The Franchise Disclosure Document

Franchise Disclosure Document

Before you invest in any franchise, get a copy of the franchisor’s Franchise Disclosure Document (FDD). Under the Franchise Rule enforced by the FTC, you must receive the document at least 14 days before you are asked to sign any contract or pay any money to the franchisor or an affiliate of the franchisor. You have the right to ask for — and get — a copy of the FDD once the franchisor has received your application and agreed to consider it. Indeed, you may want to get a copy of the franchisor’s FDD before you spend any money to investigate the franchise offering. The franchisor may give you a copy of its FDD on paper, via email, through a web page or on a disc. The cover of the FDD must provide information about the available formats. Make sure you have a copy of the FDD in a format that is convenient for you, and keep a copy for reference.

Read each of the 23 numbered “Items” in the FDD. Don’t be shy about asking for explanations, clarifications and answers to your questions before you invest. Here are some key sections of the FDD:

Franchisor’s Background (FDD Item 1)

Item 1 tells you how long the franchisor has been in business and its likely competition. It also lets you know if there any legal requirements unique to the franchised business, like a requirement that you get a special license or permit. This will help you understand the costs and risks you will take on if you purchase and operate the franchise.

Business Background (FDD Item 2)

Item 2 identifies the executives of the franchise system and describes their experience. Pay attention to their general business backgrounds, their experience in managing a franchise system and how long they’ve been with the franchisor.

Litigation History (FDD Item 3)

Item 3 lists important information about prior litigation — whether the franchisor or any of its executive officers have been convicted of felonies involving fraud, violations of franchise law, or unfair or deceptive practices law, or are subject to any state or federal injunctions involving similar misconduct. This item will tell you whether the franchisor or any of its executives have been held liable for — or settled civil actions involving — the franchise relationship. If there have been many claims against the franchisor, it may mean the franchisor has not performed according to its agreements. Or it could show that franchisees are dissatisfied with its performance. Item 3 also should say whether the franchisor has sued any of its franchisees during the last year. That disclosure may indicate common types of problems in the franchise system. For example, if a franchisor sued franchisees for failing to pay royalties, it could be because franchisees weren’t successful, and weren’t willing or able to make their royalty payments.

Bankruptcy (FDD Item 4)

Item 4 discloses whether the franchisor or its predecessor, affiliates or any of its executives have been involved in a recent bankruptcy. If the franchisor or its predecessor or affiliate has declared bankruptcy, carefully review the franchisor’s financial statements in Item 21 of the FDD to see if the franchisor is financially capable of delivering the support services it promises. Consider having an accountant review the required financial statements too.

Initial and Ongoing Costs (FDD Items 5-7)

These items describe some of the costs involved in starting and operating a franchise, including deposits or franchise fees that may be non-refundable, and costs for initial inventory, signs, equipment, leases or rentals. It also explains ongoing costs, like royalties and advertising fees. In addition, ask or find out about:

  • grand opening or other initial business promotions
  • business and operating licenses
  • product or service supply costs
  • real estate and leasehold improvements
  • required equipment, such as a computer system or a security system
  • training
  • business insurance
  • compliance with local ordinances, such as zoning, waste removal, and fire and other safety codes
  • employee salaries

You’ll need to investigate other initial and ongoing costs that aren’t described in Items 5-7, such as the cost of accounting and legal help.

It may take several months to start your business, and it may take more than a year to break even. Some franchises never break even. Estimate your operating expenses for the first year and your personal living expenses for up to two years. Compare your cost estimates for the franchise with what other franchisees in this system and competing systems have paid. An accountant can help you evaluate this information. You may be able to do better with another franchisor.

Supplier, Territory and Customer Restrictions (FDD Items 8 and 12)

  • These items tell you whether the franchisor limits:
  • suppliers from whom you may purchase goods
  • the goods or services you may offer for sale
  • where and to whom you can sell goods or services
  • your use of the internet to sell goods or services to customers within and outside your territory
  • the right of the franchisor (or other franchisees) to use the internet to solicit customers or to sell in your territory

These kinds of restrictions may limit your ability to exercise your own business judgment in operating your outlet. If the franchisor does not limit the territory where each franchisee can sell, the franchisor and other franchisees may compete with you for the same customers by establishing their own outlets or selling through the internet, catalogs or telemarketing.

Franchisor’s Advertising and Training (FDD Item 11)

The FDD includes important summaries of the franchise system’s advertising programs and the initial and ongoing training the franchisor will provide. Talk to the franchisor and current franchisees to get answers to your questions.

Advertising

Franchisees are often required to contribute a percentage of their sales to one or more national, regional or local advertising funds. Ask the franchisor what advertising it has done and what is being planned. Ask whether franchisees have any control over how advertising dollars are spent, and if all franchisees and company outlets contribute equally to the advertising funds. Find out if the franchisor gets a commission or rebate when it places ads. If there is a rebate, who benefits — you or the franchisor?

See what percentage of the fund is spent on:

  • administrative costs
  • national advertising
  • advertising in your area
  • selling more franchises
  • other expenses

Read Item 11 to learn whether franchisees need the franchisor’s consent to develop and buy their own advertising. If they buy their own advertising, do they get a rebate or discount on their advertising contribution?

Training

New franchisees typically count on the franchisor to provide all the business and operational training needed to run a successful franchise. The training you need depends on your business experience and knowledge of the franchisor’s goods and services. Check Item 11 for information about:

  • the trainers and their qualifications
  • who is eligible for training
  • the cost of training new employees and who pays
  • the length of training sessions
  • the amount of time spent on technical training, business management training and marketing
  • whether the franchisor offers ongoing training and at what cost
  • whether support staff are available for trouble-shooting in your area and how many franchisees they are responsible for
  • whether on-site individual assistance is available and at what cost

Be sure to talk with recent franchisees about the quality of training the franchisor provides. If — after you read the information in Item 11 and talk with franchisees — you still aren’t sure you’ll get the training you need, ask the franchisor if you can review the training materials. If the franchisor won’t provide them, even if you volunteer to sign a confidentiality agreement, consider a different franchise opportunity.

Renewal, Termination, Transfer and Dispute Resolution (FDD Item 17)

Item 17 covers important topics. First, it states whether you can renew your franchise at the end of the term, and, if you can renew:

  • what you must do to qualify for renewal
  • whether fees and other contract terms may change

Item 17 also explains what your obligations would be to the franchisor after termination. For example, after termination, restrictions in the contract typically will stop you from operating a business that would compete with your prior franchise, if the new business is within a specified distance of your prior outlet. The restrictions may also prevent you from operating a new business within a specified distance of any other outlets of the franchise. The restrictions may last as long as three years.

Additionally, Item 17 describes what you must do to get the franchisor’s approval if you want to sell your franchise. Lastly, it states whether you have the right to go to court if you have a dispute with the franchisor, or must use arbitration instead.

Financial Performance Representations (FDD Item 19)

Item 19 contains claims the franchisor chooses to make about the sales or earnings of its franchises for which there is a reasonable factual basis. The Franchise Rule doesn’t require a franchisor to provide sales or earnings information, but most do. Any claims the franchisor makes about sales, income or profits must be in Item 19. No other spoken or written financial performance claim may be made if it doesn’t appear in Item 19. There are two exceptions to this:

  1. The franchisor may provide the actual records of an existing outlet you’re thinking of buying.
  2. The franchisor may add to the information in Item 19. For example, the franchisor may provide information about possible performance at a particular location or under particular circumstances.

For tips on how to evaluate this information, see Evaluating Potential Earnings.

Franchisee and Franchise System Information (FDD Item 20)

Item 20 provides charts showing growth and owner turnover in the franchisor’s system. If the charts show more than a few franchised outlets in your area have closed, transferred to new owners, or transferred to the franchisor, it could be due to problems with the franchisor’s support or because franchises aren’t profitable.

Current and Former Franchisees

Look for the required disclosure of contact information for current franchisees and franchisees who have left the system during the franchisor’s last fiscal year. Talking to these people may be the most reliable way to verify the franchisor’s claims. Visit or phone as many of them as possible to chat about their experiences. Some current franchisees may be reluctant to talk to you if they’re having problems. If that’s the case, try contacting others on the list.

Some franchisors may give you a separate reference list of franchisees to contact. To ensure you get the full picture, you may want to contact a number of franchisees listed in the disclosure document and some on the separate list. Talk to several franchisees who have been in business just over one year. They’re in the best position to tell you: their total investment

  • whether they were able to open their outlet in a reasonable time
  • whether they were satisfied with the franchisor’s training, opening assistance and advertising
  • whether the franchisor provided ongoing help and assistance
  • whether they have been able to break even

It’s also a good idea to talk to several franchisees who have been in business for five years. Ask:

  • how long it took them to break even, earn a reasonable income and recoup their investment
  • whether the franchisor is providing the services and assistance it promised and fulfilling its contractual obligations
  • what problems, if any, they are having with the franchisor
  • whether they would invest in another outlet
  • whether they’re satisfied with the advertising program
  • whether they are satisfied with the cost, delivery and quality of goods or services they must buy from the franchisor, its affiliates or sole approved suppliers

It’s worth tracking down former franchisees (using contact information from Item 20), although some of them may have signed confidentiality agreements that prevent them from talking with you. Prior owners can tell you:

  • the problems they had with their outlet
  • whether they broke even or made a profit
  • when and for how long they operated the outlet
  • their business background
  • why they left the franchise system

Some franchisors may buy back failed outlets and list them as company-owned outlets. If you’re thinking about buying an existing outlet that the franchisor acquired from a prior franchisee, ask to see the financials showing the outlet’s actual operating results. The franchisor must tell you who owned and operated the outlet for the last five years. If a franchise has had several owners in a short time, perhaps the location isn’t profitable or the franchisor hasn’t supported that outlet as promised. Contact as many of the previous owners as possible to learn about their experience operating the outlet that failed.

Franchisee Associations

Associations of a franchisor’s franchisees are an important source of information. Franchisors are required to list in the FDD the associations they sponsor or endorse and independent associations that ask to be listed. An association, whether it’s sponsored, endorsed or independent, can provide information about the relationship between the franchisor and its franchisees. You may want to ask members of a franchisee association about:

  • the kinds of system problems or issues they discuss
  • system problems they successfully resolved
  • any problems franchisees face in the operation of their outlets
  • any problems franchisees have with the franchisor

Financial Statements (FDD Item 21)

Item 21 provides the franchisor’s three most recent audited annual financial statements. If you know how to read financial statements, this information will give you a good understanding of the franchisor’s financial health. If you don’t, it’s a good idea to hire an accountant to review the statements and explain them to you. Investing in a financially unstable franchisor is a significant risk; the franchisor may go out of business or into bankruptcy after you have invested your money. An accountant can help you understand whether the franchisor:

  • has steady growth
  • has a growth plan
  • makes more of its income from royalty payments from successful existing franchisees or from the sale of franchises
  • devotes sufficient funds to support its franchise system

 

Source: Federal Trade Commission