Red flag

Franchise Times presents a shortcut to spotting warning signs in a franchise's FDD.

Reading an FDD, the multiple-page franchise disclosure document required for any franchise offered for sale, seems daunting, but at Franchise Times we have some tips to make it easier for prospective franchisees. 

I call this my 60-minute shortcut research tool, learned over eight years of reporting at Franchise Times. It is meant not to give the last word on whether to buy a franchise but rather to provide a snapshot to avoid early warning signs or at least investigate further. 

Here are the four items in the FDD that are most useful to prospective franchisees, and why they're important: 

Item 1 details the franchisor and its parents and affiliates so prospects know who owns the company. I'll tell you why that matters below.

Item 3 includes "material" litigation at the franchisor so prospects can learn who's litigious and who's not—meaning which franchisors are more likely to land franchisees in court.

Item 19 details the financial performance of the franchise—or not, because the franchisor is not required to provide one. If an Item 19 is blank or lacks sufficient detail, Franchise Times' advice is simple: Do not pursue.

Item 20 lists number of outlets open year by year, so prospects can separate the "sold" hyperbole from the "open" reality—and avoid a franchise system in danger of collapse.

For more on Item 1 and Item 3, read on:

Item 1: The description of the franchisor and any parents, predecessors and affiliates may seem like boilerplate, but this item is actually very revealing. Especially in an era when private equity, family office and strategic investors are flooding the sector, you may find that your franchise is a subsidiary of a subsidiary that's owned by a giant corporate parent. 

That's the case with Camp Bow Wow, for example, owned several rungs up the ladder by the Mars family, maker of candy bars. You might like that fact, believing that a deep-pocketed private company would make a patient owner, or you might be turned off to learn your franchise is just a speck in a much grander scheme and fear it may be ignored. Either way, Item 1 will detail the ownership structure. 

If your franchise is one of many under a single corporate umbrella, as is more and more likely these days, Item 1 will lay that out as well and most importantly allow you to gauge the pace of acquisitions at the umbrella company and judge how well those brands are being integrated into the system. 

Authority Brands, for example, has acquired seven brands since October of 2018, most recently STOP Restoration. Two of those brands—Benjamin Franklin Plumbing and One Hour Heating & Air Conditioning, acquired in September 2019—were performing more poorly than some of their peers in 2019, according to the Franchise Times Top 200+. Systemwide sales at Benjamin Franklin were down 15 percent from the year before and One Hour's were down 2 percent. Buyers should be aware that poor performers are likely to take outsized corporate attention, possibly affecting the support for their franchise whether it's a strong or weak brand itself. Take a look at everything under that umbrella before deciding whether to hop in.

Finally, the word "affiliates" seems innocuous but is anything but. This is where franchisors must disclose companies that bring in revenue to them, but not necessarily profits to the franchisee, and it can be a major bone of contention between 'zors and 'zees. Edible Arrangements, for example, has several affiliates, most notably EA Connect, the online platform it developed that handles all e-commerce transactions and charges franchisees 6.5 percent of sales in fees, up from 2 percent in 2018, meaning a lot more money flowing to the franchisor. That's not necessarily a bad thing, but franchisees should know who's reaping rewards via which affiliates.

Item 3. Any "material" litigation in the last 10 years must be disclosed in this item, and you may be surprised by the huge variance in how many or how few lawsuits franchisors show. At least I was when Franchise Times researched this topic for an illuminating article published in October 2019. Some franchisors almost never set foot in court, while others are steeped in legal battles, we found. Subway listed 855 cases in Item 3, or about 20 per thousand units. McDonald's, by contrast, lists 32 cases, or a mere one case per thousand.

Part of the reason for variations is that franchisors can decide themselves what is "material," and some err on the side of including everything while others do the opposite. But general counsels told me a more important factor is the mindset of the franchisor—do they want to duke it out in court or do they want to work things out with franchisees? 

I always recommend a read of Item 3, and a rule of thumb that 10 cases or more is a red flag. More important than the number, though, is the content: who's suing whom and over what? Outdoor Lighting Perspectives, for example, shows six complicated sets of lawsuits dating back to 2012, showing at the least that the parent company's Chairman and CEO Chris Grandpre doesn't shy away from lawsuits and at the worst that franchisees may face major legal fees in this system. I'd investigate more thoroughly if I see a hefty Item 3, and since lawsuits are public record that's not difficult to do.

Up next: Two more red flags when buying a franchise.

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