Buying a Franchise: The Steps to Reviewing the Franchise Disclosure Document (FDD)
Before you buy a franchise, it’s important to review the FDD. Below we discuss what an FDD is, the FDD review process, and how it can help you make a decision when choosing a franchise opportunity.
What Is the FDD?
The Franchise Disclosure Document (FDD) is a legal document the franchisor must provide to you at least 14 days before you sign a franchise agreement or pay any fees to the franchisor. The FDD is broken down into 23 sections (each section is referred to as an “Item”). These items contain detailed information about the franchise system, the franchisor's management team, litigation history, and your legal rights and obligations as a franchisee.
Steps to Reviewing the FDD Before You Buy a Franchise
You should follow these steps when reviewing the FDD and buying a franchise:
1. Get the Most Current FDD
The first step is to get a copy of the most current FDD from the franchisor. Typically, franchise brands will email you a link so you can download a copy of the FDD. Once you receive the FDD, check the “issuance date” on the first page of the document. Confirm that you have the most updated version.
2. Conduct a Preliminary Review
Conduct your own initial review of the FDD. Some items you should focus on reviewing are:
(a) Item 5 - the initial fees that you will be required to pay to the franchisor.
(b) Item 6 - recurring fees that you will pay to the franchisor.
(c) Item 7 - estimated start-up costs.
If everything makes sense, is consistent with your discussions with the franchisor, and you are still interested, continue with Step 3.
3. Hire a Franchise Lawyer to Review the FDD
The next step is to hire an experienced franchise lawyer for an FDD review. This should involve consultations and a detailed legal review of the FDD and franchise agreement. An understanding of why you are buying the franchise is very important as well.
Before you sign any agreements, your franchise attorney should provide you with your legal rights and specific recommendations for franchise agreement negotiations. Your franchise lawyer could also help your corporate formation and other legal issues, such as your lease agreement review.
4. Negotiate with the Franchisor
Once the FDD has been thoroughly reviewed, you or your franchise attorney will start to negotiate with the franchisor. Many times, your franchise agreement may be amended to enhance your legal rights. This is done through a franchise agreement addendum.
5. Finalize and Sign the Franchise Agreement
Once negotiations are complete, your attorney will go over the final agreements with you. If everything is in order, now it’s time to sign your franchise agreement.
What Are the FDD Disclosure Items?
Item 1: The Franchisor
Item 1 has information about the franchisor, the franchisor's predecessors, and its affiliates. It also includes important information about the operational history of the franchisor and franchise system.
Item 2: Business Experience
Item 2 contains information about the franchisor's management team, like their experience. You’ll gain insight into how competent the support team may or may not be.
Item 3: Litigation
In Item 3, you’ll find information about current and prior litigation history of the franchisor. This section does not include every lawsuit, only ones relevant to franchising, such as lawsuits between the franchisor and its franchisees. It can also include administrative actions between a franchisor and state regulators.
Item 4: Bankruptcy
This section has information about whether or not the franchisor, predecessors, or members of the management team previously filed for bankruptcy.
Item 5: Initial Fees
Fees that franchisees are required to pay can be found in Item 5. Initial fees usually include the one-time initial franchise fee and other recurring mandatory fees. You’ll have to pay these fees to the franchisor before opening and operating your business.
Item 6: Other Fees
Information about additional fees is found in Item 6. These include important recurring fees such as ongoing royalty fees, advertising fund fees, and many others. Operating margins and expenses are influenced by these recurring fees in franchise owners’ day-to-day operations.
Item 7: Estimated Initial Investment
Estimated costs that a franchisee will incur in establishing and opening a new franchised location are in Item 7. These investment estimates include expenses necessary to get a franchised location up and running. It includes initial franchise fees, expenses for furniture fixtures and equipment, buildout fees, reserve capital requirements, and all other expenses.
Item 8: Restrictions on Sources of Products and Services
The information about products and services that a franchisee may or may not sell is found in Item 8. This item also includes detailed information about certain products and services the franchisor requires franchisees to use directly from either the franchisor or designated suppliers.
This information is critical to understanding the franchisor's supply chain, along with factors that may influence a franchisee’s supply chain costs. Information about the revenues that a franchisor earns from its direct sale of goods and services to its franchisees is also in Item 8.
Item 9: Franchisee's Obligations
Item 9 explains the franchisee’s legal obligations under the franchise agreement. This section lists the term length, renewal rights, non-compete restrictions, confidentiality requirements, termination rights, and choice of law and forum selection provisions.
Item 10: Financing
Information about whether or not the franchisor offers any type of financing to franchisees is in Item 10. For example, some franchisors will allow franchisees to pay initial fees over time instead of all at once.
Item 11: Franchisor's Assistance, Advertising, Computer Systems and Training
Item 11 discusses the support you’ll get before and after you open your new business. It lists the point-of-sale system you have to use, any electronic data access, and the training schedule. Item 11 discloses where and how long training will be.
Item 12: Territory
This section contains information about territory protection and if franchisees are given a protected territory. It also discloses if you’ll be competing with other franchisees in the system, and if the franchisor may or may not compete with its franchisees.
Item 13: Trademarks
Item 13 discloses if the franchisor’s primary trademarks are legally protected and registered with the United States Patent and Trademark Office (USPTO). It should also let franchisees know if the franchisor is aware of any challenge to the trademarks.
Item 14: Patents, Copyrights, and Proprietary Information
Information about other intellectual property assets that the franchisor has will be described in Item 14. If a franchisor claims an advantage or asset related to a patent or copyright, then it must be disclosed in this item. Also within Item 14, franchisors disclose their proprietary information, such as their confidential Operations Manual.
Item 15: Obligation to Participate in the Actual Operation of the Franchise Business
Item 15 explains if you’ll need to participate in the day-to-day operation and management of the franchised business or if you can rely on employee managers. Item 15 notifies franchisees if they are expected to be owner-operators or if they can be absentee owners.
Item 16: Restrictions on What the Franchisee May Sell
Typically, franchisors will keep full control over what products and services franchisees can offer. Item 16 explains the degree of control the franchisor will have over the products and services.
Item 17: Renewal, Termination, Transfer and Dispute Resolution
Item 17 summarizes core legal rights relating to:
- franchise agreement term length
- renewal rights
- when the franchisor can terminate the franchise agreement
- franchisee cure rights
- non-compete obligations
- information about dispute resolutions
- applicable state franchise law and state forums that govern disputes between the franchisor and franchisee
Item 18: Public Figures
Some franchise systems pay public figures to promote the franchise. Item 18 will let you know if these public figures are part of the management team, too.
Item 19: Financial Performance Representations
Item 19 is where franchisors can make a financial performance representation: information franchisors can provide (written or orally) as to the corporate or franchised outlets’ financial performance.
Financial performance representations include, among other things: gross sales, EBITDA, and other financial metrics. Franchisors are not allowed to make any financial performance representations unless they are specifically included in Item 19.
Item 20: Outlets and Franchisee Information
Information about the past three-year history of corporate-owned and franchised outlets will be listed in Item 20. Multiple tables contain information about opened, closed, transferred, and terminated outlets. The schedules in the FDD also includes details identifying current and former franchisees.
Item 21: Financial Statements
For established franchisors, financial statements in Item 21 must include three years of complete and audited financial statements. New and start-up franchisors may have more limited financial statements.
Item 22: Contracts
Item 22 contains a list of all the legal agreements and contracts attached to the FDD. The primary contract is called the franchise agreement.
Item 23: Receipts
There are two copies of a receipt for prospective franchisees to sign and date. This acknowledges that the prospect received the FDD. Today, FDDs are commonly delivered electronically, so the franchisor's receipt is an electronic acknowledgment.
The FDD is a critical information tool in the franchise review process. Learn more about the steps to buying a franchise and the franchise agreement. You may also contact The Internicola Law Firm, P.C., at (800) 976-4904 for additional information.