What is the Franchise Disclosure Document?
When considering the purchase of a franchise, you will receive the franchisor’s Franchise Disclosure Document (FDD). What is this document? What can you expect to learn from the FDD? Why must you receive one before you sign any franchise agreements? We’ll answer these questions and more as we explore the FDD and the key components that must be included in each of these integral documents.
A Brief Background…
The franchise industry in the United States is regulated by the Federal Trade Commission (FTC). The FTC’s Franchise Rule requires franchisors to provide potential franchisees with a disclosure document. This document is the Franchise Disclosure Document (FDD) and it must be given to the prospective buyer by the franchisor at their first face-to-face meeting, or at least ten days prior to the signing of the franchise agreement, whichever action takes place first.
Why Is A Disclosure Document Necessary?
The FTC’s mission is to protect American consumers. They protect consumers by prohibiting unfair methods of competition and unfair or deceptive acts or practices in or affecting commerce. In 1979, the FTC determined that prospective franchisees needed certain critical information from franchisors. Without necessary information, business buyers could be risking a loss of finances because of misrepresented or omitted material facts about the opportunity. Therefore, disclosing the facts about a franchise prohibits deceptive practices. However, the FTC Franchise Rule does not require franchisors to disclose the unit performance statistics of the franchised system to new buyers of franchises.
The FDD is not required to be on file with any Federal government agency. In 35 states, a franchisor can sell a business as long as the prospective franchisee has 10 days to review the FDD. In 15 states, however, referred to as registration states, franchisors must file their FDD and have supplemental requirements that must be met before they can sell a franchise in that state. The objective of these laws is to protect its citizens from investment scams and to make sure the franchisor is disclosing important data before the sale of the franchise. This way, buyers can make educated decisions regarding the businesses they buy. The requirements are defined by each State and differ from each other. The list of 15 registration states with extra requirements are:
• New York
• North Dakota
• Oregon (disclosure only)
• Rhode Island
• South Dakota
The Key Components of an FDD
Currently, the FDD must be organized into 23 necessary items. These items are required to be in any FDD and must be in the following order:
Item 1: The Franchisor, It’s Predecessors, and Affiliates: This item will include background information about the current franchisor, as well as predecessors, affiliates, and a description of the business to be operated by franchisees.
Item 2: Business Experience: A five-year employment history for directors, trustees, general partners, principal officers, and other executives is listed in this section.
Item 3: Litigation: The franchisor must disclose litigation involving the franchisor, any principal officers, trustees, partners, directors, and affiliates.
Item 4: Bankruptcy: Any bankruptcies within the last ten years involving the franchisor, principal officers, trustees, partners, directors, and affiliates must be disclosed in this section.
Item 5: Initial Franchise Fee: Will include the franchise fee and all other fees or payments the franchisee will pay to the franchisor before beginning the franchised business.
Item 6: Other Fees: This lists all fees the franchisee will have to pay to the franchisor or its affiliates. Typical fees include royalty fees, marketing fees, renewal fees, and more and may be fees that the franchisee will have to pay throughout the life of their franchise.
Item 7: Initial Investment: From the franchise fee to opening inventory and business licenses, this item will include an estimate of how much it will cost a franchisee to open their business.
Item 8: Restrictions On Sources of Products and Services: This item will explain whether a franchisee is required to purchase or lease goods and services from the franchisor, from affiliates, or from suppliers who have been approved by the franchisor.
Item 9: Franchisee’s Obligations: Item 9 lists the franchisee’s obligations in 24 specific categories including: site selection and acquisition, pre-opening purchases and leases, initial training, opening, fees, compliance with system standards, proprietary information, customer service requirements, territorial development, appearance requirements, insurance, advertising, records and reports, inspections and audits, transfers and renewals, obligations when the franchise agreement ends, and dispute resolutions.
Item 10: Financing: Any financing which is offered directly by the franchisor to the franchisee must be described in this section.
Item 11: Franchisor’s Obligations: This item will have detailed information about the franchisor’s obligations pre-opening, post-opening, plus ongoing obligations such as advertising programs, training programs, computer systems, the operations manual, and more. This section will have detailed information about the franchisors system.
Item 12: Territory Rights and restrictions on location and territory are described in this item.
Item 13: Trademarks Information on the trademarks and service marks the franchisee will use will be disclosed in item 13.
Item 14: Patents, Copyrights, and Proprietary Information: As stated, any patents, copyrights, or confidential information must be disclosed.
Item 15: Obligation To Participate in the Actual Operation of the Franchise Business: Tells the franchisee whether or not he or she must participate in the operation of the business.
Item 16: Restrictions On What the Franchisee May Sell: Item 16 will describe any restrictions on goods or services the franchisee can sell and will explain any restrictions on to whom that franchisee can sell to.
Item 17: Renewal, Termination, Transfer, And Dispute Resolution: The length of the term of the franchise agreement, information about the renewal of the agreement, an explanation of how death or disability of the franchisee is handled by the franchisor, and more are explained in this section of the FDD.
Item 18: Public Figures: The franchisor must disclose whether they use a famous person in the name or logo for the franchise, or whether a famous person endorses the product. If so, the details regarding how that person is compensated and their involvement in the company must be explained.
Item 19: Financial Performance Representations (sometimes referred to as Earnings Claims): A franchisor does not have to provide this information, but if they choose to include it in their FDD it must be detailed with facts to back up all claims.
Item 20: Outlets and Franchisee Information: This section must include the number of company owned units and the number of franchised units in each state within the last three years, a list of all franchisees including their names, addresses, and phone numbers, the number of new franchises predicted to open in the coming year, the number of franchises that have not renewed, have terminated, transferred, or have been reacquired by the franchisor in the last three years, and the names and phone numbers of those franchisees who became un-involved in the franchise within the past year and have not spoken to the franchisor in the last 10 weeks.
Item 21: Financial Statements: This item includes financial statements audited by an independent CPA. It typically includes information from the last 3 years for various items including statements of operations, statements of stockholders’ equity, cash flow statements, and balance sheets.
Item 22: Contracts: Copies of any contracts the prospective franchisee will have to sign to buy the franchise are included in this section.
Item 23: Receipt: This is an acknowledgement for a prospective franchisee to sign stating that they received the FDD.
The FDD is an invaluable document for prospective franchisees. It should be read through numerous times and can be used to compare different franchises and to gain a better perspective on which opportunity is best suited to your needs and goals.
For more information on the Federal Trade Commission and FDDs, please visit the FTCs web site. For tips on what to look for in an Franchise Disclosure Agreement