What Is The Initial Investment (Item 7) In the Franchise Disclosure Document?
What Will it Cost to Buy and Start a Franchise?
If you are buying a franchise then‚ naturally‚ an important question will relate to your start-up costs. Important information that will assist you in answering this question will‚ fortunately‚ be contained in Item 7 of the franchisor's franchise disclosure document. Mandated by federal and state franchise law‚ within Item 7 franchisors are required to disclose the "estimated" costs for starting a franchised business. Presumably‚ the estimated costs contained within Item 7 will be based on the franchisor's own experience (i.e.‚ where the franchisor previously established "corporate / franchisor" owned locations) and possibly the experiences of its franchisees.
Item "7" will include information about the franchise fee that you will be paying to the franchisor and an estimated range (low to high) of start-up expenses that include:
The 7 categories of expenses detailed in Item 7 of your FDD include:
- the initial franchise fee;
- training expenses;
- real property whether purchased or leased;
- equipment‚ fixtures‚ construction‚ and decorating costs‚ whether purchased or leased;
- initial inventory;
- security deposits‚ business licenses‚ and other prepaid expenses; and
- additional funds required by the franchisee before operations begin and during the initial phase of the franchise business.
High to Low Estimated Expenses
Most of the identified expense items will appear to be straight forward. For example if the franchised business is a restaurant then you will clearly see information related to build-out costs comprised of restaurant construction costs‚ equipment expenses‚ point of sale systems‚ etc… Likewise if you business is a service based business like a tax preparation service‚ pet hotel childrens learning center‚ etc… then tyour start up expenses will include leasehold improvements‚ buildout‚ equipment and the like. Within Item 7 there should be low to high estimates for each item and as a franchisee you should work off of the "high" estimates.
Pay Particular Attention to Reserve Capital Requirements
However‚ often overlooked is a mandatory start-up expense disclosure related to "reserve capital" although this "expense" category is commonly referred to as "additional funds required" and is listed as the last expense. What does this expense category relate to? Well it relates to the reserve or extra cash that the franchisor estimates that you will need‚ i.e.‚ the money that you should have in your bank account or available to you after you establish and start running the franchised business. Presumably your new business will not be profitable on day one and during your first few months of operation you may require additional cash to fund the business and to pay ypur personal expenses. So‚ dont overlook this expense category and also understand that this is only an "estimate". In my experience franchisors typically include a "reserve" capital estimate of only 3 months. I believe this is too little and as a prospective franchise buyer you must assume that your business will not be profitable from the start and‚ as such‚ you must have funds set aside to keep your business running and to pay your personal expenses. At a "minimum" you should have 6 months reserve capital.
By Charles Internicola September 10, 2010
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