Franchisors are supposed to disclose the “estimated initial investment” required to open for business in Item 7 of the Franchise Disclosure Document (FDD). But franchisors’ estimates aren’t always as accurate as they should be, and prospective franchisees can receive a very misleading picture of how much it costs to open in some cases. This makes it critical for prospective franchisees to independently verify their startup costs during the due diligence process.
As a prospective franchisee, informed decision-making is critical. You need to know what to expect if you commit to moving forward, and you need to be confident—or at least as confident as you can be—that you have a viable chance of success.
This starts with understanding the costs involved.
When researching the costs of franchise ownership, one key source of information is Item 7 of the franchisor’s Franchise Disclosure Document (FDD). Titled “Estimated Initial Investment,” Item 7 is supposed to provide a realistic picture of the cost of opening for business. But, as national franchise lawyer Jeffrey M. Goldstein explains, franchisors’ Item 7 disclosures are not always as reliable as they should be—and this can have serious repercussions for unwary franchisees:
What Are Franchisors Supposed to Disclose in Item 7?
Franchisors’ obligations to disclose franchisees’ startup costs in Item 7 of the FDD are clear. As explained in the Federal Trade Commission’s (FTC) Franchise Rule Compliance Guide:
“Item 7 . . . requires franchisors to set out in a prescribed tabular format a franchisee’s entire estimated initial investment – i.e., all the expenses required by the franchise agreement and all other costs necessary for a franchisee to commence business.”
As the FTC goes on to explain, a franchisor’s Item 7 disclosures should give prospective franchisees, “a much more detailed picture of their likely investment than Item 5 (initial fees) and Item 6 (other fees paid to the franchisor or affiliates).”
The Franchise Rule Compliance Guide also includes a sample Item 7 disclosure table; and, while this is helpful, it is also part of the problem. While the FTC makes clear that, “Item 7 does not prescribe an exhaustive list of the types of fees or expenses that must be included in the table,” many franchisors simply copy the Compliance Guide’s sample table and fill in their own numbers.
What Are Some Common Issues with Item 7 Disclosures?
With this in mind, several common issues arise in franchisors’ Item 7 disclosures. When buying a franchise, some potential issues to pay attention to include:
- Missing Startup Expenses – When copying the sample Item 7 disclosure table, franchisors often fail to include startup expenses unique to their franchise offering.
- Unreasonably Low Estimates – In many cases, franchisors’ “estimates” of franchisees’ startup costs will be far below the costs that franchisees actually need to incur.
- Outdated Estimates – If franchisors have not recently updated their Item 7 disclosures, their outdated estimates could be far below what is reasonable today as well.
These issues (among others) require careful consideration during the due diligence process. In addition to reviewing a franchisor’s Item 7 disclosures, prospective franchisees should also do their own research, and they should speak with several current and former franchisees to find out how their initial investments compared to the franchisor’s estimates in Item 7.
What if Opening Your Franchise for Business Costs More Than You Anticipated?
Let’s say you move forward with buying a franchise, and your startup costs are more than you think. What can (and should) you do?
Unfortunately, this is an all-too-common scenario. If you have not yet purchased a franchise, you will want to avoid this scenario by working with an experienced franchise attorney and devoting the time and resources necessary to your due diligence. If you have already purchased a franchise and opening for business was more expensive than you anticipated, an experienced franchise attorney will be able to determine if you have grounds to pursue a fraud claim or if you have other legal options available.
FAQs: Conducting Effective Franchise Due Diligence
How accurate are franchisors’ Item 7 estimates?
Some franchisors’ Item 7 estimates are more accurate than others—and some are not accurate at all. While franchisors are supposed to develop custom-tailored Item 7 disclosure tables that reflect the true costs of opening one of their outlets, many franchisors fall far short of doing what is required.
How can I gain an accurate understanding of the total cost of buying a franchise?
To gain an accurate understanding of the total cost of buying a franchise, you can use the franchisor’s Item 7 disclosure table as a starting point, but you will want to do a significant amount of additional research. You should prepare a thorough list of the costs you will incur before you are ready to open for business, and then obtain pricing information specific to your geographic area. Talking to several current and former franchisees will also be helpful.
Should I hire a franchise attorney to help with my due diligence?
Buying a franchise is a major investment, and it can be high-risk if you make an uninformed decision. As a result, it is well worth working with an experienced franchise attorney throughout the due diligence process.
How Goldstein Law Firm Can Help
At Goldstein Law Firm, we help prospective franchisees make informed buying decisions. We also help current and former franchisees protect their legal rights when necessary. If you have questions about your franchisor’s Item 7 disclosures, we can explain everything you need to know in order to make informed decisions about your next steps.
Request a Free Consultation with Franchise Attorney Jeffrey M. Goldstein
If you would like to speak with an experienced franchise attorney, we invite you to get in touch. To request a free consultation with Jeffrey M. Goldstein, founding attorney of Goldstein Law Firm, please call 202-293-3947 or tell us how we can help online today.
