ALL ABOUT THE FRANCHISE DISCLOSURE DOCUMENT (FDD)
If you’re considering joining a franchise organization, there is a lot of information you can find out before you even make initial contact with the franchisor. You can research the opportunity online, read articles, attend a franchise opportunity event, check rankings and even talk to a local franchisee or two. But when you really start to get serious, you’ll need to learn the details of that business.
For any franchisee or prospective franchisee, the Franchise Disclosure Document is one of the most important documents you will have, aside from the signed franchise agreement. Most simply, it is a way to disclose franchisor information to prospective franchisees. The Franchise Disclosure Document will play an essential role once all the initial research has been done and you have narrowed your focus to a specific business opportunity. The franchisor provides the document as part of the final due diligence process, prior to committing to the brand. In this guide, we’ll explain everything you need to know about the Franchise Disclosure Document and why it is vital for all parties involved in a franchise relationship.
What is the Franchise Disclosure Document?
The Franchise Disclosure Document (FDD) is a lengthy, complex document that serves almost as a franchisee’s guidebook for their relationship with the franchisor. It is used by a prospective franchisee to gather extremely detailed information about every aspect of the franchise business, thereby helping make the decision about whether or not to pursue becoming a franchisee.
According to the FTC Franchise Rule, FDDs must be updated yearly, within 120 days of the end of the company’s fiscal year, which for most franchisors that means the end of April. FDDs follow a standard, 23-point format (“items”) that was approved by the Federal Trade Commission (FTC) in 1995 as a way to ensure that the franchisor was being honest and fully transparent about their company. Use of this format is currently required in 14 “registration” U.S. states (California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington and Wisconsin). States that don’t require the FDD format—“non-registration states”—use a similar format approved by the FTC. Because the FTC format is less stringent, the FDD format is most widely used.
An FDD can be hundreds of pages long because of the detailed information that it includes, which can make it overwhelming for a prospective franchise owner. After all, they are written by attorneys, so the language can be complex at times. To help ease the pressure of reading and understanding all the details, franchisors are required to provide the FDD to a prospective franchise owner no later than 10 business days prior to signing a franchise agreement. A receipt is signed to acknowledge and record that the FDD was received but does not in any way obligate the prospective franchisee to sign an agreement or pay any money. It just means they got a copy of the FDD, nothing more.
Signing the receipt starts the two-week clock ticking. This window is vital because it gives the prospective franchisee time to review the document in detail and consult his or her attorney about any questions or concerns. In broad strokes, items 1-4 provide information on the franchisor, their history, litigation and bankruptcy background. Items 5-10 focus on fees and other financial arrangements. Items 11-19 outline the franchisee’s obligations, restrictions, and provisions, including termination, dispute resolution, and transfer. This group also includes the franchisor financial details. Finally, items 20-23 include financial statements, a list of current and former franchisees and all contracts involved in the transaction. So you can see how extensive the material is and how it can impact the buying process.
Parts of a Franchise Disclosure Document
The FTC-approved standard FDD format includes 23 items covering every aspect of the franchisor’s business. Let’s take a look at each one in more detail:
- The Franchisor, Affiliates, Parent Company and Predecessors– This section presents a complete history, including ownership, information on any parent and affiliated companies and the types of franchises that are offered. You’ll learn about how long they have been in business and specific licensing or permitting requirements that are involved. This will help you understand additional costs or risks involved in being part of the company.
- Business Experience and Identity of Leadership– This section provides the names and backgrounds of the key executives in the company. Pay special attention to any significant franchise experience.
- Litigation– Here you will learn whether the franchisor or any of its executives have been convicted of any felonies or held liable for:
- Violations of franchise law
- Unfair or deceptive practices/misrepresentation
- Settled civil actions involving the franchise relationship
This section also includes any lawsuits the franchisor brought against their franchisees, which commonly include things such as failure to pay royalties, trademark infringement or non-compliance. It is important to understand this section because it can point to greater problems. For example, a failure to pay royalties can indicate a lack of sales.
- Bankruptcy– In this section the franchisor must disclose any bankruptcies. This includes executives that have had personal bankruptcies or have been involved in a franchisor bankruptcy in the past.
- Initial Franchise Fee– This is a key section for a prospective franchisee because it outlines how much it’s going to cost you. If there is a fee range provided, inquire about qualifying for the lower fee. Here you will find information about:
- Initial investment
- Other Fees– This section outlines any additional costs associated with training and advertising.
- Initial Investment (Estimated)– This section adds together all outlined fees to come up with an estimated total initial investment for a franchisee. It’s the bottom-line dollar amount you’ll be expected to invest to become part of the company.
- Restrictions on Sources of Products or Services– This section will explain from where a franchisee must purchase their supplies or services. Franchises are all about uniformity, and usually franchisors have designated suppliers or service providers who meet their established standards.
- Franchisee Obligations – This is an exhaustive list of the franchisee contractual obligations.
- Financing – Here you can find out whether the franchisor offers any financing programs. If they do have a lending program, understand that it will be no different than taking a loan from a bank. If a franchisee defaults, the franchisee agreement can be terminated.
- Franchisor Obligations – This section details the support that the franchisor will provide, such as advertising, computer systems, data and training.
- Territory – Here you will find out whether each franchisee has an assigned, protected territory or not. If there are assigned territories, it will detail the geographic radius of that protection zone. Territories can be modified at contract renewal.
- Trademarks – This section simply lists the trademarks of the business.
- Patents, Copyrights, Proprietary Information – Sort of a continuation of item 13, this section will list any patents, copyrights or proprietary information of the franchisor.
- Obligation to Participate in the Actual Operation of the Franchised Business – This item allows franchisors to specify whether a franchisee must participate in the actual day-to-day running of the business or whether they can hire someone else to do it.
- Restrictions on What the Franchisee Must Sell – This section outlines the products or services that franchisees are permitted to sell.
- Renewal, Termination, Transfer and Dispute Resolution– This section outlines what can and will happen upon the franchise agreement renewal (first right of refusal), termination, or transfer, as well as how the dispute resolution process will happen.
- Public Figures– If the franchise uses public figures in their advertising, this item will contain details of the relationship.
- Financial Performance Representations– This is an extremely important section, but less than half of franchisors disclose their income or profits. If a franchisor does not report the earnings of their franchisees, they have to state that. So it’s up to a prospective franchisee to examine this section very closely and watch for any red flags. A few things to watch out for:
- Figures from corporate stores
- Average sales and earnings
- Gross sales
- Geographic differences
- Number of years the franchisee has been in operation
- List of Franchise Outlets– This spreadsheet contains all the franchises that have opened, closed (terminated, canceled, non-renewal), or transferred in the past three years, including the names of the franchise owners. This is vital because, as part of your due diligence, prospective franchise owners should contact as many current or former franchise owners as possible to learn about their experience as part of the brand. Take the time to study this section to identify any growth or closure trends.
- Financial Statements – This section will show the overall health of the business, and includes audited profit and loss statements and balance sheets. A healthy franchisor will show steady growth, income from royalty payments as opposed to franchise sales and have dedicated funds to support the franchisees.
- Contracts– This section contains all of the contract documents a prospective franchisee will be required to sign. Make sure your attorney reviews these carefully before signing anything.
- Receipt– This is the receipt that a prospect signs when first receiving the FDD, as referred to earlier in this article.
All 23 sections of the FDD are important, but if we had to pick just three that stand out from the rest we’d have to point you to Litigation (3), Financial Performance Representations (19), and List of Franchise Outlets (20). Together these will tell you what sort of legal troubles the company has or has been involved in, how healthy they are financially and the rate of turnover or growth.
As you can see from this breakdown, the FDD is an extremely informative and valuable document. It is the foundation of the relationship with a franchisor. A franchise business is based on uniformity and consistency, but an FDD will indicate whether there is any negotiation room when it comes to the final franchise agreement. Thoroughly understanding and reviewing each component of the FDD will put you in a better position to enter into a positive, long-term relationship with the franchisor. If, after reviewing the FDD, there are any red flags or warning signs of possible trouble in any section, you can stop pursuing that franchise opportunity and investigate an alternative.
Because the FDD is so essential to the franchise buying process, we want you to be able to review a company FDD at your own pace. To learn more about a particular franchising opportunity and gain access to our extensive library of FDDs at no cost, sign up for your free membership.
Advantages of a Franchise
Established customer base - Franchisors offer strong advantages in return for additional capital and commitment. One advantage of owning a franchise is the inherent awareness of the company name and brand. Because corporate brand awareness is already well-established, consumers are generally more comfortable purchasing items from a firm with which they are familiar. This provides an established customer base.
Training - Franchisors provide comprehensive training for employees and managers to support their franchisees in their entrepreneurial effort, and the training usually includes continued support from the franchisor.
Safety - Franchising opportunities offer safety and low risk for both parties, and the failure rates among new franchisees is significantly lower than for other new businesses due to the brand awareness, as the product, service and reputation have already been established.
Credit - Bankers look favorably upon franchisees—successful franchise chains are perceived as being lower risk due to the historical higher repayment history.
Advertisement - Established franchise companies advertise locally and nationally, providing exposure to help boost sales for all franchisees without having to absorb the additional cost of advertising.
image 1: Krisztián Hoffer ; image 2: Jo Naylor (Creative Commons BY); image 3: Catherine Read (Creative Commons BY-ND); image 4: Steve Jurvetson (Creative Commons BY / Cropped from original); image 5: Murilo Cardoso (Creative Commons BY-NC-SA)
Disadvantages of a Franchise
High initial investment - The largest and most prohibitive disadvantage of operating a franchise is the high initial cost of buying the rights to operate the franchise. Some of the major franchises can cost between $500K and $2.5 million.
Royalties - The typical royalty rate can range from less than 1 percent to over 45 percent or more of gross revenue, depending on the company. Moreover, the franchisee is liable for continued operating expenses, which reduce profits significantly.
Restrictive agreements - Franchise agreements are usually stringent and very restricting to some franchise owners, as they must adhere to the franchise bylaws and guidelines explicitly or risk termination for non-compliance.
Lack of autonomy - Autonomy is sacrificed and business decisions in most cases must be in perfect alignment with the franchisor's operations guide.
Market restrictions - There is restricted territory that limits where and when a franchisee may operate.
Cash outlay to exit - If a franchisee sells there is the standard fee that must be paid to the franchisor per the franchise bylaws.
Uncertain continuity - At the conclusion of a franchise term, the franchisor may choose not to renew. As in all matters with legal implications, entrepreneurs should always consult a lawyer and a CPA, and not sign a franchise agreement if they do not feel the fees and costs are reasonable, focusing more on what the franchisee gets relative to what the franchisor is requiring in terms of cash outlay.