How to read an FDD like a pro
When reading FDDs, long-time franchise journalist Julie Bennett (who is not pictured above) recommends starting with Items 3 (litigation), 4 (bankruptcy) and 20 (number of franchised outlets).
When I first started writing about franchising almost 30 years ago, I approached each franchise disclosure document, then called a uniform franchise offering circular or UFOC, with dread. Rather than disclose the health of a franchise system, an FDD seemed designed to obscure it.
Thanks to years of help from many of the industry’s top attorneys and analysts, I can now scroll through an FDD quickly, spotting areas that require more scrutiny and signs that a system is thriving or heading into serious trouble.
Editor-in-Chief Beth Ewen asked me to share my hard-earned expertise by examining FDDs from two restaurant chains I knew little about. We chose Marco’s Pizza, in Toledo, Ohio, a mostly pick-up and delivery chain with 537 units at the end of 2014, and Pizza Ranch, a buffet-style family chain in Orange City, Iowa, with 182 franchises open.
Each FDD contains 23 items, or sections. Most of these provide a reading on the franchisor’s health, but when examining the viability of a franchise investment, three items stand out like a rash.
I start every FDD checkup by scrolling first to Item 3: Litigation. Franchisors are required to disclose all the lawsuits they’ve been involved in during the last five years and even the best systems tend to have a few. But any franchise that’s been sued by several franchisees claiming the same issues, like fraud or misrepresentation, is definitely ailing.
Item 4: Bankruptcy, is also a deal killer. Both Marco’s and Pizza Ranch are A-OK in this item, and Pizza Ranch has no litigation disclosed in its 2015 FDD. Marco’s Item 3 reports a single lawsuit filed by a vendor in 2010 that was eventually settled. So far so good, is my conclusion.
The most important indicator of franchise health is whether franchisees that sign on actually open a unit and stay in business. You will find that information in Item 20: List of Franchise Outlets. The first table in Item 20 tells you if a franchisor is growing or losing units; Marco’s added 296 new outlets from 2012 to 2014 and Pizza Ranch grew by 25 units.
In a healthy system, franchisees that want to exit can sell their units to other franchisees and Table 2 tracks those transfers. Pizza Ranch records 11 transfers in the last three years while Marco’s had 73.
The numbers in Item 20’s Table 3, Status of Franchised Outlets, are critical because banks will be reluctant to lend money into systems that report annual franchisee turnover (ceased operations, did not renew their contracts, were terminated or acquired by the franchisor) that’s more than 5 percent of all units.
Both systems passed easily. Pizza Ranch had only one non-renewal in 2014, or a turnover rate of 0.5 percent. Marco’s lost 14 franchised units in 2014, for a 2.6 percent rating. Item 20 also includes a checkup on a system’s franchise development. Does the franchisor expect all the franchises sold in one year to open in the next? Marco’s ended 2014 with 73 franchises sold but not open and projects 140 openings in 2015, but Pizza Ranch has a slower development schedule, with 18 unopened outlets at the end of 2014 and only 10 new franchises projected to open in 2015.
If a franchise passes my Big Three, I scroll back to the beginning of its FDD to read the other items in order. Item 1: The Franchisor, and any Parent, Predecessors and Affiliates, is important because one potential problem for a franchisee is signing on with a franchisor that’s formed separate companies to provide many required products and services, possibly at higher prices than franchisees could find on the open market.
Marco’s has affiliates that provide franchise sales, real estate services, financing, equipment sales and leasing and the distribution of products. (Marco’s pointed out franchisees should look into whether the franchisor has required purchase agreements, and if they do, are there any price guarantees.) Pizza Ranch has affiliates that provide accounting services and marketing materials. I’d make a note to track the impact of these co-owned companies through both FDDs.
Item 2: Business Experience provides short biographies of the franchisor’s management. I look for longevity and breadth of experience and found them in both FDDs.
Items 5, 6 and 7 list all the fees and expenses of opening the franchise. Item 5 begins with the franchise fee (Marco’s at $25,000 and Pizza Ranch at $30,000 are within the norms for quick- and full-service restaurants) and Item 6 outlines the royalty, marketing and other fees collected by the franchisor as a percentage of gross revenue, plus the costs of training, audits and other services.
Besides listing what the franchisor is charging now, Item 6 shows the maximum it can collect in each category and deserves a careful read. Local store marketing at Marco’s, for example, is now 0.5 percent of gross sales but can rise to 7 percent, minus some other charges.
Item 7, Estimated Initial Investment, requires careful scrutiny. Because construction and leasing costs vary, initial investment is listed as a range, from $221,592 to $421,592 for a Marco’s store with limited seating, for example. The cost of a Pizza Ranch varies from $1.03 million to $2.75 million, depending on whether you lease or build from the ground up.
I look for unusual expenses, like Marco’s Brand Launch Program, for which new franchisees are charged $33,500 to $38,000 for pre- to post-opening marketing, and make a note to ask franchisees about its benefits. I compare working capital requirements ($32,500 for Marco’s; $20,000 for Pizza Ranch) against franchise sector averages calculated by FranchiseGrade.com in London, Ontario, Canada and note that Pizza Ranch is much lower than the numbers on the research firm’s charts, a potential red flag.
Item 8, Restrictions on Sources of Products and Services, is where franchisors must disclose any rebates they receive from vendors for products and services sold to their franchisees and income from affiliated companies. Rebates are controversial and most FDDs disclose them so discreetly you will have to read each Item 8 carefully. Both Pizza Ranch and Marco’s Items 8 raise questions, but I’m out of space so will leave that digging to you.
The biggest item of all
Item 19 - Because Financial Performance Representations are so important, I usually print them out. Strong FPRs provide information on the revenue and expenses of current franchisees.
Pizza Ranch’s Item 19 is 12 pages long and parses the gross sales and annual expenses of its 182 franchised and 7 corporate restaurants in several charts, according to the length of time they’ve been open and the population areas they serve.
Pizza Ranch discloses both EBITDA (earnings before interest, taxes, depreciation, amortization) and EBITDAR (includes rent) of its franchisees and lists annual same store sales increases since its first restaurant opened in 1983. One table shows how long it took the 59 restaurants opened since 2008 to reach cash-flow break even.
I would be less worried about Marco’s financial control over its franchisees if that Item 19 indicated they are making money. But Marco’s provides only gross sales numbers for the 381 franchised stores and 32 affiliate-managed stores (at least partially owned and/or operated by Marco’s founder or current executives) open through the end of 2014.
Since Marco’s says it does not collect expense information from its franchisees, their only chart showing costs is based on affiliate-managed stores, which have higher average revenue than the franchisees and pay lower royalties—2.5 or 3 percent or more, compared with 4.5 to 5.5 percent. The Item 19 also includes the “actual revenue and expenses” for one affiliate-owned store operating in a hotel in South Dakota. Any Item 19 that provides financial information on corporate stores that prospective franchisees can misinterpret about their own futures requires further scrutiny.
Item 21 - Financial Statements—also require printouts for careful study. I begin by checking if the franchisor is making a profit and if most of its revenue comes from royalties.
Marco’s and Pizza Ranch pass both tests.
I check for debt and find that both systems have long-term debt of about $7 million. Pizza Ranch’s is the sum of several construction loans; Marco’s borrowed about $7 million in 2013 to consolidate other debt and to pay back investors $5.7 million.
I then circle all numbers I don’t understand and come back to them later, after I’ve read to the end of an FDD’s attached notes. Pizza Ranch, for example, lists a $100,000 investment in a hotel on its asset sheet and explains this in a later note.
In the notes, I read that the company pays commissions of 10 to 11 percent of franchise fees and royalties to Marco’s Franchise Services, one of the affiliates listed in Item 1.
Marco’s has a separate FDD for its Area Representatives, who, it says, collect 40 percent of franchise fees and royalties in exchange for selling franchises and supporting franchisees.
Under assets, Marco’s lists $6.1 million in “Goodwill,” and I wondered what that was all about. (Marco’s says when the current owner bought assets from the founder 11 years ago, goodwill is the difference between what was paid for the company and the hard asset values of the equipment and desks and so on; in other words, the value of intangibles such as trademarks is often worth more than the physical assets.)
It tempts me to ask, goodwill toward whom—until I correct myself that’s a bit cheeky. When reading financial items, it’s best to stick to the facts, and ask more questions when needed.
What Pizza Ranch says:
Ryan Achterhoff, chief administrative officer of Pizza Ranch, said, “We have been opening franchises for 30 years and we have written our FDD from that experience. This allows us to be very precise in our investment and financial disclosures. Marilyn Mayberry, our director of franchise development, consults with new franchisees about what they encountered when setting up their new businesses, and we incorporate that information into our franchise documents. We want our franchisees to succeed and have found that offering them accounting services through an affiliate lets us provide consultative services to our franchisees and alerts us to anything out of line when there is still time.”
What Marco’s Pizza says:
Bryon Stephens, president and COO of Marco’s Pizza, said, “We invite and welcome anyone with questions about the Marco’s Pizza FDD to contact us directly for straight answers as to why Marco’s is one of the fastest-growing franchise systems in the country. The only affiliate under a required purchase contact is MPD—they are the exclusive supplier for certain store equipment and one of three approved distributors. MPD operates under a price guarantee program, so if any franchisee finds the same specified product at a lower price, MPD will match it. Also, there is a distinct advantage in having restricted sources of product and distribution so as to ensure the quality of product being used in the system, and create the case volume in order to secure the lowest available prices to the franchisee. We are very proud of our fabulous pizza, and are confident our franchise system is one of the most fair in the industry for franchisees to invest and grow.”