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Franchise Investment Due Diligence: Go Beyond the Franchise Disclosure Document

Most franchise investors understand that reviewing the Franchise Disclosure Document (FDD) is an imperative part of due diligence when considering an opportunity with a franchise system.  Through the federally mandated 23 sections – called “Items” – the FDD not only provides detail about the franchise system, but also offers great insight as to the prospective franchisor/franchisee relationship.  However, investors should keep in mind that the FDD only tells part of the story and the due diligence process should begin with the FDD, not end with it.  Here are three (of many) means of how an investor can go beyond the FDD and take the due diligence investigation to the next level.

  1. Obtain Prior Year FDDs. Federal regulations require franchisors to update their FDD each year.  As a result, several disclosures within the FDD are annual in nature and often provide a limited “snap shot” or look-back as to the history of the franchise system. For instance, financial performance representations (FPRs) (Item 19) and estimated initial investment (Item 7) calculations are commonly based upon performance of the franchise outlets for the fiscal year immediately preceding the FDD update.  Similarly, Item 2 provides the disclosure of current directors and officers of the franchisor but there is no required disclosure for any key personnel who may have recently left the franchisor. Moreover, other disclosures, such as pending franchisor litigation (Item 3) and the franchisee unit closures (Item 20) are also limited by time constraints.

By reviewing prior year FDDs, a potential franchise investor will be able to gain a better understanding of the franchise system and the franchisor over the course of the past several years.  So how does one obtain these previous FDDs? The easiest way is to simply ask the franchisor for copies.   However, franchisors may be reluctant about turning over prior year FDDs due to restrictions imposed by disclosure laws.  Therefore, investors can inquire with state agencies in the “registration states,” i.e., states where the FDD is required to be filed.  A list of these state agencies can be found in Item 1 of the FDD (typically found in an exhibit referenced in Item 1).    For example, the Maryland Office of the Attorney General – Securities Division stores FDDs in electronic format and will typically email copies upon request.  Additionally, FDDs filed in the State of California may be available for download, free of charge, at http://www.dbo.ca.gov/CalEASI/CalEASI.asp.

  1. Written Substantiation of FPRs. The FPRs in Item 19 provide valuable insight about the success (or failure!) of the franchise units within the franchise system.  A franchisor, in making an FPR, must have written substantiation in its possession at the time the FPR is made.  Moreover, prospective franchisees may request copies of the written substantiation and, under federal regulations, the Franchisor is required to turn it over.   Upon a careful reading of Item 19, one will find that this benefit afforded to the prospective franchisee is actually disclosed in the FDD.  So, why may this written substantiation be useful?  Well, written substantiation may include market studies, statistical analyses, franchisee profit and loss statements, and similar financial reports and records which may provide a better understanding as to the how the FPRs were calculated and provide additional financial information not disclosed in Item 19.
  2. Validate with the Good, but also the Bad. In the most general sense, the “validation process” entails a prospective franchisee reaching out to current franchisees to inquire about the franchise model and system. While it may be helpful for an investor to speak with successful and current franchisees, it may also be helpful for an investor to contact former franchisees who have recently left the franchise system.  The FDD provides a complete list of current franchisees in the system along with their contact information and a list of former franchisees who left the system during the past fiscal year.  It may be wise of prospective franchisees to reach out to several current and former franchisees during the validation process in order to obtain several different perspectives as to the franchise model and relationship with the franchisor.

Scott Osborn is an attorney with the Business and Transactional practice group at Davis, Agnor, Rapaport & Skalny, LLC. For questions about this article or your own franchise investment due diligence, please do not hesitate to contact Scott at 410.995.5800 or via email at sosborn@darslaw.com.