The Federal Trade Commission’s Franchise Rule requires that a franchisor provide a lengthy and detailed Franchise Disclosure Document (the “FDD”) to a buyer before the buyer purchases a franchise. The Franchise Rule establishes 23 categories of information or “items” that must be disclosed in the FDD and sets requirements for what must be covered in each item. For a complete list of the 23 items, see my earlier post on What Do Potential Franchisees Need to Know About Franchise Law? An Introduction.
This post summarizes many of the 23 items by grouping them in four categories: 1) Information About the Franchisor; 2) Information About Franchise Fees, the Financial Investment, Franchisor Financing, and Representations About Financial Performance; 3) Information About the Franchisee’s Obligations and the Franchisor’s Support; and 4) Information About the Franchise Agreement and Key Terms of the Agreement.
What Information Does the FDD Provide About the Franchisor?
Information about the franchisor and its business is provided in Items 1, 2, 3, 4, 20, 21 of the FDD. The following are thumbnail summaries of these items:
Item 1 – The Franchisor, and Any Parents, Predecessors, and Affiliates. This item provides information on the corporate status of the franchisor, whether it is a subsidiary, and any other related business entities. It will include information on how long the franchisor has been in business and how long it has offered franchises. The franchise opportunity may involve contracts with more than one business entity. For example, the opportunity may involve leasing real estate and a building, but the company that owns the property may be an affiliate of the franchisor and not the franchisor.
Item 2 – Business Experience. This item provides information on the directors, partners, officers, and key employees of the franchisor who have responsibility for the sale and oversight of franchises. This information will include the positions and roles they have played during the past five years.
Item 3 – Litigation. In this item, the FDD must disclose any involvement in criminal, administrative, or civil litigation during the ten-year period before the date of the FDD. Any such information must be disclosed if it involved the franchisor, any affiliated company, any related business that provides financing to franchisees, and any director, partner, officer, or key employee of these businesses.
Item 4 – Bankruptcy. The FDD must disclose any bankruptcy filing or discharge by the franchisor or its affiliated companies during the ten-year period before the date of the FDD. This information must be provided for the franchisor, any related business, any director, partner, officer, or other person with management responsibility over the sale and operations of franchises. Detailed information must be included that identifies the bankruptcy case and any discharge in the case.
Item 20 – Outlets and Franchisee Information. In this item, the FDD must provide information on the number of “outlets” (both franchised and company owned) during the three years before the date of the FDD. Item 20 should include at least five tables providing information on: (a) the number of outlets; (b) transfers of outlets (from one franchisee to another); (c) changes in the status of outlets (opened, terminated, purchased by franchisor); (d) the status of company-owned outlets; and (e) projected openings.
Item 21 – Financial Information. In Item 21, the FDD must provide audited financial statements for the franchisor and, in some cases, affiliated businesses. This section must include financial statements and comparison chart covering at least the previous two fiscal years.
What Information Does the FDD Contain About the Franchise Fees, the Franchisee’s Investment, Franchisor Financing, and Representations about Financial Performance?
The FDD must provide information about franchise fees, start-up costs, and financing in Items 5, 6, 7, 10, and 19. The following are thumbnail summaries of these items:
Item 5 – Initial Fees. In this item, the franchisor must state all fees, payments, and commitments to pay for services and goods from the franchisor or any affiliate before the franchisee opens for business. If the initial fees are calculated by a formula, the formula must be disclosed.
Item 6 – Other Fees. The FDD must disclose all other fees that the franchisee must pay to the franchisor in Item 6. This information will be set forth in table format and discuss fees for royalties (for the trademark use), leasing and related costs (for example, remodeling), training, advertising, purchasing cooperatives, audits, accounting, and other fees and costs. The table will also provide other information such as when the fees will be due.
Item 7 – Estimated Initial Investment. In Item 7, the FDD must provide information in table format on the franchisor’s investment, which might be thought of as start-up costs. The initial investment costs can include, among other things, the initial franchise fee, training, real estate purchases or leases, equipment, fixtures, remodeling, utilities, and deposits.
Item 10 – Financing. If financing is offered by or arranged through the franchisor, the terms of the financing must be provided in Item 10 and may be presented in table format. The information must include what the financing covers, the identity of the lender and its relationship to the franchisor, detailed information on the financing (term, interest rate, etc.), any waiver of defenses, and whether the franchisor or affiliate intends to sell or transfer the financing.
Item 19 – Financial Performance Representations. The franchisor is not required to make any representations about the anticipated financial performance of the franchise opportunity. If any statements about expected financial performance are made, the franchisor must have a reasonable basis for the representations (and be able to back it up with documentation). This information must include how the representations were developed—for example, based on historical data, a subset of all franchises, and basis for financial forecasting.
What Information Does the FDD Provide About the Franchisee’s Obligations and the Franchisor’s Support?
In Items 9 and 11, the FDD must include information on the franchisee’s obligations and the support provided by the franchisor. These items are briefly summarized as follows:
Item 9 – Franchisee’s Obligations. Item 9 provides a table listing over 20 different franchisee obligations and cross-references to the section in the franchise agreement or other agreement that relates to the obligation. The key obligations that must be indexed in this table include following, but keep in mind that some franchise opportunities will not involve all these obligations:
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- Location and Real Estate Matters
- Training Requirements
- Fees
- Compliance Standards and Operations Manual
- Restrictions on Products and Services
- Warranty and Customer Service Requirements
- Territory
- Ongoing Product and Service Purchases
- Insurance
- Advertising
- Indemnification
- Owner Participation
- Records and Reports
- Inspections
- Transfer
- Renewal
- Dispute Resolution
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Item 11 – Franchisor’s Assistance, Advertising, Computer Systems, and Training. Item 11 is intended to help the potential franchise purchaser understand the assistance and support that will be provided by the franchisor. More importantly, this item helps the potential franchisee understand the operational and other support that will not be provided by the franchisor. The areas addressed in item 11 cover:
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- Pre-Opening Obligations
- Typical Length of Time Between Signing the Franchise Agreement and Opening for Business
- Extent of the Franchisor’s Obligations During Operation of the Franchise
- The Franchisor’s Advertising Program
- Electronic Cash Registers and Computer Systems
- The Table of Contents of the Franchisor’s Operating Manual
- The Franchisor’s Training Program
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What Information Does the FDD Provide About the Franchise Agreement and Specific Contract Terms?
The franchise agreement is the primary document governing the relationship between the franchisor and the franchisee. Some of the more-important provisions of the agreement must be discussed in Items 12, 13, 15, and 17. Copies of the franchise agreement and any other contracts must be provided in Item 22:
Item 12 – Territory. Territory is a key provision of the franchise agreement, and the FDD’s Item 12 must provide information on the territory included in the franchise opportunity. This part of the FDD will discuss:
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- If outlet’s territory has been defined or needs approval by the franchisor
- Any minimum territory to be granted by the franchisor (for example, by radius, population density, or other designation)
- Conditions for relocation of an outlet or the franchisee’s establishment of another outlet
- Franchisee’s right of first refusal, option rights, and other rights related to acquiring additional franchises
- If the franchisee’s territory will be exclusive
- Any restriction on the franchisor’s ability to accept orders from consumers within the franchisee’s territory
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Item 13 – Trademarks. The trademark is another key part of the franchise opportunity, and it may be the most-important driver of the franchisee’s business success. Item 13 will provide information on whether the trademark is registered with the U.S. Patent and Trademark Office, any state trademark registration, pending registrations and challenges or opposition to the registration, and any pending federal or state court litigation regarding the trademark.
Item 15 – Obligation to Participate in Actual Operation of the Franchise Business. In this item, the FDD must disclose whether the franchisee will be obligated to personally participate in the operation of the franchise. If the franchisee is not required to be personally involved in operations, the FDD must state the franchisor’s recommendations or restrictions regarding supervision of the franchise by another person and requirements related to hiring a supervising manager or employee.
Item 17 – Renewal, Termination, Transfer, and Dispute Resolution. The “term” or length of a franchise agreement can be quite long—eight years, ten years, or longer. To help the franchise purchaser understand the long-term commitment, Item 17 provides an explanation of the renewal provision of the agreement, how to terminate the franchise agreement as the end of the term approaches, how to transfer (sell) the franchise to another franchisor, and the system for resolving any disputes that may arise.
Item 22 – Contracts. The FDD must include complete copies of the franchise agreement and any other contract related to the franchise opportunity.
Conclusion
Purchasing a franchise is a significant investment of money, time, and effort, and the financial risk should not be taken lightly. The purpose of the FDD is to provide lengthy and detailed information about the franchise, which allows potential franchise buyers to gain a full understanding of the franchise opportunity, the upside potential of the franchise, and the downside risks. Because of the detail and complexity of the FDD, the best approach for anyone new to owning a franchise or running a business is to discuss the FDD with an attorney before signing a franchise agreement.
Attorney James D. Griffith at Endurance Business Law, PLLC, is an experienced business attorney who can review FDDs and provide advice and guidance on the legal risk. To set up a consultation regarding a franchise FDD, please call our office at (480) 997-2951 or use the Contact form on this website.