Item 5 of the Franchise Disclosure Document
Within Item 5, franchisors must disclose all upfront fees that a franchisee must pay to the franchisor before the franchisee opens the franchised business.
For franchisors in the process of developing their Franchise Disclosure Document (FDD), it’s important to understand how to determine which fees to disclose in Item 5.
In 16 CFR 436.5 § 436.5, the Federal Trade Commission (FTC) defines initial fees as “all fees and payments, or commitments to pay, for services or goods received from the franchisor or any affiliate before the franchisee's business opens, whether payable in lump sum or installments.” Initial fees often include fees for training, marketing, trademarks, opening extensions and more.
In this article, we’ll discuss the fees that must be disclosed in Item 5, as well as specific situations where certain fees don’t need to be disclosed, to make sure your FDD communicates the right information to prospective franchisees.
Which Fees Must Be Disclosed
Typically, the most common fees disclosed in Item 5 include the initial franchise fee and other upfront pre-opening fees that a franchisee must pay to a franchisor before opening the franchised business.
Initial Franchise Fee
An initial franchise fee is a fee that franchisees must pay to franchisors when they purchase a franchise. Its purpose is to compensate franchisors for the license granted to the franchisee to use the franchisor’s trademarks, systems, and proven processes, and to reimburse the franchisor for costs associated with administrative tasks and pre-opening support.
Upfront Pre-Opening Fees
The purpose of Item 5 is to help prospective franchisees assess the costs associated with buying a franchise before making an investment. Because of that, franchisors need to include accurate and complete information in Item 5, including often-overlooked upfront pre-opening fees.
While pre-opening fees vary depending on the franchise and industry, they can include fees related to training, pre-opening inventory, equipment that must be purchased from the franchisor, marketing and more. When determining the fees to disclose in Item 5, it’s a good idea to seek the guidance of an experienced franchise attorney.
Although initial fees are often required in a lump sum, in circumstances where any initial fees must be paid to the franchisor by the franchisee on an installment basis, the franchisor must disclose the terms of the installment payments in either Item 5 or Item 10 of the FDD per the amended Franchise Rule.
Uniformity of Fees Disclosure
In Item 5, the franchisor must indicate whether initial fees are charged uniformly. In circumstances where a franchisor does not charge the same uniform fees to every franchisee candidate, such as when costs increase or change over time, franchisors may choose to disclose a range of fees paid during the last year in Item 5. Alternatively, franchisors may choose to disclose the formula used to calculate initial fees paid in the fiscal year prior to the issuance date of the FDD, including any other factors used to determine those fees beyond the formula.
Because fees from the occasional sales of company-owned outlets to franchisees may skew the disclosures of initial fees paid to the franchisor and thus potentially mislead prospective franchisees, fees from occasional sales of company-owned outlets do not need to be disclosed in Item 5.
Refundability of Fees Disclosure
The FTC does not require franchisors to refund any initial fees paid by prospective franchisees to the franchisor. However, should a franchisor elect to make any of the initial fees refundable, either in whole or part, the franchisor must disclose the terms and conditions under which a franchisee may obtain such a refund in Item 5.
When developing your FDD, it’s important to make sure that every disclosure item is thorough, accurate, and complete to prevent potentially misleading prospective franchisees during the sales and review process. Because of that, it’s important to seek the advice of an experienced franchise attorney when determining which initial fees to disclose in Item 5, as well as in other items in the FDD.