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.