Reviewing the Franchise Disclosure Document
If you are buying a franchise, reviewing the franchise disclosure document (also called the “FDD”) is a critical first step in your due diligence process. The FDD is a legal disclosure document that franchisors must provide to you not less than 14 days before you sign a franchise agreement or pay any money to the franchisor. Required by federal law, the FDD contains 23 disclosure sections (each section is called an “item”) that contains detailed information about the franchisor, the franchise system and the franchise opportunity that you may be buying into. In addition to the franchise investment disclosures contained in the FDD, the FDD also includes a copy of the franchise agreement and other legal documents that you will be required to sign when you become a franchisee.
Before investing in a franchise or paying any money to a franchisor, you should review the FDD with an experienced attorney. Below we outline the 23 disclosure sections / items contained in a FDD and we provide a breakdown of what you should expect to find in each section.
Every FDD must include information about the following 23 disclosure items:
- Item 1: The Franchisor – Contains information about the franchisor, the franchisor’s predecessors and its affiliates. This item includes important information that franchisees need to review to understand the operational history of the franchisor and the history of the franchise system.
- Item 2: Business Experience – Contains information about the franchisor’s management team. Within item 2 you can measure the experience of the franchisor’s management team and gain insight into the competency of the support team that the franchisor may or may not possess.
- Item 3: Litigation – Contains 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 and administrative actions between a franchisor and certain state agencies that regulate franchising. You should carefully evaluate any disclosed litigation.
- Item 4: Bankruptcy – Contains information about whether or not the franchisor or its predecessors or members of its management team previously filed for bankruptcy.
- Item 5: Initial Fees – Contains information about the fees that you will be required to pay to the franchisor. Important initial fees typically include the one-time initial franchise fee and other one-time and other fees that you must pay to the franchisor before you open the franchised business.
- Item 6: Other Fees – Contains information about other fees (in addition to the Item 5 Initial Fees) that you will be required to pay to the franchisor. Typically, these fees include recurring fees such as your obligation to pay on-going royalty fees, advertising fund fees, technology fees and other recurring charges These recurring fees will influence the operating margins and expenses that franchisees will incur in their day to day operations.
- Item 7: Estimated Initial Investment – Contains a range of estimates as to the costs that you, as a franchisee, may incur in establishing and opening the franchised business. These initial investment estimates include expenses such as initial franchise fees, expenses for furniture fixtures and equipment, build out fees, reserve capital requirements and all other expenses that will be required to get a franchised location up and running.
- Item 8: Restrictions on Sources of Products and Services – Contains information about the products and services that you may or may not sell from the franchised business. This item should also include detailed information about designated products and services that the franchisor requires you to purchase directly from either the franchisor or the franchisor’s designated and exclusive suppliers. This information is critical to understanding and evaluating a franchisor’s supply chain and factors that may influence your operating costs as a franchisee.. This item also includes information about the revenues that a franchisor earns from its direct sale of goods and services to its franchisees.
- Item 9: Franchisee’s Obligations – Contains information about your legal obligations and rights, as a franchisee, under the franchise agreement including renewal rights, non-compete restrictions, confidentiality requirements, termination rights and choice of law and forum selection provisions.
- Item 10: Financing – Contains information about whether or not the franchisor may or may not offer financing to its franchisees. For example, this item will disclose whether or not the franchisor allow franchisees to pay initial fees over time and whether or not the franchisor offers other types of financing to its franchisees.
- Item 11: Franchisor’s Assistance, Advertising, Computer Systems and Training – Contains information about support and assistance the franchisor will provide prior to the opening of the franchised business and on a recurring basis after the franchised business is opened. This item also discloses important information about the computer and point of sale systems that a franchisee must utilize, the access that the franchisor will have to a franchisees electronic data and the franchisor’s training program, including the training schedule, where training will occur and the length of time training will take.
- Item 12: Territory – Contains information about whether or not you, as a franchisee, will be granted a protected territory or other forms of territory protection. This item will disclose whether or not a franchisee will be competing with other franchisees in the system and other channels of distribution that a franchisor may or may not adopt in competition with its franchisees.
- Item 13: Trademarks – Contains information as to the franchisor’s primary trademarks and whether or not these trademarks are legally protected and registered with the United States Patent and Trademark Office. Item 13 should include other disclosures if the franchisor is aware of any challenge to the Franchisor’s trademarks .
- Item 14: Patents, Copyrights, and Proprietary Information – Contains information about other intellectual property assets that the franchisor may or may not possess. If a franchisor claims an advantage or asset related to a patent or copyright, then it must be disclosed in Item 14. Also within Item 14 franchisors are required to disclose information about their proprietary information such as the franchisor’s confidential operations manual.
- Item 15: Obligation to Participate in the Actual Operation of the Franchise Business – Contains information about whether or you, personally, as the franchisee will be required to participate in the day to day operation and management of the franchised business or whether or not you may rely on employee managers. Item 15 disclosed whether or not a franchisee must be an owner operator or if it may be an absentee owner.
- Item 16: Restrictions on what the Franchisee may Sell – Contains information about the degree of control that a franchisor possesses over the products and services that you may or may not offer from the franchised business. Typically, franchisors will maintain full control over what may or may not be offered.
- Item 17: Renewal, Termination, Transfer and Dispute Resolution – Contains a detailed chart that references to provisions in the franchise agreement and summarizes core legal rights that you may or may not possess relating to items such as the length of the franchise agreement, renewal rights, events allowing the franchisor to terminate the franchise agreement, franchisee cure rights, non-compete obligations, whether or not the franchise agreement contains dispute resolutions and the applicable state law and state forums that govern in the event of a dispute between the franchisor and franchisee.
- Item 18: Public Figures – Contains information as to whether or not the franchisor pays any public figures to promote the franchise and whether or not these public figures are a part of the franchisor’s management team.
- Item 19: Financial Performance Representations – Contains information as to whether or not the franchisor makes financial performance representation. A financial performance representation relates to written or oral information that a franchisor may provide as to the financial performance of the franchisor’s corporate owned or franchised outlets. Financial performance representations include, among other things, information about gross sales, EBITDA and other financial metrics. Franchisors are not permitted to make financial performance representations unless they are specifically included in Item 19.
- Item 20: Outlets and Franchisee Information – Contains multiple tables summarizing the three year history of the franchisors corporate owned outlets and franchised outlets including the information about outlets that have been opened, closed, transferred and terminated. The schedules to the FDD will also include detailed information identifying current and former franchisees.
- Item 21: Financial Statements – Contains financial statements of the franchise company. For established franchisors, the financial statements must included three years of complete and audited financial statements. New and start-up franchisors may have more limited financial statements.
- Item 22: Contracts – Contains a list of all the legal agreements and contracts attached to the FDD. The primary contract is the franchise agreement.
- Item 23: Receipts – Contains, in duplicate, a receipt that the franchisor will ask you to sign. The purpose of this receipt is for the franchisor to record and document the date that franchisor disclosed its FDD to you. FDD’s are commonly delivered electronically and you may be asked to sign an electronic receipt.
Keep in mind that the accuracy of the information reported by a franchisor in its FDD is not verified by any government agency. So, while reviewing the FDD is a critical step in buying a franchise, its not the only step.