for a 10 year relationship and going into business with someone who is a stranger to you.
Not only does the FTC tell the franchise that they must create an FDD, they tell them what it must include in sections they break down into “Items.” Every FDD has the same information included in each “Item” or section of the FDD. Every FDD will consist of the cover page, table of contents and 23 Items with standard headings. The five you need to focus on are:
Item 5 Initial Franchise Fee (also royalties and advertising)
This segment of the FDD will tell you not only what the initial fee but also any ongoing costs. Want to know the royalty rate? Here’s where you find it? Want to know about the ad fund and what you have to contribute? This is in Item 5.
Item 7 Franchisee’s Estimated Total Investment “Start Up Costs”
In this item, the franchise is required to tell you the high and low of the costs associated with starting the franchise brand. How is that helpful to you? As a new buyer, it helps you to understand your costs. As a resale buyer, it lets you know how much you are saving over the expected initial cost to build the franchise from scratch. One very important tip on Item 7 is the working capital cited in this section. What most happy franchise buyers do not realize is that the FDD requires the brand to list the estimated three months of capital required. That is THEE MONTHS. In the restaurant broker’s experience, we do not see restaurants that are profitable after three months. It will take on average, 18 months for a business to operate in the black. Do not rely on this much understated amount in Item 7 if you’re starting a business from the ground up. If you are buying a franchise resale, this is not as important because you have actual cash flow on the business, not projections to rely upon in building your business plan.
Item 17 Renewal Transfer of the Franchise Agreement
Especially as a franchise transfer candidate, you should focus on Item 17. This reveals the costs for renewing the agreement and transferring the agreement. The most common cost for renewal of a franchise is “50% of the ‘then-current’ franchise fee.” What that means is that when the franchise renews is 6 years or 10 years, your cost to renew the agreement will be half of whatever they are charging at that time. That could be less (rarely) or more (generally) than the current cost of the franchise.
Item 19 Financial Disclosures
If you’re buying a restaurant, the numbers matter and Item 19 is where they are found. Now while the FDD requires that you have a section titled Item 19, they do not require that a franchise provide any financial information. It is the choice of the operator whether they want to include information on not. For new franchise restaurant buyers, there may very well not be any financial information available. The benefit, obviously, of buying a franchise restaurant resale that’s already open and operating, is that the actual numbers are available. You are able to see the actual food costs, labor costs and sales up to the latest time period. Here’s a very important tip on the financial disclosures. Make sure you carefully study which numbers the franchise is providing you. In other words, read the fine print at the bottom. It is not uncommon for franchises to footnote and provide “select” data such as, “Data reflects average of top 20% of all franchises in the system” or “Reflects stores open more than 2 years” or ‘Includes Corporate Stores”. Think about the ways this could be manipulating the data you are getting. The top 20% of any brand is not representative of the total system as it leaves out the average and bottom performers. If there are only five stores in a chain and they show only data for the 1 open more than two years, again, you are getting data that is not representative. Lastly, systems are famous for including their corporate stores in results. A system with an airport store or high volume location can skew all of the results. The best tip you can take away from this article – study the footnotes and make sure you understand what “cherry picked” data you’ve been provided.
Item 20 List of Franchise Outlets
The FDD requires the franchise to list the name, address and phone number of every franchise outlet. This is where a franchisee may want to start dialing and talking to other franchisees. Note that the information is typically for the storefront location, not personal information on the individual that owns the store but it is a starting point for your investigation of the brand. One quick tip here. Franchises often have their “go-to” cheerleading group they will send people to for what’s known in the industry as “validation”. While you should definitely follow up with the ones recommended by the franchise, the restaurant brokers would also encourage you to find an equal number of franchisees outside that group.
In our estimate, these are the top five items in the FDD that deserve your time and attention. While there are definitely other important pages, these will give you the key financial information you need to make an informed decision when buying a franchise restaurant.