Going Deeper in Validation: Using Item 20 Insights To Improve Your Validation Insights

Buying a franchise is a big decision. It is important to make it an informed one. Knowing the right questions to ask is a good place to start when beginning any validation process. Franchise Disclosure Document (FDD) Item 20 contains valuable information savvy franchise buyers can use to determine the health and important practices of a brand they are considering.

A quick glance will provide growth rates, transfers and unit closure information. Delving deeper into this information leads to critical benchmarking statistics like continuity and “churn rates”. Through critical analysis of the data in Item 20, a vivid depiction of the franchisor’s “personality”, and its relationships with its franchisees begins to emerge.

By understanding what these numbers mean and using the derived information to guide your validation, you will be able to ask the right questions, leading to a decision aligned with your goals.

In part one of this article, we will look at the five core charts included in Item 20 and highlight key insights to further probe in the validation process. In part two of this article, published on the Sport Clips* Franchise blog, we will use the specific data included in Sport Clips’ Item 20 to show how this information can be applied practically.

Unit growth trends

This table shows the net change in franchised and company-owned units over a three-year period. Growth is obviously a good sign. While declining unit counts are a strong indication of unit performance issues or larger system troubles, how the company is growing is just as important.

It is important to look for trends here. Is the growth steady or are there wild fluctuations in unit openings? Is the pace of growth increasing or decreasing?

Does the franchisor seem to be more focused on growing franchised locations or company-owned locations? Use these observations to formulate specific questions you want to ask franchisees.

• “Why was there such a gap in openings in 2015 vs 2016?”
• “Are existing franchisees opening additional units or is most of the growth coming from external sources?”
• “Has operational support suffered during peaks in the growth trend?”

There are additional important insights in the company-owned unit data, but we will return to that later when we examine Table No. 4 - Status of Company-Owned Outlets.

Transfer rates and churn

Regulators have come up with unflattering terms such as “churn rate” to measure the activity of transfers. While commonly seen as negative, transfers should be given close consideration. There are many valid reasons a franchisee may decide to transfer their unit to another party that are actually positive.

This generally means franchisees who want to sell their units are able to but most franchisees are happy to hold onto and continue to grow their investments. For this reason, potential franchise buyers should be wary of transfer rates that are either too high, or too low. Experience tells us that a rate between four and eight percent of the total number of units in the network represents a healthy balance.

• “Why do you feel so many franchisees are looking to exit the system?”
• “Are most transfers being acquired by internal or external parties?”
• “Are there many franchisees who would like to sell their units but are unable to find buyers?”
• “What do you think is going on in ________? The transfer rate seems higher there.”

Franchisor performance metrics

This table contains a lot of important information. It details openings, terminations, non-renewals, unit reacquired by the franchisor and units that ceased operation for other reasons, all broken down by state. If you are looking for insight into franchisor/franchisee relations, this is where to find it. Looking at the trends you can get a better picture of: How aggressive is the franchisor in enforcing the franchise agreement? Does the franchisor have a strategy in reacquiring units? How many units are failing? Why? These numbers can help form questions about this relationship.

• “Does the franchisor adequately protect the brand through enforcement of the franchise agreement?”
• “Is the franchisor too aggressive in pursuing compliance?”
• “What is the franchisor’s strategy in reacquiring units?”
• “Are they buying units that are profitable or units that would otherwise close?”
• “Upon transfer, do units typically perform better?”
• “Do you perceive the closures are due to operator or system issues?”
• “Why aren’t other franchisees acquiring these units before they close?”

This table is much like table three, however, it provides detail for company-owned units. It shows by state, how many were opened, reacquired, closed or sold to franchisees. It provides a lot of insight into the strategy behind company-owned unit operations. Are the company-owned units geographically consolidated or are they spread all over the country? Is the company in an acquisition mode or a refranchising mode? Always ask “Why”.

• “What is the franchisor’s strategy behind operating company-owned units?”
• “Do the company-owned units generally outperform or underperform the franchised units?”
• “Do you feel the company-owned units compete with the franchised units for customers or resources?”
• “If the concept is so strong, why doesn’t the company operate more/any units?”
• “How does the franchisor test new initiatives or promotions if they do not operate any units themselves?”
• “How does the franchisor stay in touch with what is happening at the unit level if they do not operate any units themselves?”

This table details units sold but not yet opened, as well as projects franchised and company-owned unit openings over the next year. Depending on the model, it may give insight into what the company’s development strategy looks like. For example, many multi-unit concepts will include undeveloped licenses in a multi-unit development schedule and will necessarily disclose a large number of sold by not yet opened units.

This may or may not be a cause for alarm. It should give you an idea of how many units are “in line” before you. It is important to understand how the franchisor manages the placement of units within a territory.

The franchisor should be able to provide confidence that there is more than enough room within the market to place the units already opened, the units sold but not yet opened, and any units they plan to award to you.

• “Is the number of unit openings the franchisor is projecting next year realistic?”
• “Do you feel the company is responsible in executing its growth strategy?”
• “What is the company’s policy on extending licenses that are not developed on schedule?”