Within every Franchise Disclosure Document (FDD), franchisors are required to include the previous three years of financial statements. Within the financial statements, there is a story. Even if you do not consider yourself a financial guru, you need to read these documents, and consider having your accountant review them as well. Not only will these documents help paint a picture of the franchisor, but they will also provide you with a framework for validating the claims the brand makes about its franchisees’ financial performance.
1) Where is the franchisor making their money?
Most franchisors have two sources of revenue: the franchise fee and royalties. While the franchise fee is a one-time payment, royalties are continuous payments and typically represent a certain percentage of all revenue each franchisee generates. In the franchisor’s financial statements, take note of the ratio of new franchise fees to total revenue. If a particular concept derives a higher percentage of its revenue from new franchise sales, that may be an indication of where their focus lies. It may also just mean that they are a startup franchisor. This is not necessarily good or bad, but it’s good to notice this and then follow the path it takes you down in terms of your questions to the franchisor and its franchisees. Ultimately you’ll want to understand whether the franchisor needs to sell new franchises in order to pay its bills. Or, put another way, if the franchise stopped selling franchises today, would the company still remain intact based on royalty revenue alone?
2) Find a franchisor’s system wide sales and average sales per location in the FDD.
Using the royalty rate disclosed in Item 6 of the FDD, the number of locations disclosed in Item 20, and the total royalty revenue disclosed in the financial statements of the franchisor, you can determine the average sales per location. Of course, some franchisors now disclose this data in Item 19. In these cases, this analysis is still good because it allows you to crosscheck what is in that section. But be mindful – most franchisors typically exclude the newest franchisees (those open for less than a year or two) from the analysis in Item 19 so prospective franchisees can get a sense of what the business performance looks like over the long term. Therefore using the formula that I’m about to mention may not produce the exact same result that you see in Item 19, but it will give you another way of evaluating the data.
Now the math: to find out the franchisor’s system wide sales, divide the total royalty revenue by the royalty rate disclosed in Item 6. Once you uncover system wide sales, find the number of units listed in Item 20 and divide the system wide sales by the total unit count to find the average sales per location. For example, let’s assume that the franchisor’s total royalty revenue is $4,000,000, they collect 5% in royalties and have 125 units open.
- System Wide Sales = Total Royalty Revenue/Royalty Rate
- $4,000,000/.05 = $80,000,000
- Average Sales Per Location = System Wide Sales/Total Unit Count
- $80,000,000/125 = $640,000
Of course, this is a very rough guideline and should not be used in lieu of your own personal analysis of the franchisees’ performance. Please bear in mind that there are some variables that might skew this analysis one direction or the other. As an example, a concept that has a lot of new franchisees will obviously show lower average sales per location than a more mature concept. Also, if a franchisor lumps royalty revenues from their international business into their financial statements, that might skew data a bit depending on the performance of the international franchisees and currency conversion rates.
3) Don’t disregard the small print and forget to look at the footnotes of the financial statements.
There are very interesting details disclosed in the footnotes that will provide further insight about the franchisor. You might find everything from leased luxury vehicles for senior staff to details on their corporate office lease structure. If there’s anything going on that might put the company at risk, such as a pending settlement for a lawsuit, that will likely be disclosed there too.
As is the case with most things involving research and due diligence, the specific suggestions listed here are only part of the story. Perhaps even more importantly is the dialogue with the franchisor that comes from looking at the things that I mention above. By reviewing the franchisor’s financial statements, you can begin valuable conversations about the franchisor’s strategic focus, financial stability, and the performance of their franchisees.