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Buying a Franchise? You Better Understand Item 7 of the FDD

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Item 7 in the Franchise Disclosure Document requires franchisors to set out in a prescribed format a franchiseeís estimated initial investment needed to start the franchise business. Itís important for individuals looking to purchase a franchise to fully understand what Item 7 contains. A leading cause of franchisee failure is being undercapitalized. Learn how to avoid falling into that situation.

The FTC requires that every Franchise Disclosure Document includes a schedule, under Item 7, that provides prospective franchisees the estimated investment in that franchise. Initial and on-going franchise fees are in Items 5 and 6.

In Item 7 franchisors are not required to list every type of fee or expense that might be part of the investment in the franchise. Instead, it contains the likely investment needed to start the franchise. The FTC requires that Item 7 list typical start-up expenses, such as the initial franchise fee; training expenses; real property (whether purchased or leased); equipment; beginning inventory; and business licenses and related fees. In addition to these typical expenses, franchisors must itemize and identify any other specific required payments such as additional training, travel, and advertising expenses that franchisees will incur to begin operations. The information will vary somewhat depending upon the type of franchise. Itís important to keep in mind the words "estimated" and "typical." You should use this information to develop your own investment number with your accountant or advisors.

Each item listed in Item 7 must disclose:

  • the amount of the payment;
  • the method of payment;
  • when the payment is due; and
  • to whom the payment is to be made.

Additional Funds:

Since most of the expenses in Item 7 cover the period prior to the date the franchise opens, a delay in the start of the new franchise or an initial operating problem could increase the investment.  An important category in Item 7 and one sometimes misunderstood is Additional Funds. In this category, franchisors must list any other required expenses that franchisees will incur both before operations begin and during the initial period of operations.

This initial period of operations can vary from franchisor to franchisor. In general, a reasonable period and the one most often used is three months. Additional Capital is described in the footnotes to Item 7.  When you do your business plan and estimate your future capital requirements remember that the Additional Capital estimate is usually for 3 months. Few businesses reach break- even in 3 months.

Low Amount-High Amount:

Most franchisors use a range from low to high in Item 7 since some items may vary. Examples include rental costs, leasehold improvements, training expenses, equipment, salaries, insurance and professional fees. Since these costs represent a range, youíll need to do a more detailed analysis to project what your costs would be.

Item 7 reflects the typical initial investment made by a prospective franchisee when buying a franchise. Since the investment schedule in Item 7 is based upon an estimate, costs can vary and should be verified. Finally, donít rely upon Item 7 as an indication of your full investment since it describes whatís needed to start up the new franchise operation not to get it to break-even. Be sure to rely upon qualified financial advice in order to identify what your investment will be and as always err on the side of caution. Finally, remember this is one part of the franchise due diligence process.

© 2010 FranchiseKnowHow, LLC

Ed Teixeira is the President of FranchiseKnowHow, LLC. He can be reached at franchiseknowhow@gmail.com

 

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