Saturday, February 8, 2014

FDD Fundamentals: Item 7

Like Items 5 and 6, Item 7 addresses a potential franchisee’s financial considerations when entering into a particular franchise. In fact, the figures from Item 5 are incorporated into Item 7’s totals (Item 6’s figures are separate). Keeping in mind that there is some overlap between Items 5, 6, and 7, Item 7’s purpose is not to indicate the magic number where the franchise will begin to turn a profit, but instead to give the franchisee the information necessary to determine if she has sufficient capital to survive the initial phase of a franchise. This initial phase typically lasts for three-months, however, the franchisor may use a different period(generally when a different period is customary in the franchisor’s industry). Finally, it is important to remember that Item 7 contains only estimated values, may include high and low ranges, and in some instances no concrete numbers at all (e.g., real property costs may be disclosed through a general description of the requirements for the property). Thus, it is important to clearly understand which costs are and are not included in Item 7.

Item 7 includes the franchisor’s estimated amounts for the initial franchise fee; training expenses; real property requirements; equipment, fixtures, construction, and decorating costs; initial inventory costs; security deposits; business licenses; other prepaid expenses(Item 5) and finally “additional funds” required before and during the initial phase of the franchise business. Some of these costs are clear and do not require any estimation, e.g., franchise fees, however, others like the costs associated with real property requirements can be a little misleading because the difference between high and low costs may vary significantly.

However, as implied by Item 7’s title, estimated initial investment, this Item is not intended to disclose all fees. Specifically it likely will not include costs that extend beyond or begin after this initial period. Additionally, there are certain exceptions such as, the franchisee’s salary, which do not necessarily need to be disclosed in Item 7. Some examples of other costs that are likely to be omitted from Item 7’s disclosures include interest and financing costs. However, the fact that Item 7 does not disclose all costs does not mean that the franchisee cannot find additional information. A potential franchisee may get a more complete understanding of the initial and ongoing costs by contacting current and former franchisees. Current and former franchisees understand well the total costs to open and operate the franchise business.

Franchisors and franchisees should remember a few key takeaways with respect to Item 7. Franchisees should first remember that Item 7 does not disclose all the expenses required to open a franchise. Second, the disclosures in Item 7 are only estimates. Third, the costs disclosed in Item 7 cover only the initial phase of the franchise. Thus, before signing a franchise agreement and undergoing the significant expense of leasing, remodeling etc. of a franchise location, it is wise to get additional information regarding all the expenses during the initial term of the franchise, and to have capital reserves greater than the minimum ranges listed in Item 7.

Franchisors, when making your estimates it is important to balance at least two factors: sticker shock and franchisee success. Sufficiently accurate estimates simultaneously promote an appealing offering and the long-term growth and lasting success of your franchise system. Accurate high and low ranges can both appeal to potential investors in varied financial situations, and increase the likelihood that your new franchisees will be able to survive the initial phase of the franchise business. Accordingly, if your costs are inaccurately estimated, and you accept a franchisee with insufficient capital to last through the initial phase, you may be left with only a closed location (that reflects poorly on your brand and will need to be disclosed in future FDDs), and an unhappy potentially litigious former franchisee. In short, Franchisors should always remember that their success is closely tied to the success of their franchisees, and their primary goal should be to promote their franchisees success.

FDD Fundamentals: Items 5 & 6 (Part 2)

The primary purpose of Item 6 is to help the franchisee better understand the capital requirements for operating a particular franchise business. Accordingly, Item 6 generally requires the franchisor to disclose any recurring or occasional fees the franchisee must pay to the franchisor or an affiliate, including fees collected by the franchisor or an affiliate for the benefit of a third party, during the initial term of the franchise agreement. Additionally, Item 6 requires the franchisor to disclose the existence of any purchasing or advertising cooperatives and the franchisor’s participation and control over these cooperatives.

It is important to remember that similar to Item 5, the franchisor is only required to disclose operating fees or payments payable to the franchisor or its affiliates, i.e., the franchisor will not include operating costs imposed by and payable directly to third parties. Accordingly, Items 5 and 6 do not provide a complete picture of the opening and operating costs of the franchise business. And, in some instances, the undisclosed costs can be significant. For example, construction, labor, licensing, etc. are all costs that may not be disclosed in Items 5 or 6, but are likely to be significant.

Additionally, Item 6 requires the franchisor to disclose any purchasing or advertising cooperatives. This disclosure provides two important pieces of information to the franchisee. First, it indicates how much freedom the franchisee will have with respect to advertising and purchasing, and second, it provides additional information about the costs of operating the franchise business. Finally, Item 6 requires the franchisor to disclose the existence of any advertising or purchasing cooperative and the participation and voting power of any franchisor owned (company owned) stores that participate in the cooperatives. Additionally, if the franchisor owned stores have controlling voting power in a particular cooperative, the franchisor must also disclose the required fees associated with that particular cooperative.

However, understanding what information is required to be disclosed in Items 5 and 6 is only part of the battle. It is important for the franchisee and franchisor to understand how this information may affect them. When reading and applying the information in Items 5 and 6 the franchisee will want to remember that although these items provide valuable information about costs and control, they do not provide a complete picture of all the costs involved in starting a franchise business. Additionally, the franchisee should remember that these numbers are not necessarily set in stone. The franchisee can attempt to negotiate these fees and if a range is provided in the FDD , under appropriate circumstances, the franchisee should consider negotiating for fees outside that range.

Accordingly, it is important to consider some general negotiation principles. One key principle, probably the most important thing to remember, is that you have alternatives to entering a franchise agreement with a particular franchisor. There are multiple franchisors in every sector of franchise business For example, Holiday Inn, Marriot Hotels, Best Western etc. are all franchisors selling franchise opportunities in the hospitality sector. Franchisees should look at the various franchisors in a particular sector, compare their initial and ongoing fees, compare their services provided, their success rate etc. and use all this information to determine his or her favorite franchisor systems. When negotiating with these franchisors have this information in mind, and remember that if one of these franchisors unwilling to negotiate, you have other alternatives you are interested in and walking away from this negotiation is a viable option.

The effects of Items 5 and 6 for the franchisor are similar to the effects for the franchisee, but from a very different perspective. Franchisors need to consider several factors when determining whether to negotiate and enter an agreement with a prospective franchisee. First, it will be important to remember that any deviation from your standard agreement will need to be disclosed in subsequent FDDs, and disclosing this agreement may adversely affect your ability to aggressively bargain in the future. Second, it is important to consider your alternatives to selling a franchise to the prospective franchisee. Do you have prospective franchisees beating your door down, or is this franchisee the only person who has been interested in your system for some time? You may want to be more or less flexible depending on the current demand for your franchise offering. However, either way a franchisor should consider the unique addition a franchisee could make to her system, and if you believe a particular franchisee is going to be a great asset to your system you may want to consider negotiating.

Additionally all franchisors should take time to understand their competition. What other systems are competing with you for prospective franchisees? What services are they offering? What fees are they charging? Etc. Understanding the differences between your system and others will help you to explain why your system is different from others. For example, if your fees are a little higher than your competition’s, but you provide additional assistance, have a much higher success rate, or a stronger brand, you can explain this to a franchisee. Conversely, if your franchise system is having difficulty growing it may be partially due to your fees, services etc., and if you know this then you can work to make your franchise offering more attractive to prospective franchisees.

FDD Fundamentals: Items 5 and 6 (Part 1)

Items 5 and 6 both address the fees a franchisee must pay to the franchisor or its affiliates between signing the franchise agreement and the end of the franchise agreement’s initial term. Item 5 discloses the required fees a franchisee must pay before opening the franchise outlet. Item 6 discloses the required fees a franchisee is likely to pay during the initial term of the franchise agreement. Since these two items are so closely related, they will both be addressed in this post.

Item 5 serves a few purposes. First, Item 5 gives the franchisee an idea of the costs she will incur before the franchise business opens. Second, it gives the franchisee an indication of whether the franchisor is willing to negotiate these fees and the range within which the franchisor has negotiated these fees in the past. Finally, it informs the franchisee whether any of these fees are refundable and the requirements or conditions associated with any refund. Each of these purposes merits some additional attention. First, it is important for a franchisee to remember that she will have to pay the franchisor fees even before she opens the franchise business (except some states require the franchisor to escrow, defer, or impound these initial costs until the franchisee’s business opens). Thus, the franchisee should not think it can use the profits from the franchise business to cover these costs. Additionally, it is important to remember that these fees are not all the costs that are involved in opening the franchise business, but only the fees that the franchisee must pay to the franchisor or its affiliates. Thus, the costs provided in Item 5 represent only the fixed costs imposed by the franchisor.

Second, since Item 5 requires the franchisor to disclose the range of initial fees it has charged other franchisees in the past, it opens the door to negotiation of these fees. Additionally, it is important to note that the range listed in Item 5 neither functions as a floor nor a ceiling for negotiation purposes, i.e., the franchisee and franchisor may negotiate terms outside the range provided in Item 5. The freedom to negotiate outside the range in Item 5 has benefits as well as costs for both the franchisor and the franchisee. One benefit for both parties is that the freedom to negotiate outside the range gives the franchisor and franchisee the ability to be creative and look for areas of mutual gain that they may not otherwise consider. However, some costs of this additional flexibility are that the franchisor will have to disclose any deal outside the range in the future and may have more difficulty aggressively bargaining in the future. Franchisees should remember that just because the FTC rule permits the franchisor to negotiate outside any range disclosed in the FDD, this does not imply that the franchisor will negotiate outside that range or at all. Consequently, franchisees shouldn’t have unrealistic expectations for a significant discount based on the range provided in Item 5.

Third, Item 5 also has a requirement that the franchisor disclose whether the Item 5 fees are refundable, and the conditions associated with any possible refund. This is valuable because it provides additional information that the franchisee can use when determining what initial fees and other terms it would like to agree to during negotiations with the franchisor. For example, a franchisee who can receive a refund under certain circumstances may be more willing to commit additional capital up front, for the security that it can receive at least a partial refund under certain circumstances.