Franchise Disclosure Document and Agreement
You should be aware that when you commit to a franchise that there is a legal and binding commitment where each party has rights, responsibilities and obligations to the other. Franchising is regulated by the Federal Trade Commission and it is mandated that the franchisor provide you with a Franchise Disclosure Document when you are contemplating a purchase and fourteen calendar days prior to signing the franchise agreement or accepting any payments. Similar to an Initial Public Offering, this document spells out all of the particulars of the offering in a specific format. It contains twenty-two separate items (plus a receipt page) that will provide you information about: The history of the Franchisor (Items 1, 2, 3, 4). Information on the costs of the franchise (Items 5, 6, and 7). Information on Restrictions ( Items 8, 15, 16 and 18). Mutual obligations (9 and 11). Territorial rights (12). Renewal, Terminations, Transfer and Disputes (17). Earnings and Sales Claims (Item 19). List of Outlets, Former Owners and Closings (20). Financials and Contracts (21 and 22). Take the time to make sure that you understand all of the particulars of both the Franchise Disclosure Document and the Agreement; they might have a terrific product, but offer you a lousy agreement or vice versa offer you a great deal that sounds almost too good to be true, but then you find out that they have a substandard product. A reputable franchisor will want you to succeed, because they understand that you are their greatest asset and they will want to support you in every way they can.
At least two weeks before you sign a franchise agreement, you’ll receive a Franchise Disclosure Document (FDD) from the franchisor, as mandated by the Federal Trade Commission. It can appear very daunting, since it is usually very large. So in this lesson we are going to break it down into its basic parts to make it easier for you to understand and deal with.
As previously mentioned, there are 23 items in the Franchise Disclosure Document (FDD) and we will walk through them one by one and explain the important features of each and what to watch out for.
- Item 1 – The franchise company:
This is an overview of the history, ownership and corporate family of the franchisor, including the types of franchises offered. Watch out for: A company overview that is difficult to discern. If you can’t get an accurate picture of the organization here without a lot of effort, it is likely you will have issues deciphering the rest of the FDD.
- Item 2 – Business experience of franchise executives:
Gaining knowledge of the franchisor’s leadership is crucial, because it will help you decide whether you’ll feel comfortable dealing with the people involved. Look for a solid group with experience in management and franchising. Watch out for: executives who have been involved in failures with other businesses.
- Item 3 – Litigation:
This item lets you know about any litigation involving the company and its principals and directors. It notifies you of potential claims against the franchisor, as well as whether it has filed suits against entities infringing on its trademarks or against franchisees not in compliance with quality standards (which may be a good thing). Watch out for: Multiple lawsuits filed by franchisees alleging fraud or misrepresentation on the part of the franchisor. Is there a pending class action by franchisees or consumers that, if successful, could bankrupt the company?
- Item 4 – Bankruptcy:
This item is rarely of great interest, because your due diligence should have indicated whether the franchisor is in bankruptcy. Any officer or director who has a personal bankruptcy, or was previously involved in a bankrupt franchisor, also must be listed.
- Items 5, 6 and 7- Initial fees, other fees and initial investment:
Item 5 is an overview of the initial fees required to open your franchise. If you see initial fees listed as a range, ask if you qualify for a lower fee. Item 6 is a chart of other fees, including royalty and advertising fees, which you will be required to pay on an ongoing basis. Be aware that not all fees are listed here, including the cost of products and inventory. Item 7 lays out the fees and expenses required to open and operate your franchise for the first three months. If you are undercapitalized in the beginning, it could make it difficult for you to succeed. Do not assume that the working capital listed in Item 7 is sufficient to sustain your business until you start making money. Go over these items with a trusted advisor before signing a franchise agreement.
- Item 8 – Restrictions on sources of products and services:
The franchisor has a vested interest in knowing that the products and services you are utilizing or selling meet its standards. To ensure that, the company may sell you products itself or insist you use designated suppliers. Ask current franchisees if they feel the prices they pay for designated products are fair.
- Item 9 – Franchisee’s obligations:
This is the single best disclosure you will get: a list of your contractual obligations, with cross-references to the franchise agreement and the rest of the FDD. Item 9 allows you to see each obligation, then go back and read the language by which you will live and breathe. Watch out for: FDD descriptions that are vague or inconsistent with the franchise agreement.
- Item 10 – Financing:
This tells you whether the franchisor offers a lending program, or whether the franchisor has deals with lenders who have agreed to help finance its franchisees. The item also discloses any financial relationship the outside lender has with the franchisor. Watch out for: Don’t forget that borrowing from your franchisor is no different than borrowing from a bank, with the same credit terms. If you default, the franchisor can terminate your franchise agreement.
- Item 11 – Franchisor’s assistance, advertising, computer systems and training:
This item outlines the content and scope of the franchisor’s support services. It should include disclosures about cash registers and related information involving the use of extremely sensitive franchisee data to which the franchisor has access. Watch out for: Subtle qualifying words, such as “at our discretion” or “as needed,” and know that you cannot count on receiving those services. Look carefully to see how much of your required advertising fees actually get spent on advertising and that there is accountability.
- Item 12 – Territory:
Whether you need a protected territory depends on the nature of the business. The franchisee of a retail outlet wants to know that another unit cannot open within a certain radius; a service business might require five to 10 franchisees in a geographic area. Be aware that any territorial protection lasts only for the duration of your franchise agreement; the franchisor has the flexibility to change it when you renew your contract. Watch out for: Retail franchises that provide no geographic protection.
- Items 13 and 14 – Trademarks and patents, copyrights and proprietary information:
These straightforward items list the trademark and copyright registrations the franchisor has obtained. Watch out for: A trademark that is not registered.
- Item 15 – Obligation to participate in the actual operation of the franchise business:
Franchisors want to be sure franchisees are devoting full time and effort to running each location. Some franchises require franchisees to run the business themselves; others allow them to be passive owners and hire someone else to manage day-to-day operations.
- Item 16 – Restrictions on what the franchisee may sell:
This item lets you know that you can sell only what the franchisor allows. Watch out for: Franchisors whose product offerings are too limited.
- Item 17 – Renewal, termination,transfer and dispute resolution:
This chart provides a summary of the franchise relationship to the franchisee, with cross-references to the franchise agreement, showing terms of termination and renewal and stating where and how disputes will be resolved. Watch out for: In franchising, you don’t have a right to renew, only a right of first refusal on a new contract, which may contain higher royalties and other charges. When signing your first contract, try to perpetuate as many financial conditions into the renewal contract as you can. Most disputes must be settled in the hometown of the franchisor, which can put the franchisee at a disadvantage.
- Item 18 – Public figures:
This is relevant only if you are buying into a franchise system that uses public figures in their advertising.
- Item 19 – Financial performance representations:
Although this is one of the most important pieces of the FDD, where franchisors can opt to provide information on how much their current franchisees are earning or state that they choose not to make such a claim. Watch out for: Earnings claims based on corporate stores, because they pay no royalties and may have different labor, rent, product and shipping costs than you will experience. Be sure to look at the caveats in relationship to the claims; they are usually in small print at the bottom. ( See our take on item 19 at the end of this article).
- Item 20 – Outlets and franchise information:
These charts show the number of franchises opened, transferred and closed in the last three years, which lets you see whether the system is growing or shrinking. The most important part of the FDD is the list of current and former franchisees. You would be completely remiss not to contact as many as possible to get an independent perspective on the health of the system. Watch out for: A large number of closures, which could mean the business model is trending out of favor.
- Item 21 – Financial statements:
These audited financial statements let you know if the franchisor is stable. Look at the profit-and-loss statement first, then the balance sheet. You may need an accountant to figure out whether the current ratio of assets to liabilities is favorable and how the franchisor accounts for deferred revenue. Be sure to read the footnotes. Watch out for: Franchisors who earn most of their money from franchise sales. Good franchisors sustain themselves on royalty payments.
- Items 22 and 23 – Contracts and receipts:
These items include the contracts you will be required to sign and the receipt you must sign when you receive the FDD. It is critical that you read and understand the contracts and keep copies of all documents (including the receipt); you’ll need them if you ever wish to bring an action against the franchisor.
FranchiseYouniversity Take on the Legal Aspects of Item 19
It is estimated that nearly 50% of franchisors have a item 19, Financial Performance Representation. Of course the legal community would like all franchisors to have item 19s; not only is it a source of revenue in creating it, but also if there is a conflict it can become a point of contention. Many different formulas can be used to express a Financial Performance Representation and as long as there is full disclosure and caveats it could be said that it is objective. Even the most recognized and successful brands may have some franchisees that are making high six figure incomes while some others may be losing money, but when the aggregate numbers are put on paper it looks like the average franchisee is wildly successful. This can create a false sense of confidence and deter a prospective franchisee from doing the due diligence on their own.
As an example, there is a successful fast food franchise that originally used the numbers from their two original company owned units for their Financial Performance Representation; now that may seem reasonable and of course the caveats are stated, but those units were in a large college town where everyone eats out every morning, afternoon and night. My point is that each individual location and franchisee is unique, and each has its own set of variables that should be considered.
As a conscientious franchisor, I would rather encourage a prospect to do their homework, create a cost analysis based on the hard data available, cash flow projections, a business plan, etc. Also, at the same time they are doing their evaluations, the franchisor should be evaluating them to see if they are suited for their system. It is particularly important to any reputable franchisor that their franchisees succeed and have realistic expectations. In many cases an item 19 Financial Performance Representation can be deceptive to the untrained eye and cloud rather than clarify the perspective of a prospective franchisee.