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Are Many Franchisors Underestimating Startup Costs In Item 7?

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Item 7 is one the more important disclosures in the Franchise Disclosure Document, since it estimates the investment a franchisee will make in a franchise.

I know that this subject could open up a proverbial can of worms and we may never know the answer to an important question in franchise disclosure. How accurate is Item 7 Initial Investment and how many franchisors underestimate the entries? Is it a very small number of franchisors? Are some estimates lower than they should be, as a result of mistakes or inaccurate numbers? Are there franchisors that "shave" the numbers so they are on the low end?

Obviously, it makes no sense to underestimate the investment a specific franchise requires, since it has critical implications for both a franchisee and the franchisor. Yet, from personal experience I know that some franchisors have understated Item 7, for obvious reasons. The lower the investment the larger the pool of franchise candidates and the more likely a certain franchise may appeal to a candidate when their investment capital is at a certain level.

Although Item 7 shows an estimated low and high range for most entries, if the low entry is underestimated odds are the high entry will be as well. Hopefully, all franchisors have the good sense to portray as accurate an Item 7 as possible based upon experience and fact. A failure to fulfill this requirement can result in new franchisees entering the franchise system being undercapitalized from the start.

Item 7 Explanation follows:

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. It's 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. T

he last entry in Item 7 is Additional Capital or Funds which is an estimate of the low and high amount of funds a franchisee may require to meet their personal expenses. This is an important category in Item 7 and one often misunderstood. 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.

In general, the time period most often used is three months. When a franchise candidate does a business plan and estimates future capital requirements they should remember that the Additional Capital estimate is usually for 3 months and few businesses reach break- even in 3 months.

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