What franchisors need to know before sending their FDD to a franchise broker
Most seasoned franchisors will tell you that the key to building a successful franchise system is selling franchises to qualified franchisee candidates – a process often made easier by working with franchise brokers.
Before reaching out to brokers about offering franchise opportunities, though, franchisors need to make sure they’re in the right position to attract strong franchisee candidates. To do that, a good place to start is knowing what franchise brokers look for when evaluating the Franchise Disclosure Document (FDD) before connecting you with their network of prospective buyers.
Below, we’ll explore the key qualities that franchise brokers expect to find in a franchisor’s financials – especially when it comes to reviewing Item 19.
1. A track record of success
According to Lisa Welko, a certified franchise executive and president of Integrity Franchise Group, having an Item 19 in the FDD is necessary for the majority of franchisors – no matter what they might have heard elsewhere.
“Sometimes we'll hear from a franchisor, ‘No, we don't have [an Item 19] because we're too small, and we only have a corporate location.’ Both – you should still have an Item 19. We need something to go after. Even if it's a fabulous P&L (profit and loss statement) of that corporate location, the franchisee candidates can use that,” Welko says.
Because Item 19 contains important information about the franchise system’s financial performance over time, franchise brokers and the franchisee candidates they work with rely on its disclosures to make decisions about investing in a business – something they can’t do without numbers to review.
“[Franchisee candidates] need those expense items, those income items – where are we going to make money from – so they can come up with their own conclusions,” Welko explains.
For new brands and franchisors that don’t have many franchisees yet, Welko recommends working to provide as much financial information as possible within Item 19 for the sake of transparency. Even with newer or smaller brands, she says a skipped Item 19 can sometimes mean the difference between a broker choosing to work with your brand, or passing it by.
“For me, a new brand or not a ton of franchisee candidates and no Item 19 is like, okay, you sit on the bench until you have one – because there's a million other franchisors like you, probably in the same category, that are going to give us that information,” Welko says.
2. The right timing
Although franchising is a proven business model, it isn’t for everyone. Because prospective franchisees are looking for investment opportunities with franchise systems that exhibit a strong track record of financial success, the numbers in Item 19 can help candidates – and brokers – determine whether a business is in a position to succeed as a franchise.
According to Charles N. Internicola, a franchise attorney with over 25 years of experience and the founder of The Internicola Law Firm, a law firm that specializes in franchise law and development, new franchisors often seek help when preparing their Item 19 disclosures – only to discover that their numbers aren’t strong enough to franchise their business yet.
Recalling a client that approached his firm seeking advice about Item 19 after working with a “one-stop-shop” developer that hadn’t explained the significance of financial disclosures, Internicola says a review of the company’s numbers showed it wasn’t in a position to sell franchises yet – even though the owner had already franchised the business.
“I asked why she didn't have an Item 19, and then when I asked about the data, my explanation was like, ‘Hey, I wouldn't go down the franchising path even though you've done it already. Your numbers aren't good enough for the industry, but maybe in a couple of years.’ And she explained, ‘Well, the developer really didn't explain anything and the lawyer said that if her numbers are too good, it's gonna give the wrong impression. And if they're not good enough, then you don't want to disclose them. – I'm like, that's bad,” Internicola says.
Instead, for businesses with financials that don't stack up against franchise industry standards, Internicola recommends owners take time to build up their company’s numbers and pursue franchising later down the road when it’s more viable.
“If your numbers aren't good enough, it doesn't mean franchising isn't in your future. But go make them good enough and don't franchise just yet,” Internicola says.
3. Strong unit-level economics
Beyond a brand’s overall financial health, franchise brokers want to work with franchise systems that exhibit good unit-level economics – that is, each of their franchisees is performing well with numbers that can validate the franchisor.
To make sure their unit-level economics are represented in the FDD, Welko advises franchisors to provide franchisees with an easy method of keeping track of their numbers. One method she’s seen used recently is a simple, pre-formatted spreadsheet.
“There are several franchisors right now that are sending those out blank as a ‘Unit Economics’ blank Excel spreadsheet, and then [franchisees] have to put the numbers in,” Welko says.
Welko stresses the importance of making sure franchisees include income from all revenue sources in their own categories, which can help identify the unit’s strengths and weaknesses during future evaluations.
Welko also recommends franchisors make sure each franchisee understands how the data will help them improve their own business, in addition to the franchise system itself.
“Franchisees don't want to think that they're just doing this new chart of accounts in order for the franchisor to make money. No – we're doing this to help you make more money. We're going to help you make better business decisions,” Welko says.
By breaking down the ways categorized data can help franchisees improve their own business models and identify opportunities for increased profits, Welko says financial tracking can become a valuable tool across the entire system.
“Make it a franchisee-centric type of project in [that] we're all going to get a more detailed P&L and a more detailed balance sheet to help you become better franchisees, better business owners – but that's also going to help franchisors bring it full circle into validation, because now you have successful business owners who are validating to these candidates,” Welko says.
Because a properly-prepared FDD and detailed Item 19 is a franchisor’s ticket to attracting quality franchise brokers – and well-qualified franchisee candidates – Welko advises franchisors and franchisees to get familiar with their numbers and be prepared to discuss them with brokers and candidates throughout the entire year.
“[Validation calls] are being recorded, and they're going to be put into perpetuity. Make sure your franchisees know their numbers and the percentages, and what their business looks like on paper,” Welko says.
4. Numbers that tell a story
Beyond simply providing franchise brokers with pages of numbers, Internicola says it’s important for the financial performance data in Item 19 to come together to tell a story about the brand itself – something brokers and candidates notice.
“Your Item 19 needs to fit in with a bigger story about the brand, the business model. … That economic story [is] not how much money can I make, but what does it look and feel like? What are the revenue levers? What are the expense categories?” Internicola says.
To make Item 19 financials more appealing to brokers during the evaluation process, Internicola recommends breaking revenue streams down and looking for stories within them that align with the brand, including its business model and services.
“Before you even get past gross sales, evaluate if there's a story there. Can we break up your revenue streams? For example, is a part of your revenue recurring revenue? And can you identify the recurring [streams]? Are there different service categories? Should you be identifying different service categories? I think that's a very overlooked advantage that franchisors drop the ball on – or their attorneys,” Internicola says.
5. Categorized revenue streams
Welko echoes the importance of breaking revenue streams into categories, noting that the differentiation between stronger and weaker revenue streams can be helpful for brokers and franchisee candidates when evaluating the franchise’s financials.
“If the business has three or four income streams, it's great for you to list out those income streams. [If] we take 50% of our revenue from Christmas lights two months a year, that's a big deal that might be overlooked in somebody's [business where] we paint houses, we do gutters, we do power washing – oh, by the way, we do Christmas lights,” Welko explains.
Like Welko, Internicola sees value in tracking revenue streams by category – a practice that can help brokers and candidates, as well as franchisors and franchisees, easily identify which parts of the business are more profitable. For businesses where revenue can’t be divided into categories, though, there are still options.
“One thing we always default to when we're modeling out Item 19 for, say a service-based business or whatnot, [is] first, can we break their sales down by category? And then, if we can’t break it down by category, can we give service data like number of service visits, average sale per service transaction,” Internicola says.
6. Investment in franchisees
Another quality franchise brokers look for when reviewing a franchisor’s financials is the support they provide to franchisees – something that can build trust with franchisee candidates considering investing in the brand.
“This is a new industry for [some franchisee candidates]. That's why they're choosing the franchise world, because they have someone that's going to help them and hold their hand. So show that from the very beginning – I'm going to help you, I'm going to help you get this going, I'm going to be with you, and then we're going to work on scaling your business and you know, making you an empire,” Welko says.
Because the success of a franchisor rests on the success of their franchisees, brokers tend to value franchisors that prioritize setting their franchisees up for success from the start by providing proper training, marketing, pre- and post-opening support and more.
“From the beginning, you are showing what kind of franchisor you're going to be. Are you going to be transparent? Are you going to be supportive? Are you going to help me with the details? Or are you going to give me a training manual, wish me luck, pat me on the back and I'll call you in a month when my royalties are due?” Welko says.
Because the purpose of the FDD is to provide franchisee candidates with enough information about a franchise system to weigh its potential benefits and risks, franchise brokers typically look for an Item 19 that is informative enough for candidates to draw their own conclusions about the brand.
“The level of franchisee candidate questions is very business-oriented, at least for the people that I've been working with. So they are asking, based on what they're seeing in Item 19, [for] validation – they’re validating what you think you heard to what's actually happening. And so I think it's important that we take it all the way through the process, and that those franchisees also know their numbers,” Welko says.
To make sure a franchise’s Item 19 disclosures are thorough, Internicola advises doing a deeper dive into the company’s numbers to ensure they provide a realistic picture of the brand’s daily operations.
“The other point is a deeper dive in the data – not just through sales, but through sales breakdowns, different categories of revenue streams, types of customers, cost of goods sold. So we have those drill-downs,” Internicola says.
For new franchisors with few existing franchisees, Welko says most brokers won’t mind if Item 19 isn’t full – but it still needs to provide enough information for a candidate to work with.
“It's okay if [Item 19 is] not full. I mean, I know you have some fabulous brands that give us 19-page Item 19s with a full P&L and I love them and have done a couple deals with them. But if you can't do that, give us something to go on. [Candidates] do need to come up with their own conclusions, and they can do that in validation. But they need to have some sort of structure in order to put that together,” Welko says.
In addition to complete, accurate numbers that tell a cohesive story, franchise brokers are also on the lookout for franchisors that take initiative – especially when it comes to meeting deadlines.
“By December, every franchisor should have a fully modeled out Item 19. And the only steps left are to drop in the actual data that's been collected and then review it. Too many times, it becomes an afterthought in January and everyone's throwing things together,” Internicola says.
At The Internicola Law Firm, the team keeps clients on track for success by getting a head start on FDD renewals earlier in the year.
“We have a big target – Q3 is when we start working on next year's Item 19s. So the point is, [by late May] we're through renewal season. Now is the time to say, let's see what it can look like in 2023. What’s the data we will need to collect? Because you can start working on it now,” Internicola says.
Welko agrees that franchisors should take time to evaluate their numbers annually and make sure their FDD is renewed on time – a practice that can demonstrate a sincere commitment to accountability.
“If you can figure it out right now [mid-year] and just keep it nice and clean, and launch that FDD when you're supposed to, instead of in November because you're behind – that's huge,” Welko says.