Items 5 through 7 of any franchise disclosure document (FDD) broadly outlines the fees a prospective franchisee should expect to pay in the opening months of the business. These areas cover the franchise fee and additional initial fees, “other fees” that include royalties and advertising fees and, finally, the initial investment. Experts say that knowing these fees and fully understanding the other components of the FDD before crafting a business plan is essential to success regardless of whether a franchisee is financing the opening. For more on this continue reading the following article from Blue MauMau.
This is the third in a series of articles for prospective franchisees that discuss the components of a franchise disclosure document. Unlike almost all other articles about what you will learn in a franchise disclosure document, however, this series will focus on what you may not learn. This focus is intended to help you both refine and expand your due diligence efforts.
ITEM 5-7 – INITIAL AND ON-GOING COSTS
The first two articles in this series covered what I view as the most important disclosure items in the franchise disclosure document (FDD), Items 19 and 20. Not too far behind are Items 5 – 7, which collectively require a largely tabular presentation of the costs involved in starting and initially operating a franchise. These costs include all fees and expenses payable before the franchisee’s business opens as well as those that the franchisee will incur during the "initial period" of operations, which is defined to be at least the first three months of operations. There is some amount of overlap in the items, but generally,
- Item 5 addresses the franchise fee and other initial fees,
- Item 6 covers on-going and recurring fees, and
- Item 7 captures likely expenses that may be incurred in a franchisee’s start-up phase.
The disclosure of initial and on-going costs is particularly important as a roadmap for a big chunk of a prospective franchisee’s business plan. Irrespective whether a franchisee plans to finance any part of the franchise investment, writing an effective business plan is an absolute must. And it would be impossible to craft a sound business plan without a full understanding of all initial and on-going franchise costs. Indeed, Craig Tregillus, the Franchise Rule Coordinator at the Federal Trade Commission (FTC), the federal agency that regulates franchises, advises that "a start-up franchisee’s business plan cannot provide a useful financial roadmap without fully accounting for the costs required to be disclosed under Items 5 through 7."
What you will learn
ITEM 5 – INITIAL FEES. Item 5 is where the per unit franchise fee is disclosed. The required disclosure is broader than the franchise fee, encompassing all immediately payable fees and payments as well as commitments to pay at a later date, for franchisor- or franchisor affiliate-supplied goods and services that the franchisee receives before his or her business commences. But, typically, the franchise fee is the headline. Below the fold costs may include things like design fees, initial promotional materials, and opening supplies and inventory.
Importantly, Item 5 requires disclosure of any conditions under which initial fees are refundable. Don’t be too disappointed if they are not. While I certainly haven’t read all or even most FDDs, initial fee refunds are likely the exception rather than the rule.
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Finally, a franchisor is required to disclose the range or formula used to calculate initial fees paid in the last fiscal year if they are not uniform, a useful piece of information in gauging whether the franchisor may be receptive to fee negotiation.
ITEM 6 – OTHER FEES. There was actually some discussion in the FTC Franchise Rule release about what to call this item. The Uniform Franchise Offering Circular (UFOC), the predecessor to the FDD, titled this item "Recurring or Occasional Fees," but the FTC agreed with certain commenters that the leaner "Other Fees" somehow adds more clarity. But whatever it’s called, Item 6 principally focuses on on-going fees, including royalties, advertising fees and transfer fees. It requires tabular disclosure of payments made directly to the franchisor or an affiliate, or collected by the franchisor or affiliate for the benefit of a third party.
The disclosure includes fee amounts, due dates and, maybe most importantly, remarks. Remarks, if long, may be included in footnotes. And we all read footnotes, right? Well, the answer has to be yes for a couple of reasons. First, even if the franchisor can squeeze the remarks into a column in the "Other Fees" table, you still may see footnotes that explain fairly important things like what constitutes "gross revenues" (the number upon which royalties are based). Second, the substance of the remarks can be critical. For example, the "Remarks" column or footnote must disclose, among other things, whether the fees are uniformly imposed (again perhaps tipping you off that there may be room for negotiation) and the maximum and minimum fees that may be imposed.
ITEM 7 – ESTIMATED INITIAL INVESTMENT. Let’s focus here for a minute on how Item 7 differs from Items 5 and 6. It’s like the difference between making the car payment and filling the tank with gas. Mr. Tregillus says that Item 7 "is really designed to let a prospective franchisee know whether he or she has the financial resources to get moving." Another important difference is that Item 7, unlike Items 5 and 6, covers items that you are likely to pay to third parties, like rent and equipment. Accordingly, Item 7 gives a better overall picture of your likely investment than Item 5 and 6.
Item 7 requires a table, "Your Estimated Initial Investment," that lists expenses that are required both before operations begin and during the "initial period," which is typically (but at least) three months. For each of these expenses, the franchisor must disclose
- The amount of the payment (fixed, a high-low range or, in the case of real property that cannot be estimated, a property description)
- The method of payment
- The due date and
- To whom the payment will be made
The franchisor also must
- total the initial investment, incorporating the range of fees if applicable
- state whether each payment is non-refundable or the circumstances when each payment is refundable and
- in the case of franchisor (or affiliate) financing, disclose the loan terms (down payment, interest rate, etc.).
What you will not learn.
The most common misperception about Items 5 through 7 is that they provide a start-to-finish summary of the costs for a franchise. This, of course, is not the case and a simple look at the item titles should ordinarily dispel that misunderstanding. The lion’s share of the Item 5 – 7 disclosure concerns pre-operating expenses. In fact, the only post-opening disclosure requirements are set forth in Item 7 and, even then, most Item 7 disclosure covers only pre-opening expenses and only concern start-up phase post-opening expenses. Consequently, the most important information that you will not learn in Items 5 – 7 is life-of-franchise cost information. But that was never the intent of the FDD. So, even after slogging through these cost disclosures, you still need to sharpen your pencil and figure out for yourself what the longer-term costs of running your franchise will be.
Item 5 may provide only a range of initial fees for the past fiscal year if such fees are not uniform. Alternatively, the franchisor may disclose the formula and factors used to calculate the initial fees in the last fiscal year. There are some plusses and minuses here. On the plus side, if a range of fees is disclosed, you will know that you may have some bargaining power. On the negative side, you really won’t know your relative position within the range of fees.
When the new franchise rule was in the proposal stage in 2007, the FTC staff and some commenters recommended that that Item 6 be expanded to require franchisors to disclose required payments made to third parties (versus the franchisor or an affiliate). One commenter noted that in the "vast majority of franchise cases we see, the franchisee’s ongoing legal obligations to third parties far exceed the franchisee’s ongoing legal obligations to the franchisor" and that third party obligations continue even if the franchise is terminated. This may very well be the case, but the FTC concluded that a third-party fee disclosure requirement would be overbroad and, at the end of the day, such fees are a "consumer education issue" and not a pre-sale disclosure matter. The FTC had some pretty sound reasons for this conclusion (difficulty in obtaining reliable information and the fact that third-party fee disclosures are required in other parts of the FDD, including Item 7). But the fact remains that some of the heftiest on-going fees that a franchisee is likely to incur are not disclosed in Item 6.
In addition, unlike Item 5, which, as described above, requires disclosure of the range or formula used to calculate non-uniform fees paid in the last fiscal year, Item 6 has no such requirement. As a result, you will not learn from the FDD whether ongoing fees charged in prior periods were different from the currently disclosed fees.
Again, Item 7 was never intended to capture all expenses made over the life of the franchise. This item is squarely focused giving a prospective franchisee important information about the start-up phase of a franchise. In addition, even for the start-up phase, a franchisor need not disclose exact expenses figures. For example, if a franchisor does not know the exact amount of real property expenses, the franchisor may instead disclose an estimate or high-low range. If the franchisor cannot determine even these metrics, the franchisor may simply describe the property requirements (size, type, location, etc.).
Finally, if you’re looking through an FDD for working capital or break-even disclosure, put it down and start calling current and former franchisees and trademark-specific franchisee associations. You won’t find this disclosure in Item 7 of the FDD. Concerned in part by what might amount to a "back-door" mandatory earnings claim (recall from the first article in this series that Item 19 financial performance representations are permitted, but not required), the FTC concluded that franchisors should not be required to disclose either working capital or a breakeven point. These are metrics that you need to determine.
Of course, what you will not learn in Items 5 – 7 is far outweighed by what you will learn. You simply need to supplement what you will learn with some additional due diligence, a calculator and some phone calls.
Mike Sheehan is a franchise consultant and attorney. He is the president of Focus Ventures (www.focusonfranchise.com) and formerly served as a securities attorney and as general counsel for a Fortune 100 financial services company. His Franchise Focus Blog (www.franchisefocus.blogspot.com) focuses on helpful information, tips and current news for prospective franchisees.