Within Item 7, the franchisor must include a low to high estimate of the estimated cost for a franchisee to establish and open the franchised business. This estimate must include everything from build-out costs to reserve capital for the first three months of operation. The biggest expenses in Item 7 relate to costs for building out and equipping the franchised business.
Whether you’re a franchisor in the process of developing your Franchise Disclosure Document (FDD) or a franchisee candidate that’s in the process of reviewing one, understanding the disclosures in Item 7 is critical.
To help prospective franchisees understand the initial capital requirements for opening a franchised business, Item 7 contains important information that can make or break the financial health of a new franchisee. Because of that, franchisors need to understand what information to include in Item 7 to comply with federal laws and ensure franchisee candidates are properly capitalized.
In this article, we’ll discuss the estimated initial investment disclosures that must be included in Item 7 of the FDD to help franchisors make sure their franchisee candidates are well-qualified and positioned for success.
Item 7 Expense Disclosures and Format
Like several other disclosure items in the FDD, federal law requires the disclosures in Item 7 to be presented uniformly. Under the Federal Trade Commission’s amended Franchise Rule, franchisors must disclose estimated initial investment expenses in Item 7 in a tabular format containing five specific columns. The title “YOUR ESTIMATED INITIAL INVESTMENT” must also appear above the table in bold type and capital letters to be compliant with federal regulations.
Within the columns of the expenditure table in Item 7, franchisors must state the following information about each disclosed expense, starting with pre-opening expenses:
Column 1: Type of expenditure.
Column 2: Amount of expenditure (if the amount is unknown, franchisors must state a low to high estimate range based on their most current experience. For uncertain property costs that cannot be stated within a low to high range, property size and planned locations may be used).
Column 3: Method of payment.
Column 4: Due date of payment.
Column 5: To whom payment must be made.
Per 16 C.F.R. §436.5(g), franchisors are required to use footnotes to state whether each expense is refundable and, if so, the circumstances for obtaining a refund. Using footnotes, the franchisor must also disclose whether the franchisor or their affiliate will finance part of the initial investment and, if so, “the amount that it will finance, the required down payment, the annual interest rate, rate factors, and the estimated loan repayments.” (Referring to Item 10 can be helpful for these disclosures.)
For longer descriptions, definitions, remarks or other nuances related to expenses in Item 7, franchisors may also use footnotes to elaborate on those points.
Finally, the total initial investment – including ranges of fees, if applicable – must be stated at the bottom of the expenditure table.
Types of Expenses to Disclose in Column 1
Under the amended Franchise Rule, within Item 7, franchisors are required to disclose all expenses that must be paid by the franchisee per the franchise agreement, as well as any other expenses necessary for the franchised business to begin operations. These costs should be listed in column 1 of the expenditure table by expense type.
The types of expenses stated in column 1 of the Item 7 expenditure table vary by business. While there are no limits on the types of disclosures that can be included in Item 7, 16 C.F.R. §436.5(g) requires that specific typical expenses be disclosed in Column 1 when applicable to the franchised business, including:
Real property, purchased and/or leased.
Purchased and/or leased equipment, fixtures, other fixed assets, and build-out expenses including construction, remodeling, decorating, leasehold improvements, etc.
Inventory to start operating.
Prepaid expenses like security deposits, utility deposits, business licenses, etc.
Other Required Payments
In addition to the typical expenses above, the amended Franchise Rule requires that franchisors list separately and by name all required payments that the franchisee must make to open their franchised business within column 1 of Item 7. Depending on the franchise, these payments might include additional training, advertising costs, business travel, etc.
Additional Funds for the Initial Period
Under the amended Franchise Rule, franchisors are required to include a special expense category at the end of column 1 in the Item 7 expenditure table entitled “Additional funds - [initial period].” The duration of the initial period must be defined by the franchisor (the FTC considers at least three months as reasonable when defining the “initial period” of operations).
The disclosures in this category should include any other estimated expenses the franchisee will incur before opening the franchised business and during the initial period of operations, including any reserve capital requirements that might be necessary for the franchisee to have available to cover their personal expenses while waiting to generate a profit during the initial period of operations.
Per 16 C.F.R. §436.5(g), within this category franchisors must also describe “the factors, basis, and experience that the franchisor considered or relied upon in formulating the amount required for additional funds.”
Time Range for Item 7 Disclosures
With the exception of the “Additional Funds” category covering the initial period of operations, the majority of expenses disclosed in Item 7 should cover the period before the date the franchised business will open.
Although the expenses disclosed in Item 7 are often straightforward, franchisors should be aware of some less common situations in which additional information or expenses must be disclosed to franchisees.
Variations in Expenditures
In situations where estimated expenses vary by venue (for example, a store in an airport versus a stand-alone store), the amended Franchise Rule allows franchisors to include additional expenditure tables in Item 7 “to show expenditure variations caused by differences such as in site location and premises size.”
Company-Owned Outlet Sales
In general, Item 7 estimated initial investment disclosures do not need to reflect investment purchases of company-owned outlets. However, in situations where the sales price of a company-owned store exceeded the highest initial investment for franchised outlet sales during the prior fiscal year, franchisors are required to disclose the amount by which the company-owned store sales exceeded the highest initial investment for franchised outlet sales in a footnote.
Because expenses and circumstances vary by business and industry, franchisors should consult an experienced franchise attorney when preparing Item 7 of their FDD.