CFC CFC Franchise Due Diligence & Disclosure Documents 2 — Questions and Answers
Question 1: What does 'churning' mean in the context of franchise due diligence?
- A franchisor repeatedly terminating and reselling the same franchise location to collect multiple fees (Correct answer)
- A franchisee rotating between multiple franchise brands
- The process of updating the FDD annually
- Marketing activities to attract new leads
Correct answer: A franchisor repeatedly terminating and reselling the same franchise location to collect multiple fees
Churning occurs when a franchisor terminates a franchisee's agreement and resells the same location to a new buyer, generating repeated franchise fees from a single territory.
Question 2: Which metric, found by analyzing Item 20 of the FDD, is a key indicator of franchise system health?
- Average franchise fee amount
- Franchisee turnover rate (closures + transfers relative to total units) (Correct answer)
- Number of years the franchisor has been in business
- The franchisor's advertising budget
Correct answer: Franchisee turnover rate (closures + transfers relative to total units)
Analyzing the ratio of closures, terminations, and transfers to total units in Item 20 reveals the franchisee turnover rate, a critical health indicator for the system.
Question 3: What is the significance of a 'state registration' requirement for franchise sales?
- All states require franchisors to register before selling franchises
- About 15 states require franchisors to register their FDD with the state before offering franchises there (Correct answer)
- Only California requires franchise registration
- Registration is optional in all states
Correct answer: About 15 states require franchisors to register their FDD with the state before offering franchises there
Approximately 13–15 states (registration states) require franchisors to register their FDD with state regulators and receive approval before selling franchises within their borders.
Question 4: When reviewing a franchise agreement, what does 'right of first refusal' typically mean?
- The franchisee's right to open the first unit in a new market
- The franchisor's right to purchase the franchisee's business before it can be sold to a third party (Correct answer)
- The right to refuse renewal of the franchise agreement
- The franchisee's right to refuse territory reassignment
Correct answer: The franchisor's right to purchase the franchisee's business before it can be sold to a third party
Right of first refusal gives the franchisor the option to match any bona fide third-party offer and purchase the franchisee's business before the franchisee can sell to that outside buyer.
Question 5: What is the purpose of reviewing a franchisor's audited financials (Item 21) during due diligence?
- To calculate the franchisee's projected royalty payments
- To assess the franchisor's financial stability and ability to support the franchise system long-term (Correct answer)
- To determine the advertising fund allocation
- To confirm the number of existing franchisees
Correct answer: To assess the franchisor's financial stability and ability to support the franchise system long-term
Reviewing the franchisor's audited financial statements allows a prospective franchisee to evaluate whether the franchisor is financially solvent and capable of delivering ongoing support and services.
Question 6: Which professional should a franchise candidate always consult before signing a franchise agreement?
- A franchise broker affiliated with the franchisor
- A franchise attorney independent from the franchisor (Correct answer)
- The franchisor's in-house legal team
- A certified public accountant only
Correct answer: A franchise attorney independent from the franchisor
An independent franchise attorney (not affiliated with the franchisor) can review the FDD and franchise agreement to identify unfavorable clauses and protect the candidate's interests.
CFC CFC Franchise Due Diligence & Disclosure Documents 2
What does 'churning' mean in the context of franchise due diligence?