Venturing into franchise ownership means navigating a complex world of legal and financial details that can be overwhelming for first-time, or even experienced, franchisees.
At the heart of this process lies the Franchise Disclosure Document (FDD), a thorough document required by the Federal Trade Commission (FTC).
Enacted in 1978, the FTC Rule requires franchisors to furnish the FDD to potential franchise buyers at least 14 days before the completion of a sale. This document serves two purposes: safeguarding the interests of potential buyers and protecting franchisors from allegations of misinformation.
Buying a franchise is a complex investment for first-time franchisees and multi-unit owners alike, and the information in a franchise disclosure document can help you make the best decision possible.
In this franchise fundamentals breakdown, we delve into the crucial role of the FDD and its 23 specific items, breaking down the key information featured in each item.
The Basics of the Franchise Disclosure Document (FDD)
The purpose of the FDD is to empower buyers with vital information to assist in their purchasing decisions. According to the Federal Trade Commission (FTC) Rule, franchisors must submit a Franchise Disclosure Document (FDD) annually and provide it to potential franchise buyers. FDDs provide valuable insights into a franchisor's offerings and the overall health of the organization, much like looking into a public company's corporate 10-K filing. It is vital to examine the FDD with industry experts like franchise attorneys and accountants.
Franchisors must share the FDD with prospective franchise candidates upon request, ensuring a minimum of 14 days (requirements may vary by state) before entering into a binding agreement or making a payment to the franchisor or any affiliated entity. It’s also mandatory for franchisors to update the document annually or in the event of any material changes.
An FDD comprises 23 distinct pieces of information referred to as items. These items comprise the franchisor's franchise agreement and various exhibits, such as a comprehensive list of current and past franchisees, along with audited financials of the franchisor.
Some of the key items included in an FDD are the franchisor's background and experience, fees and expenses associated with owning a franchise, initial and ongoing training and support, territory restrictions, advertising requirements, and any litigation or bankruptcy history. Additionally, the FDD also outlines the terms of the franchise agreement, such as length of term, renewal options, termination rights, and transferability.
Let’s break down each of the items disclosed in a typical FDD.
Breaking Down the 23 Items in the Franchise Disclosure Document (FDD)
Item 1: The Franchisor and any Parents, Predecessors, and Affiliates
Item 1 provides an overview of the background and history of the franchisor. A few important things to look for include: How long has the franchisor been in business? Has the franchisor started any other businesses? Did they have a predecessor?
The history of a franchise can provide a more complete understanding of the company’s future growth and success. This item also provides a summary on the business being franchised, the type of franchise agreement provided, and any competition or regulations the franchisor is aware of that affect the business offering.
Item 2: Business Experience
This item identifies the executive involved with the franchisor as well as a summary of their background and experience.
Item 3: Litigation
This section provides information on prior litigation — whether the franchisor or any of its executives have been convicted of felonies relating to fraud, violations of franchise law, or unfair and/or deceptive practices law. This includes whether they are subject to state or federal injunctions involving similar misconduct.
This item will also list whether any of the franchisors executives have been held liable for or settled civil actions involving the franchise. If there are significant claims listed against the franchisor it may indicate that franchisees are unhappy with the franchise system.
The last aspect this item will flag is if the franchisor has sued any of its franchisees during the last year. An example would be a franchisor suing for unpaid royalties which could be an indicator that franchisees are unsuccessful.
Item 4: Bankruptcy
Item 4 of the FDD provides information regarding the financial situation of the franchisor. Franchisors are required to disclose whether the company or any of its executives have recently been involved in bankruptcies. Franchisors may or may not provide additional context.
Item 5: Initial Fees
This section provides a summary of the upfront fees associated with the purchase and operation of a franchise. Typical fees may include:
- Franchise fees
- Development fees (and associated deposits)
- Upfront equipment and supply purchases
- Technology and software fees
- Training and certification costs
- Opening assistance fees
- Delayed opening fees
Item 5 should be reviewed carefully. All or many of these fees are typically not refundable and vary wildly from franchisor to franchisor.
Item 6: Other Fees
Item 6 provides a summary of additional non-refundable fees related to the operation of the franchised business. Typically a franchisor's Item 6 will include their royalty and ad-fund rates, which can be a percentage of revenue or fixed dollar values depending on the franchise. Other fees that may be listed may include: transfer fees, additional training fees, insurance premiums, costs for attending conferences, and any potentially punitive fees, such as interest on late payments, insufficient funds fees, audit expenses, and so on.
Be sure to read through each fee, when the fee is due, the amount, and any notes associated. We recommend that anyone looking into a franchise speaks to a franchise attorney to better understand the remarks and notes associated with each fee.
Item 7: Estimated Initial Investment
This section typically outlines the expenses a franchisee would pay in order to launch the franchised business, and, in some cases, the funds necessary for the first 90 days.
This may include such fees as:
- Upfront franchise and development fees
- Rent
- Security deposits
- Utilities
- Insurance payments
- Equipment
- Training fees
- Professional fees
- Leasehold improvements
- Computers and AV equipment
- Signage
- Travel
- Additional funds, and so on
Franchisees should pay close attention to this section, as it typically breaks down the costs into investment ranges. Franchisees should utilize due diligence for all of these expenses when creating their business plan.
Item 8: Restrictions on Sources of Products and Services
The specifics of Item 8 hinge on the type of franchise under consideration. This section delves into the franchisor's interactions with suppliers, including authorized suppliers, and outlines any related restrictions or required purchases.
Item 9: Franchisee’s Obligations
This section is usually presented as a table, detailing the primary obligations of franchisees within the franchise and other agreements. The table cross-references different sections of the FDD for more comprehensive details on your responsibilities.
Item 10: Financing
In this item, franchisors will disclose financing available to franchisees. Some franchisors offer financing plans, packages, and terms while others do not.
Item 11: Franchisor’s Assistance, Advertising, Computer Systems, and Training
Item 11 covers what the franchisee should expect when it comes to assistance or training from the franchisor. This includes a summary of the franchisor’s training program which is typically represented as a training agenda in chart format with associated hours of training provided.
Franchisees should consider the time associated with training for themselves as well as their management team and staff.
Item 12: Territory
This section outlines the territory the franchisee will receive. Item 12 varies greatly from franchise to franchise, depending on company specifics.
Item 13: Trademarks
Purchasing a franchise provides the franchisee the right to use a company's trademark for a certain period of time, which is one of the exciting benefits of franchising!
Item 13 of the FDD will provide a summary of the company’s trademarks and how they can be used by the franchisee.
Item 14: Patents, Copyrights, and Proprietary Information
Similar to Item 13, this section will disclose pending and current patents, copyrights, or other relevant proprietary information.
Item 15: Obligations to Participate in the Actual Operations of the Franchise Business
This item provides an overview of operational obligations of the franchisee. Be sure to review this section in detail to ensure you are prepared to operate the business in compliance with the Franchisor’s expectations.
Some brands will expect you to operate your franchise as an active investment and may require you to hire a general manager or equivalent that has received specific training to operate the business.
In addition, Item 15 will also cover expectations around who is required to sign payment and performance guarantees as well as nondisclosure and noncompete agreements.
Item 16: Restrictions on what the Franchisee May Sell
Item 16 provides a summary of what product or services a franchisee may sell, what suppliers they should use, and where they are permitted to sell it.
Item 17: Renewal, Termination, Transfer, and Dispute Resolution Procedures
In this section of the FDD, franchisees can review terms, rights, and restrictions related to the termination or transfer of the Franchise Agreement.
Franchisors are also obligated to disclose the methods used to resolve legal disputes. For example, some franchisors may prefer to settle disputes through arbitration, rather than the court system.
Item 18: Public Figures
This section will reveal any public figures linked to the franchise. If a public figure (e.g., a major athlete or celebrity) is tied to the franchise, franchisors must disclose any agreements with the individual in this section. This may encompass benefits, roles, or responsibilities offered, along with specifics of the investment involving this individual.
Item 19: Financial Performance Representations
The section will include any of the franchisor’s financial performance representations.
The FTC's Franchise Rule allows a franchisor to share details on the actual or potential financial performance of its franchised and/or company-owned outlets, provided there is a valid basis for the information and it is included in the disclosure document.
It’s important to note that there is no guarantee that your business will achieve the same results. You should always review this information carefully with a franchise attorney and accountant.
Item 20: Outlets and Franchisee Information
Section 20 of the Franchise Disclosure Document (FDD) details the company's franchised locations over the past three years. This section offers potential franchisees insights into the franchisor's scale and expansion.
In addition to the number of units, this section will also provide directions to the contact information of existing franchisees in the system as well as franchisees that have recently left the franchise.
Anytime you are looking into a franchise, it is recommended that you call as many franchisees as you can to fully review the offering!
Item 21: Financial Statements
Item 21 of the FDD comprises audited financial statements from the franchisor for potential candidates to examine. These statements offer insights into the financial health of the franchisor.
It is recommended you review this section thoroughly with an accountant.
Item 22: Contracts
All agreements and contracts that a potential franchisee is expected to sign in their state for the franchise offering are provided in item 22. This includes the Franchise Agreement.
Item 23: Receipts
The last two pages of every Franchise Disclosure Document are acknowledgements that you received the Disclosure Document — as required by Federal Law. Franchisors will request that you sign and return the receipt pages upon receiving the documents. Franchisors are required at minimum to provide you 14 days to review the FDD in full. It is recommended you review the document with a Franchise Attorney and an Accountant.
Maximizing the Full Potential of the FDD Process
Aspiring franchisees, equipped with the knowledge embedded in the Franchise Disclosure Document (FDD), gain a solid understanding of the franchise they are considering. Beyond a mere legal requirement, the FDD becomes an invaluable tool when evaluating the health and offerings of a franchisor.
Equipped with this knowledge, franchisees can confidently navigate the process, thoroughly exploring their options. This empowers them to make informed decisions that lay the foundation for successful and sustainable franchise ownership.
More information on franchising, such as “A Consumer’s Guide to Buying a Franchise,” which can help you understand how to use a disclosure document, is available from the Federal Trade Commission. You can contact the FTC at 1-877-FTC-HELP or by writing to the FTC at 600 Pennsylvania Avenue, NW, Washington, D.C. 20580. You can also visit the FTC’s home page at www.ftc.gov for additional information. Call your state agency or visit your public library for other sources of information on franchising.
There may also be laws on franchising in your state. Ask your state agencies for more information about them.
Franchise Tip
Franchise Disclosure Documents have to be provided to you upon request or at least 14 days before signing a binding agreement with a franchisor.
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