Buying a franchise is a significant investment, and all investments have one thing in common: they require an investment of money. You will need to contribute capital for your new venture, not only throughout the course of the franchise relationship but in upfront costs and fees as well. No reasonable investor would make any decision about a potential opportunity without making a very deep dive into the dollars-and-cents involved, especially at the outset, and that is precisely what Sections 5, 6, and 7 of the Franchise Disclosure Document (FDD) are about.
Those three sections require extensive due diligence because they address issues that can directly impact the franchise’s financial viability: initial fees, other fees, and the estimated initial investment. Together, these sections help prospective franchisees understand what they will have to pay, when they will have to pay it, and how much capital they may need to open and operate the business.
Section 5: Initial Fees
Section 5 of the FDD addresses the initial fees a franchisee must pay to the franchisor or its affiliates upon signing the franchise agreement. The “initial franchise fee” is typically paid in exchange for the right to operate under the franchisor’s brand and business system. And while it may be reasonable to expect that the initial franchise fee for a well-known brand such as McDonald’s would be significantly higher than that of a small, newly established QSR, there is really no correlation. Many initial franchise fees are modest when compared to the amount of the total initial investment required.
The initial franchise fee can vary substantially depending on the franchise. Most franchisors charge a flat fee, while others may offer different fee structures based on factors such as territory size, location, or the type of franchise being purchased. Usually, the fee is designed to cover initial training, site assistance, business consulting, or other services; however, in many franchise systems, the initial franchise fee is nonrefundable once certain conditions are satisfied.
Section 5 also may disclose circumstances in which the franchisor charges different initial fees to different franchisees. Discounts or reduced fees may be available to certain groups, such as veterans, first responders, existing franchisees, or purchasers of multiple units.
Critically, prospective franchisees must keep in mind that the initial franchise fee is only one component of the overall cost of becoming a franchisee. A relatively modest initial fee does not necessarily mean that the franchise is inexpensive to launch, as Sections 6 and 7 of the FDD should make apparent.
Section 6: Other Fees
Section 6 identifies the recurring and transaction-based fees a franchisee may be required to pay after signing the franchise agreement. These fees usually include royalties, advertising or marketing fees, technology fees, renewal fees, transfer fees, audit fees, training fees, and other charges. Depending on the franchise system, some fees may be fixed dollar amounts while others may be calculated as a percentage of gross sales or another metric.
Royalty payments to the franchisor should be a significant focus of a franchisee when evaluating which franchise system to purchase. Royalty rates can vary from a low of 3% to as high as 9%, but are usually in the 5-6% range. Since royalty payments are a percentage of a franchisee’s gross revenues, a franchisee can owe royalties even when the business is operating at a substantial loss. Needless to say, this can be an overwhelming or existentially threatening financial obligation in such circumstances.
Advertising fees also require careful review. Paying into a national or regional advertising fund does not necessarily mean the franchisee will receive an equivalent amount of advertising directed specifically toward its location and market.
Other fees discussed in the FDD may seem inconsequential at first glance, but can add up over time. Technology charges, software fees, required training, equipment maintenance, inspection fees, credit card processing requirements, and other recurring expenses can materially affect a franchisee’s operating costs.
Section 7: Estimated Initial Investment
Section 7 provides an estimate of the franchisee’s total initial investment. This is often one of the most important sections for a prospective franchisee because it addresses the larger financial picture rather than just the fees paid directly to the franchisor. The estimated initial investment may include expenses such as real estate, leasehold improvements, equipment, furniture, signage, inventory, insurance, professional fees, licenses, deposits, employee wages, and other startup expenses. It should also include an estimate of additional funds needed to operate the business during its initial period.
Pay close attention to the range provided by the franchisor, as the delta between the low and high estimates may be substantial. A prospective franchisee should understand what assumptions and factors account for that difference. For example, construction costs, rent, labor expenses, permits, insurance, and other costs can vary considerably from one market to another. A franchisee should therefore avoid assuming that the midpoint of the franchisor’s estimated range represents a realistic budget for a particular location.
Working capital is another critical consideration. Opening a business requires more than simply paying construction and equipment costs. The franchise may generate limited revenue during its first several months, while payroll, rent, utilities, insurance, loan payments, and other expenses continue. For that reason, prospective franchisees should consider whether they have sufficient cash reserves to withstand a slower-than-expected opening or an extended period before the business starts to break even.
Financial Due Diligence Goes Beyond the Franchise Disclosure Document
All three of these FDD sections should be considered holistically, as they collectively paint a realistic picture of the capital a franchisee will need to have available to purchase and operate a unit. But the financial due diligence involved in evaluating a potential franchise investment should not end at the four corners of the FDD. An experienced franchise attorney can help identify obligations that may be easy to overlook and help evaluate whether the projected investment and ongoing expenses make sense for your circumstances.
And, as I always emphasize to any potential franchisee, your due diligence must include conversations with existing franchisees in the system. As a key example, ask existing franchisees whether the projections in Item 7 of the FDD were accurate for their situation.
If you have questions or would like assistance in evaluating a franchise opportunity, please contact Roy Hibberd at Ansell.Law.