There are several required items that should be drafted when creating the Franchise Disclosure Document. Some may not apply to the company owing the franchise, others will. Be sure to have an attorney review the document prior to releasing for potential franchisees to read.
Item 1 the franchise company
This is a summary of the history, ownership and corporate family of the franchisor, including the form of franchises offered. A company summary that isn’t clear or readable does not allow you to get an accurate picture of the organization without a lot of effort. If so it is likely you will have issues interpreting the rest of the FDD.
Item 2 Business Experience Of Franchise Executives
Gaining knowledge of the franchisor’s leadership is critical, because it will help you decide whether you’ll feel comfortable working with the people involved. Look for a solid group with experience in management and franchising. An executive team that is new to franchising may be a problem unless they have extensive business expertise. If the executives have been involved in failures with other businesses then this is an indication of a problem.
Item 3 Litigation
This item lets you know about any litigation involving the company and its principals and executives. It notifies you of potential accusations against the franchisor, as well as whether it has filed suits against entities violating its trademarks or against franchisees not in obedience with quality standards (which may be a good thing). If there are multiple lawsuits filed by franchisees contending fraud or misrepresentation on the part of the franchisor this is an indication of a serious problem. 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. 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. Watch out for: Franchisees get into trouble when they are undercapitalized. Do not assume that the working capital listed in Item 7 is sufficient to sustain your business until you start making money. Ask other franchisees how long it took them to break even. Go over these items with an accountant 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 selected suppliers. Beware of Franchisors who are getting large rebates from 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 review each obligation, then go back and read the language by which you will operate. Descriptions that are not consistent with the franchise agreement are problematic.
Item 10 Financing
If the franchisor offers a lending program, or has arrangements with lenders who have agreed to help finance its franchisees. The item also discloses any financial relationship the outside lender has with the franchisor. Remember 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 subject matter and extent 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. Subtle qualifying words, such as “at our discretion” or “as needed,” generally indicate 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 how much can be used in areas mainly benefit the franchisor. Also note that if franchisees are not involved in managing the national marketing fund and program, it can be a major red flag for investors.
Item 12 Territory
The need for 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 find different stipulations. Any territorial protection lasts only for the term of your franchise agreement; the franchisor has the flexibility to change it when you renew your contract. Retail franchises that provide no geographic protection are challenging.
Items 13 and 14 Trademarks, 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, others allow them to be passive owners and hire someone else to manage day-to-day operations.
Item 16 Restrictions on What You May Sell
This item lets you know that you can sell only what the franchisor allows. Franchisors whose product offerings are too limited could negatively impact the business.
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 asserting where and how disagreements will be resolved. 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 maintain as many financial conditions in the renewal contract as you can. Most disputes must be resolved in the hometown of the franchisor, which puts the franchisee at a disadvantage.
Item 18 Public Figures
This is relevant only if you are buying into the less than 1 percent of franchise systems that use public figures in their advertising.
Item 19 Financial Performance Representations
Although this is one of the most important pieces of the FDD, only 30 to 40 percent of franchisors provide information on how much their current franchisees are earning; the others must state that they choose not to make such a claim. Earnings claims based on corporate stores may not be accurate as they pay no royalties and may have different labor, rent, product and shipping costs than you will experience. Beware of earnings based on franchises that have been open for five to 10 years, which may pay lower rents.
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. A large number of closures 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. Franchisors who earn most of their money from franchise sales are not sustaining their business. Good franchisors that operate more efficiently do so with 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.