Chapter 36 — Self-Check Quiz

Twenty-six questions. Answer them cold, then check the key at the bottom. If you miss anything in the Item 19 block (questions 9–14), reread §36.4 before you go on — that section is the one that costs people money.

Multiple choice

1. A franchisor's customer is:

  • A. the guest who walks in hungry
  • B. the next franchisee
  • C. the approved supplier
  • D. the landlord

2. A royalty is almost always computed as a percentage of:

  • A. the franchisee's operating profit
  • B. the franchisee's prime cost
  • C. the franchisee's gross sales
  • D. the franchisee's contribution margin

3. How many numbered items does a Franchise Disclosure Document contain?

  • A. 12
  • B. 17
  • C. 23
  • D. 31

4. Under the FTC Franchise Rule, the FDD must be furnished to a prospective franchisee at least:

  • A. 7 calendar days before signing or paying
  • B. 14 calendar days before signing or paying
  • C. 30 calendar days before signing or paying
  • D. at the closing table, before signature

5. Which FDD item contains the lists of current franchisees and of franchisees who left the system during the last fiscal year?

  • A. Item 3
  • B. Item 17
  • C. Item 19
  • D. Item 20

6. Which FDD item contains the franchisor's own audited financial statements?

  • A. Item 7
  • B. Item 19
  • C. Item 21
  • D. Item 23

7. A franchised unit does \$1,200,000 in gross sales at a 5.0% royalty and a 2.0% advertising fund. The annual cost of those two items is:

  • A. \$60,000
  • B. \$84,000
  • C. \$96,000
  • D. \$108,000

8. A franchised unit earns 20.0% operating profit before franchise fees and pays a 5.5% royalty plus a 2.0% advertising fund. Its operating profit after fees, and the share of pre-fee profit the fees consumed, are:

  • A. 12.5% and 37.5%
  • B. 12.5% and 7.5%
  • C. 14.5% and 27.5%
  • D. 18.0% and 10.0%

9. Item 19 of the FDD is:

  • A. mandatory, and must include a full unit-level P&L
  • B. mandatory, but may be limited to gross sales
  • C. optional; a franchisor may make no financial performance representation at all
  • D. optional, but only for systems with fewer than 25 units

10. An Item 19 states an average unit volume and discloses that 41.9% of the included outlets attained or exceeded it. This tells you that:

  • A. the distribution is right-skewed and the average is pulled up by the top performers
  • B. the distribution is symmetric and the average is a safe planning figure
  • C. 58.1% of the system's units are unprofitable
  • D. nothing useful; the percentage is a formality

11. A development representative tells you over the phone that a nearby unit "does about a million four." Item 19 makes no representation. That number is:

  • A. a binding representation because it was made by an agent of the franchisor
  • B. not a permitted financial performance representation, and not something to rely on
  • C. as reliable as Item 19 provided you write it down
  • D. legally equivalent to an Item 19 disclosure if repeated in an email

12. An Item 19 covers "the 74 franchised outlets open the full 12 months, operated by the same franchisee throughout, located in freestanding buildings with drive-through service," out of 186 franchised outlets. The most important thing to notice is:

  • A. that 74 is a large enough sample to be reliable
  • B. that the inclusion criteria systematically remove the units most likely to be weak
  • C. that the franchisor is required to disclose the highest and lowest figures
  • D. that company-operated units were excluded

13. Where an FDD contains a financial performance representation, the franchisor must state that:

  • A. the figures are guaranteed for the first two years
  • B. written substantiation will be made available to a prospective franchisee upon reasonable request
  • C. a franchisee may terminate without penalty if the figures are not met
  • D. the state regulator has approved the figures

14. The best single response to an FDD with no Item 19 representation is:

  • A. walk away immediately; silence always means bad numbers
  • B. accept it; most systems do not disclose and it means nothing
  • C. treat it as incomplete information and go complete it yourself, using the Item 20 contact lists
  • D. ask the development representative for the figures verbally

15. In most franchise agreements, "renewal" means:

  • A. an automatic extension of the current agreement on identical terms
  • B. the right to sign the then-current form of franchise agreement, often with a renewal fee, a release, and a required remodel
  • C. a renegotiation in which both parties start from scratch
  • D. a transfer of the unit back to the franchisor

16. The advertising fund differs from every other line on a franchisee's P&L because:

  • A. it is tax-deductible
  • B. it is capped by federal rule
  • C. the franchisee pays it but cannot direct it
  • D. it replaces all local marketing spend

17. Which of these is the most reliable sign that a franchisor's economics currently depend on selling new franchises rather than on the performance of existing units?

  • A. a high royalty rate in Item 6
  • B. a wide range in Item 7
  • C. initial franchise fees making up a large share of revenue in the Item 21 financial statements
  • D. the absence of an Item 19

18. Under the FTC Franchise Rule, an arrangement is generally a franchise where three elements are present. They are:

  • A. a trademark, a written contract, and a territory
  • B. a trademark, significant control or assistance over the method of operation, and a required payment
  • C. a required payment, a training program, and an approved supplier list
  • D. a shared brand, shared profits, and shared liability

19. In an area development agreement, the usual consequence of missing the development schedule is:

  • A. an increase in the royalty rate
  • B. loss of the territory rights, and often of the development fee
  • C. automatic conversion to a master franchise
  • D. termination of all existing units

20. Which of the six systems tests does Bellwether fail because of arithmetic rather than because of documentation or skill?

  • A. transferability
  • B. teachability
  • C. margin headroom
  • D. documentation

Short answer

21. In one sentence each, state the customer, the product, and the principal risk for a franchisee and for a franchisor.

22. Name the six FDD items this chapter says to read first, and give the one-line reason for each.

23. List four questions to ask about a "protected territory" before accepting the description.

24. Bellwether's plan earns \$261,020 of operating profit (16.8%) on \$1,550,000 of revenue. Applying an illustrative 5% royalty and 2% advertising fund, what is the new operating profit in dollars and as a percentage of sales?

25. Explain, in three sentences, why a franchisor business loses money at 18 units and earns a 26.6% margin at 40, and what that fact means for a prospective franchisee reading Item 21.

26. State the six systems tests in order, and give Bellwether's one-line verdict on each.

Answer key **1. B.** The franchisor's customer is the next franchisee. Its product is a documented operating system, not food. (§36.1) **2. C.** Gross sales. This is the structural fact that makes the royalty a top-line cost indifferent to your margin. (§36.1, §36.5) **3. C.** Twenty-three, in a fixed order in every FDD — which is the reader's great advantage. (§36.3) **4. B.** At least 14 calendar days before the prospect signs any binding agreement or makes any payment. A separate, shorter period (commonly described as seven calendar days) applies to unilateral material changes to the agreement. Verify current requirements with counsel. (§36.3) **5. D.** Item 20 — outlets and franchisee information. It is the only item that hands you primary evidence you can go verify yourself, and the departed-franchisee list is the highest-value part of it. (§36.3) **6. C.** Item 21. Read the revenue mix: it tells you whether the system is funded by royalties or by selling franchises. (§36.3, §36.8) **7. B.** \$84,000. \$1,200,000 × 5.0% = \$60,000 royalty; × 2.0% = \$24,000 ad fund; total \$84,000. (§36.6) **8. A.** 12.5% and 37.5%. 20.0 − 5.5 − 2.0 = 12.5% of sales. The fees are 7.5 points out of 20.0 points of pre-fee profit: 7.5 ÷ 20.0 = 37.5%. (§36.6) **9. C.** Optional. A franchisor need not make any financial performance representation; if it does not, the Rule requires Item 19 to say so. This is the single most surprising fact in the chapter. (§36.4) **10. A.** Right-skewed. Fewer than half the included units reached the average, so the mean is dragged up by the top of the distribution; plan with the median and stress-test below it. (§36.4) **11. B.** Not a permitted financial performance representation, and not reliable. Write down exactly what was said with the date and speaker, email to request it in writing, and tell your franchise attorney before signing. (§36.4) **12. B.** The inclusion criteria — full year, same operator, freestanding with drive-through — remove new openings, units that changed hands, and every in-line location. The conditions *are* the disclosure. (§36.4) **13. B.** That written substantiation will be made available on reasonable request. Make the request; it costs nothing and it is your right. (§36.4) **14. C.** Treat it as incomplete information and complete it yourself. The absence is ambiguous — young systems and highly variable systems omit it for legitimate reasons — so the correct response is more phone calls from the Item 20 lists, not fewer, plus a written question to the franchisor about why no FPR is made. (§36.4) **15. B.** The right to sign the then-current form, commonly with a renewal fee, a general release, and a remodel to current brand standards at the franchisee's expense. Read Item 17 and then the cited agreement sections. (§36.5) **16. C.** You pay it and you do not direct it — which makes it the one cost line an operator cannot manage. Note also that a local marketing minimum is usually required *in addition*, not instead. (§36.5) **17. C.** Item 21's revenue mix. A young franchisor whose royalties do not cover its cost base is structurally dependent on the next signature, which is exactly what the disclosure regime exists to surface. (§36.8) **18. B.** A trademark; significant control over or assistance to the licensee's method of operation; and a required payment. What you *call* the document does not decide the question, and several states apply broader tests. (§36.9) **19. B.** Loss of the territory rights, and often the development fee. The schedule is a commitment made against your own forecast. (§36.9) **20. C.** Margin headroom. Bellwether earns 16.8% before fees, with two working owner-partners already on modest pay; there is no six-to-eight points available to hand over. The other failures are about documentation, skill, and sourcing. (§36.7) **21.** *Franchisee:* customer is the guest; product is food and hospitality; principal risk is the lease, the build, the crew, and a term that ends on someone else's schedule. *Franchisor:* customer is the next franchisee; product is a documented system and a brand; principal risk is regulatory exposure and a system that stops growing before it reaches scale. (§36.1) **22.** **Item 20** — what happened to everyone who came before me (and their phone numbers). **Item 19** — will I make money, or has the seller declined to say. **Item 21** — is the franchisor solvent, and is it funded by royalties or by selling franchises. **Item 6** — what is the *full* recurring fee load, not just the royalty. **Item 7** — what will this really cost to open, and is the "additional funds" line a real reserve. **Item 17** — how does this end, what does it cost to leave, and can I sell. (§36.3) **23.** Any four of: What exactly is the boundary — radius, population, map, or nothing? What are the carve-outs for non-traditional venues and alternative channels? How does the agreement treat third-party delivery radii and online-order address assignment? Is protection conditional on a performance or development minimum? Does it survive renewal? Does protection against the franchisor opening a unit come with any right for me to open the second one? (§36.5) **24.** Fees of \$1,550,000 × 7% = \$108,500. \$261,020 − \$108,500 = **\$152,520**, which is **9.8%** of sales. (§36.6) **25.** The franchisor business has a large fixed core — legal and annual FDD maintenance, training infrastructure, brand, technology, executive — that does not scale with unit count, while royalty revenue scales linearly with it; below a certain number of units the fixed core swallows the royalties, and above it every additional unit is nearly pure margin. At 18 units the illustrative system loses \$333,000 on royalties alone and is profitable only because it sold eight new franchises; at 40 units it earns \$683,000, a 26.6% margin. For a prospective franchisee, this means Item 21's revenue mix is a direct read on whether the franchisor's current economics depend on selling you a franchise — which changes how much of Item 20 you should verify, and how hard. (§36.8) **26.** **1. Documentation** — no operations manual; the systems live in two people's heads. **2. Transferability** — 22 seasonal items on live fire by a four-person line cannot be executed to standard from a written spec. **3. Teachability** — hearth cookery is a feel skill and the menu changes four times a year, so there is no defined training window. **4. Economic repeatability** — one unit in one trade area, and Chapter 35 has just said the business is not yet profitable without the owners in it. **5. Supply chain** — seasonal, local, small-producer sourcing is the deliberate opposite of a contractable franchise supply chain. **6. Margin headroom** — 16.8% pre-fee, already assuming two working owner-partners on modest pay, leaves nothing to hand over. Score: zero of six. (§36.7)