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The Key to Understanding a Company's FDD

Thinking of investing? Check out these three critical sections of the franchise disclosure document first.
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You'll find a lot of stats packed into the Franchise 500(R), including unit counts, costs, royalties and financing info. But it's impossible for us to show you every detail of every franchise system, which is why we always tell you to do your research before investing. Most important to that process? Carefully reading through the company's Franchise Disclosure Document (FDD).

Here, we take a look at three key sections from the FDD. You won't find this information among our listings, but if you are interested in a particular company, you'd be wise to check out these items carefully.

Item 3 of the FDD contains information on pending and prior litigation against the franchisor, as well as litigation filed by the franchisor against franchisees. Some litigation is inevitable, especially when dealing with old and large companies. But if a company's Item 3 goes on for page after page, take a closer look. Take note of who filed the suits, when they were filed and why. If there are many filed by franchisees, that could be a red flag. Likewise, a large amount of franchisor-initiated litigation could signal deeper problems.

Item 3 offers some of the greatest insight into whether franchisees are satisfied with the system. It reveals what the areas of conflict are and how the franchisor typically handles conflicts when they arise. But if you want to know even more (and you should), the best thing you can do is talk to current and former franchisees--who should also be listed in the FDD--to get their take.

Earnings Claims
It's the biggest question on the minds of prospective franchisees: How much money can I make? That's where Item 19 comes in. This is the one place where franchisors are allowed to make financial performance representations. Disclosure is optional, but more and more franchisors are choosing to include information in this section; in fact, two-thirds of this year's Franchise 500(R) companies do.

But beware: Not all Item 19s are created equal. Some franchisors offer a comprehensive look at how all the franchises in their system are faring financially. But others offer only the average sales for their system, sales for a select few units or sales of company-owned units rather than those of franchisees. Also, Item 19 may not necessarily show the whole picture; gross sales are one thing, but profits are another.

In short, when seeking the answer to the big money question, look to Item 19 as just the first step in your research, and one to be taken with a grain (or block) of salt.

Our listings show the total number of franchises year to year, but this is far from the whole picture when it comes to a company's growth. For that, you need to head to Item 20. The series of tables presented in this section offers a wealth of information on growth over the previous three years.

In particular, you'll want to look at the third table, which displays not only how many franchises were opened each year, but also how many were terminated, not renewed at the end of their term, reacquired by the franchisor or ceased operating for other reasons.

These numbers can be just as important to consider as the company's overall growth. If a company is losing numerous units each year--even if it's still managing positive net growth--it's time to ask questions. Find out why there's so much turnover and whether franchisees are actually experiencing long-term success with the business model or are simply being replaced faster than they leave.