Franchise due diligence checklist and questions to ask
Short answer
Franchise due diligence covers three things: the franchisor (FDD items on fees, litigation, outlet turnover, financial statements), the system's economics (Item 19 if provided, plus conversations with current and former franchisees), and, for a resale, the specific unit (its tax returns, bank deposits, lease, equipment and staff). Ask the franchisor and franchisees the same questions and compare answers.
Franchise diligence is different from buying an independent business because there are two businesses to evaluate: the franchisor's system and your unit. Both have to work.
The franchisor
- FDD Item 3: litigation history, especially franchisee lawsuits.
- Items 5 and 6: all fees, including technology, ad fund and transfer fees.
- Item 7: realistic initial investment.
- Item 20: openings, closings, terminations and transfers by year. High turnover is a warning.
- Item 21: franchisor financial statements.
- Item 17: renewal, termination and transfer terms.
- SBA Franchise Directory listing, if you'll finance with SBA.
The system's economics
- Item 19 financial performance representations, if any; read the footnotes on which units are included.
- Calls with at least several current franchisees, including some the franchisor didn't suggest.
- Calls with former franchisees from Item 20.
- Your own unit model with realistic sales, all fees, rent and labor.
Questions to ask the franchisor
- How many units opened, closed and transferred in each of the last three years, and why did units close?
- What does the typical new unit cost in total, compared with Item 7?
- How long do new units typically take to reach break-even?
- What changes to fees, required suppliers or technology are planned?
- What support do franchisees get after opening, and what costs extra?
- Are there any pending lawsuits or disputes with franchisees?
The unit (resale)
- Tax returns, P&Ls and bank deposits; POS reports. See proof of cash.
- Royalty and ad fund statements: another independent revenue record.
- Lease, equipment age, required remodels.
- Staff and manager retention.
- Franchisor's inspection and compliance reports for the unit.
Red flags in franchise diligence
- Item 3 shows franchisee lawsuits against the franchisor over the same issues.
- Item 20 shows rising terminations or many units "ceased operations for other reasons".
- Item 21 financials show a franchisor dependent on new franchise sales rather than royalties.
- Required suppliers charging well above market, with rebates going to the franchisor.
- Franchisees who won't talk, or confidentiality terms that stop them.
- A sales process that pushes you to sign quickly, before the 14-day review period runs.
Questions to ask
| Ask the franchisor | Ask franchisees |
|---|---|
| Why did units close or transfer last year? | Would you buy this franchise again? |
| What's planned near my territory? | How long until you paid yourself a salary? |
| How have fees changed in five years? | How do your numbers compare with Item 19? |
| What does support look like after opening? | What costs surprised you? |
| What remodels are coming? | How are disputes handled? |
FDD Item 19: how to read a franchisor's financial performance claims
Item 19 of a Franchise Disclosure Document is where a franchisor may provide information about the actual or potential financial performance of its units. It's optional: a franchisor can choose not to make financial performance representations. When provided, it must have a reasonable basis and written substantiation. Read the footnotes to see which units are included, which period, and whether figures are revenue or profit, then compare with franchisees' own experience and, for a resale, the unit's real P&L.
Item 19 is the closest thing to an earnings claim a franchisor makes. Read it like a lawyer: every footnote matters.
What to look for
| Question | Why it matters |
|---|---|
| Which units are included? | Excluding new, closed or underperforming units raises averages |
| Franchised or company-owned? | Company units may operate differently |
| Revenue, gross margin or profit? | Sales alone don't show what you'll keep |
| Average or median? | A few big units can lift an average |
| What share of units hit the figure? | Tells you how typical it is |
| Which period? | Old or unusual years can mislead |
| What costs are excluded? | Rent, royalties, owner pay, debt often missing |
Using Item 19 well
- Read every footnote and the basis statement.
- Build your own P&L: Item 19 sales, minus realistic costs, all fees (Item 6), rent and your salary.
- Ask franchisees how their numbers compare.
- For a resale, compare with the unit's own tax returns and bank deposits. See franchise resales.
Worked example: reading Item 20 for turnover
Illustrative example, not any franchisor's disclosures
Item 20 tables show a system with 240 franchised units at the start of the year. During the year, 22 opened, 9 were transferred to new owners, 6 were terminated, 4 weren't renewed, and 8 "ceased operations for other reasons". Units leaving the system: 6 + 4 + 8 = 18, or 7.5% of the starting count (18 ÷ 240). Add the 9 transfers, and 27 units (11%) changed hands or closed in one year. Growth of 22 openings can hide that. Compare three years of Item 20 tables, and call several franchisees from the list of those who left. Transfers aren't necessarily bad (owners retire), but a high and rising rate of terminations and "other" closures tells you something the sales pitch won't.
Documents checklist for a franchise purchase
- The current FDD (received at least 14 calendar days before you sign or pay), with the franchise agreement and all exhibits.
- Three years of Item 20 tables and the franchisee contact lists.
- Franchisor audited financial statements (Item 21).
- For a resale: the unit's tax returns, P&Ls, bank statements, POS data and royalty statements.
- The franchisor's written transfer conditions, fees and any remodel requirements.
- The lease, and any rider the franchisor requires.
- Your franchise attorney's review of the agreement, including renewal, termination and non-compete terms.
Some states require franchisors to register their FDD with a state regulator before selling, and those regulators can be a source of information; NASAA lists them. Not legal advice.
Questions to ask franchisees who left
Item 20 of the FDD lists franchisees who left the system in the last fiscal year, with contact information. They are often the most useful people you can call, and the least likely to be prepared by the franchisor. Ask:
- Why did you leave, and did you sell, close or have your agreement terminated?
- How long did it take to reach the sales you expected, and did you reach them?
- What did the franchisor's support look like in practice?
- Were there costs you didn't expect, such as remodels, technology fees or required suppliers?
- Did you sign a confidentiality agreement when you left?
- Knowing what you know now, would you buy into this system again?
Listen for patterns. One unhappy former owner is an anecdote; several with the same story are a finding.
Items of the FDD that change the cost
Several FDD items together set what you will actually spend, and they are easy to read separately and miss the total. Item 5 lists initial fees, Item 6 other fees such as royalties, marketing fund contributions, technology and transfer fees, Item 7 the estimated initial investment, and Item 8 restrictions on where you must buy goods and services. Build one table that adds them up for your first three years, using your own sales assumption, not the franchisor's.
Finally, ask the franchisor for the training schedule, the opening support it provides and the name of the field consultant who would work with you. Then ask franchisees how that support works in practice. A system with strong unit economics and weak support can still be hard for a first-time owner.
Frequently asked questions
What questions should I ask a franchisor?
How many units opened, closed and transferred in the last three years and why; what support new franchisees actually receive; how fees have changed; what's planned for your territory; and how disputes are handled.
What should I ask existing franchisees?
Would you buy again? How long until you paid yourself? How do your numbers compare with Item 19? What surprised you? How is the franchisor to work with?
Where do I find franchisee contacts?
FDD Item 20 lists current franchisees and those who left in the last fiscal year.
Do I need a franchise attorney?
It's strongly advisable. Franchise agreements are long, favor the franchisor, and are rarely negotiable on big points, so you need to understand what you're signing.
Do all franchisors provide Item 19?
No. Item 19 is optional. If a franchisor doesn't make financial performance representations, its FDD says so.
Can a franchisor tell me what I'll earn outside Item 19?
Under the FTC Franchise Rule, financial performance representations generally must be in Item 19. Be wary of earnings claims made only verbally or in marketing materials.
Sources
- FTC Franchise Rule, 16 CFR Part 436 (eCFR)
- SBA: Franchise Directory
- FTC Franchise Rule, 16 CFR Part 436
- FTC Franchise Rule: disclosure items, 16 CFR 436.5
- FTC Franchise Rule exemptions, 16 CFR 436.8
- NASAA (state securities and franchise regulators)
- SBA SOP 50 10 8.1 (franchise lending)
Related guides
General information, not legal, tax, financial or investment advice. Rules and lender practices change; check the linked sources and talk to your attorney, CPA and lender about your deal. Examples with named numbers are illustrations, not real businesses. OKtoBuy's Deal Check does not value businesses or give price opinions.