Why an Emerging Franchise Brand’s FDD Item 7 is so Important
One of the most influential elements in any Franchise Disclosure Document is Item 7, “Estimated Initial Investment.”
Ideally, potential franchisees will have their entrepreneurial spirit whetted after reading Item 19, “Financial Performance Representations,” and Item 20, “Outlets and Franchisee Information.” But, Items 19 and 20 beg the question, “How much will it cost me to get a franchise unit up and running?”
Item 7 can help answer that. It typically covers the first few months of expenditures by the franchisee and includes:
- Franchise fee
- Architectural fees
- Leasehold improvements
- Initial inventory
- Grand opening expenses
Item 7 is important for emerging franchisors, too, because they must be transparent about these costs. High expenses could scare off some potential franchisees, which could risk system growth, but that needs to be balanced against setting realistic expectations for the franchisee.
The simple formula is that after reviewing Item 7 for their start-up costs, a franchisee should reasonably expect to make back their money in 3 to 4 years (at a pre-tax level of EBITDA). If that is not possible, an emerging franchisor should look to decrease the initial investment without changing or impairing their brand offering, or work on increasing their unit level economics and profitability per unit before they sell more franchises.
Conduct a Self-Audit
Return on investment (ROI) goes hand in hand with unit-level economics (ULE). Before drafting Item 7 of the FDD, emerging franchisors need be sure each location generates a healthy amount of revenue and profit. Your concept needs to provide a strong enough financial return in order to attract franchisees.
To determine your brand’s pre-tax ROI for franchisees, use the expected cash flows for the next year and divide by the total amount of the initial investment. You want the ROI to be at least 30-35 percent or approximately a three-year return.
For example, if the expected EBITDA per unit each year for three years is $180,000 and the initial investment is $600,000, your franchisees will experience a 30 percent ROI. In other words, franchisees should expect to earn one-third of their investment back every year for three years.
As mentioned above, there are only two options for a franchisor to take if their return on the initial investment does not meet this criteria. You can either reduce the initial investment, increase the level of EBITDA per unit, or do a combination of the two.
Keep Costs Low
A sound way to improve the ROI for franchisees is to invest in items that make financial sense. Emerging franchisors often have a tendency to include unnecessarily expensive items that will not make a difference to customers and therefore will not be advantageous to the franchisee’s bottom line. Typically, they do it in the name of ‘branding.’ Many founders believe that doing anything differently than what they originally did is denigrating the brand. Be careful not to get caught in this trap and use outside opinions where necessary to help keep egos in check and investments reasonable.
Costly furniture, fixtures and equipment are some of the items new franchisors include in Item 7 of their FDD's that drive up the initial investment. For example, a custom made beverage station made out of stainless steel could be replaced with a standard beverage station at half the cost. Or, depending on the look of the restaurant, a franchisor could decide to replace tile or wood flooring with a concrete stain coating at a significantly reduced cost.
If the investment does not add to the guest experience or satisfaction, a franchisor may want to consider looking at less expensive alternatives.
You can also help keep initial inventory costs for franchisees low by exercising your buying power with suppliers. The discounts you negotiate with suppliers should be a savings for the franchise system.
The lower you can drive down investment costs without compromising the quality of your brand, the better position you’ll be in to help franchisees generate a quicker return on investment and the greater opportunity for franchise system growth.
For help creating a strong FDD, turn to Winmark Franchise Partners. With 30 years of franchising experience and more than 800 franchise owners representing over 1,225 locations for five brands, Winmark Franchise Partners can you help grow your brand through sound strategy and expert franchising advice. Contact us here or at (844) 234-8520