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Deconstructing the Franchise Disclosure Document

March 31, 2015
Small Business
Guide to a Franchise Disclosure Document
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Whether it’s a Subway restaurant, an H&R Block office or a UPS Store, starting a franchise is an investment opportunity and a chance to dip your feet into entrepreneurship.

A franchise, or chain store, is a business operating under the same model, trademark and brand as a larger company. A franchisee, or individual business owner, purchases a franchise from the franchisor, the larger company. The two parties sign a franchise agreement that lasts for up to 20 years. There will be more than 780,000 franchise establishments in the United States by the end of 2015, up more than 12,000 from 2014, according to the International Franchise Association.

As with starting any business, opening a franchise brings both risks and potential rewards. Franchisees are responsible for the costs of starting the franchise, and they have to give up control of some business decisions to the franchisor. However, unlike those who start a business from scratch, franchisees benefit from knowing that the franchise has a proven business model and an established brand.

Before you purchase a franchise, it’s your responsibility to research potential franchisors to determine the best company to invest in. You can do the bulk of this research by looking at companies’ Franchise Disclosure Documents, or FDDs. Each company’s FDD reveals the costs and obligations of being a franchisee for that company and includes details about the company’s management and financial history. 

How an FDD can help you

The Federal Trade Commission legally requires all franchisors to give potential franchisees an FDD at least 14 days before the franchise sale. The document includes 23 detailed sections explaining the franchisor history, franchisor responsibilities to the franchisee, costs to the franchisee and franchisee obligations under the franchise agreement. It’s designed to help prospective franchisees weigh the costs and benefits of purchasing a specific franchise.

Before you purchase a franchise, read several franchisors’ FDDs in full, and compare the financial strengths and the costs of operating a franchise under each of the companies. Potential franchisees can request the document prior to 14 days before the franchise sale, and franchisors have to comply if the franchisee is reasonably far along in the purchasing process. Franchisors do not have to make their FDD public.

NerdWallet dissected the FTC Franchise Rule Compliance Guide to help you understand what information each of the 23 sections in the FDD contains. We also talked with Barry Kurtz, a franchise and distribution attorney at Lewitt Hackman in Encino, California, about why each item of the FDD is important to potential franchisees.

Items 1-4: Franchisor history

  • Item 1: The Franchisor and any parents, predecessors and affiliates. The first section of the FDD includes the name of the franchisor and the franchisor’s business structure, such as a corporation, partnership or limited liability company. It also includes the name and address of any affiliate company, company that controls the franchisor or company the franchisor acquired in the past 10 years.
  • Item 2: Business Experience. Section 2 of the FDD lists the business experience of the franchisor’s key executives, including directors, major officers and any franchisor employees involved in managing the sales and operation of the company’s franchises.
  • Item 3: Litigation. Section 3 of the FDD lists lawsuits involving the franchisor, parent company, predecessor, affiliates and the executives from item 2. It includes pending lawsuits, suits the franchisor has filed against other franchisees, prior lawsuits involving franchises and government injunctions.
  • Item 4: Bankruptcy. Section 4 of the FDD includes bankruptcy histories from the past 10 years of the franchisor, parent company, affiliate companies, franchisor executives and franchisor employees who manage the sale and operation of the company’s franchises.

Why they’re important: Together, items 1-4 paint a picture of the franchisor and who’s responsible for directing and operating it. A series of bankruptcies, for example, could be an indication that a franchisor isn’t a solid company, Kurtz says.

sec-regulation-opens-doors-ipo-lite-option-businesses-story-750x420Items 5-7: Costs

  • Item 5: Initial Fees. Section 5 of the FDD outlines upfront fees the franchisee is required to pay to the franchisor before the franchise opens. It also details how the fees should be paid — in a lump sum or installments — and whether the fees are refundable. The initial fee is known as a franchise fee and covers the franchisee’s right to use the franchisor’s brand, trademark, business model and operating system. The franchise fee amount varies by company, but is typically tens of thousands of dollars.
  • Item 6: Other Fees. Section 6 of the FDD includes a table that outlines additional fees that the franchisee will be required to pay the franchisor throughout the franchise agreement. These fees include royalty and advertising fees, which are usually charged as a percentage of the franchisee’s weekly or monthly sales. 
  • Item 7: Estimated Initial Investment. Section 7 of the FDD includes a table that outlines the entire estimated cost of starting the franchise to the franchisee, including the initial franchise fee outlined in item 5 and additional costs paid to third parties. Additional costs include rent, utilities, equipment, inventory, signs, an initial advertising fee, training and licenses. The definition of the initial investment period varies by franchisor, but typically it’s at least three months.

Why they’re important: Items 5-7 outline all of the costs you’ll have to pay as a franchisee. Make sure you understand how much money you’ll have to put into the franchise relative to the money you’ll get out of it. One way to be sure is to review these costs with an accountant, Kurtz says.

Item 8: Restrictions on sources of products and services

Section 8 of the FDD describes products the franchisor requires the franchisee to buy and any restrictions the franchisor has about where franchisees can buy necessary supplies and services. Some franchisors require franchisees to buy or lease equipment, inventory, computer hardware, software and real estate directly from the franchisor or from a specific supplier.

Why it’s important: This section lists specific expenditures the franchisee will have to make and how they’ll be required to source those purchases.

Item 9: Franchisee’s obligations

Section 9 of the FDD includes a table that lists the franchisee’s obligations outlined in the FDD and the franchise agreement. Common obligations including site selection and development, fees, compliance with standards, ongoing purchases, maintenance, appearance and remodeling requirements, insurance, advertising, management, records and reports, inspections and audits.

Why it’s important: If you’re not familiar with an FDD, this section is a good place to start, Kurtz says. It acts as a table of contents for the FDD and the franchise agreement, telling you what’s covered and where to find it.

Item 10: Financing

Section 10 of the FDD describes any financing options the franchisor offers, such as an installment contract, lease or loan guarantee. It also outlines the terms of that agreement, including interest rates, finance charges, number of payments and default penalties. However, these terms are not set in stone; the franchisee can negotiate them with the franchisor.

Why it’s important: Starting a franchise is a big investment that you’ll likely need outside funding to finance. Franchisors aren’t required to offer a financing option. If the franchisor doesn’t, you’ll have to find another way to get the money, either through a traditional small business loan or an online lender.

Item 11: Franchisor’s assistance, advertising, computer systems and training

Section 11 of the FDD describes the franchisor’s obligations to the franchisee, which can include site selection, advertising and training. If the franchisee is required to contribute to an advertising fund as described in item 6, this section explains what the money in the fund was used for last year, such as production and media placement.

This section also discusses the computer system or electronic cash register the franchisee is required to use, the cost of purchasing or leasing the system and required upgrades and maintenance. Finally, the section includes a description of the training program the franchisor offers franchisees, including a list of the subjects covered during the training, how many hours the training takes, the cost of the training and who is required to attend. 

Why it’s important: This section gives prospective franchisees an expectation of how much support they’ll receive from the franchisor and a clear idea of the day-to-day operations involved in owning a given franchise, Kurtz says.

Franchise Disclosure Document GuideItem 12: Territory

Section 12 of the FDD states whether the franchisor will offer the franchisee the exclusive right to open a franchise in a given area. It also describes the circumstances in which the franchisor would approve a franchise relocation and any plans the franchisor has to open a competing franchise system.

Why it’s important: Territory rights are important because they protect the franchisee from competition. For example, if a restaurant franchise opens on the corner of 1st and Main, an exclusive territory right could prohibit the franchisor from opening another outlet or franchise within a three-mile radius of that location, Kurtz says.

Items 13-14: Intellectual property

  • Item 13: Trademarks. Section 13 of the FDD states whether the franchisors’ trademarks are registered with the United States Patent and Trademark Office.
  • Item 14: Patents, copyrights and proprietary information. Section 14 of the FDD lists the franchisor’s registered patents, copyrights and proprietary information.

Why they’re important: If a franchisor has a registered trademark, patent or copyright, the franchisee can legally use it, too. If not, the franchisor and franchisee are at risk to be challenged for their use of the intellectual property.

Item 15: Obligation to participate in the actual operation of the franchise business

Section 15 of the FDD states whether the franchisee is required to personally be involved in the franchise’s day-to-day operation, or whether the franchisee can hire a supervisor to manage the franchise location.

Why it’s important: If you’re a franchisee who wants to own the franchise but not manage it, make sure that the franchise agreement allows you to do that.

Item 16: Restrictions on what the franchisee may sell

Section 16 of the FDD lists any restrictions the franchisor has on what goods or services the franchisee can sell.

Why it’s important: As a franchisee, you’ll be responsible for offering the products or services the franchisor approves, so you need to be aware of any restrictions on what your franchise can offer.

Item 17: Renewal, termination, transfers and dispute resolution

Section 17 of the FDD includes a table summarizing the franchise agreement, including terms about renewal, extension and transfers of the agreement. It explains if a renewal means the franchise agreement terms will be extended, or if the terms are subject to change at the time of renewal.

Why it’s important: This section summarizes the franchisee’s rights under the franchise agreement.

Franchise Disclosure Document GuideItem 18: Public figures

Section 18 of the FDD lists public figures who have control of the franchise system, use their image to endorse the franchise or invest in the franchisor. Public figures include athletes, actors, musicians and other celebrities.

Why it’s important: If you are paying into a franchisor’s advertising fund as a franchisee, you have a right to know how that money is being used.

Item 19: Financial performance representations

In section 19 of the FDD, franchisors are allowed to include either historical or projected representations of how current and past franchises have performed financially. Representations can be a chart, table or mathematical calculation to represent franchise earnings or room occupancy rates for a hotel franchise, but they are not required. 

Why it’s important: If the franchisor discloses financial performance of its franchises, prospective franchisees can more easily see how much money they stand to make by buying the franchise.

Item 20: Outlets and franchisee information

Section 20 of the FDD includes five tables showing the number of franchised outlets and other company-owned locations in the past three years. It also includes contact information for current and former franchisees and states whether those franchisees have signed a confidentiality agreement during the last three years. If they have, the prospective franchisee can’t speak with those franchisees about their experience with the franchise system.

Why it’s important: A growing number of franchises shows that the franchise system is thriving, while a shrinking number shows the prospective franchisee that franchises in the system may have struggled. Additionally, if the franchisor doesn’t disclose the financial performance of its franchises in item 19, a prospective franchisee should talk to current and former franchisees and ask about their financial performance. Franchisees don’t have to disclose this information, but they can choose to, Kurtz says.

Item 21: Financial statements

Section 21 of the FDD includes the franchisor’s audited financial statements from the previous three fiscal years, prepared using the U.S. Generally Accepted Auditing Standards. In some cases, this section also incudes financial statements for the parent corporation or affiliate companies.

Why it’s important: This information reflects how successful the franchisor has been in the past and shows how financially secure the franchisor is.

Item 22: Contracts

Section 22 of the FDD includes copies of the franchise agreement, leases, options, financing agreements and purchase agreements.

Why it’s important: If you decide to purchase a franchise, you’ll have to sign these contracts. It’s important to understand the terms of the contracts to know what you will be expected to do as a franchisee. 

Item 23: Receipts

The last section of the FDD contains two copies of a receipt for the disclosure document. The franchisee must sign one copy to indicate they received the disclosure document and return it to the franchisor, and keep the other copy for at least three years.

Guide to Franchise Disclosure Document

Next steps

When you’re ready to purchase a franchise, meet with a franchise attorney to review the FDD and franchise agreement more thoroughly. Franchise attorneys are specialized in catching details of the FDD you might not notice. You should also have an accountant review the costs sections of the FDD and help you create a 3-5 year projection of your income and expenses, Kurtz says.

For more information about starting and growing a business, visit the NerdWallet Small Business Guide.

Teddy Nykiel is a staff writer covering personal finance for NerdWallet. Follow her on Twitter @teddynykiel and on Google+.

Photo via iStock.