Both federal and state franchise laws require franchisors to make presale disclosures to prospective franchisees. The franchise disclosure document, or FDD, describes the franchise offering for the benefit of a potential franchise buyer. The FDD must be written in plain language so that it’s easy for any prospective franchisee to read.
The FDD is not a sales document. It is a disclosure document. It is intended to provide prospective franchisees with a clear explanation of what they are buying and the potential risks, just like a securities offering document.
Much of the Franchise Disclosure Document is a plain language explanation of the terms of the franchise agreement. The form of franchise agreement must be included in the FDD, but the FDD contains much more.
Disclosures – FDD contents
The Franchise Disclosure Document contains 23 sections. These sections are referred to as “items”, and each one has a number. The fact that the franchisor presents the required disclosures in a uniform format allows prospective franchisees to compare one franchise offering to another, even if they are in different industries.
Item 1 contains a description of the franchise company and its affiliates, an overview of the franchise being offered, the general market for the product or service the franchisee will offer, a general description of the competition and of any laws specific to the industry.
Item 2 gives the names and positions of the people who manage the franchisor and lists the positions each one has held in the last five years.
Items 3 and 4 describe any litigation or bankruptcy history of the franchisor, its affiliates or its managers.
Item 5 calls for disclosure of all initial fees that the franchisee will pay to the franchisor or any of the franchisor’s affiliates. Are these fees refundable and, if so, under what conditions? Can the initial fees be paid in installments?
Item 6 describes other fees that the franchisee will pay to the franchisor, like the ongoing royalties and marketing fees.
Item 7 contains a detailed breakdown of the franchisee’s estimated initial investment in the form of a table. This includes the initial fees described in Item 5 as well as other expenditures that the franchisee will have to make during the initial period of operations. This may be a three-month period or a longer period that is reasonable for the industry. The estimates typically show a low and high figure so that the total initial investment also appears as a range. This range also appears on the cover page of the franchise disclosure document.
Item 8 calls for disclosure of goods or services that the franchisee must buy from approved suppliers. Is the franchisor or its affiliate a supplier or certain goods or services? Is it the only approved supplier? The franchisor must also disclose whether it derives revenue from suppliers who sell required products or services to franchisees. What percentage of the franchisee’s purchases of goods and services will be required purchases?
Item 9 lists in a table many of the basic obligations of the franchisee and gives cross references to the relevant sections of the franchise agreement and the disclosure document that describe these obligations.
Item 10 describes any financing arrangements the franchisor makes available to franchisees.
Item 11 lists the franchisor’s principal obligations both before and after the franchise is opened. It includes a description of any site selection and buildout, the initial training program, advertising and marketing, computer systems, and contents of the manuals.
Item 12 describes the extent of any territorial exclusivity and the franchisor’s rights within the territory.
Items 13 and 14 deal with trademarks and other intellectual property rights.
Item 15 describes any requirement of the owners or managers to be directly involved in the business, and any restrictions the franchise imposes on managers, such as confidentiality and non-compete obligations.
Item 16 discloses any restrictions on what the franchisee may sell.
Item 17 lists in a table the provisions of the franchise agreement relating to term, renewal, termination, transfer and dispute resolution and gives cross references to the relevant sections of the franchise agreement.
Item 18 calls for disclosure of compensation to any public figure who endorses or recommends the franchise to prospective franchisees.
Item 19 deals with financial performance representations. These used to be called earnings claims. They include any representation that states or implies a specific level or range of actual or potential sales, income, gross profits or net profits that a franchisee may make. Franchisors are not required to make financial performance representations. But if they do, those representations must appear in Item 19 of the disclosure document, and the franchisor must have a reasonable basis for the representations. Written substantiation for the financial performance representation must be made available to the prospective franchisee upon reasonable request. It is a good idea for a franchisor to provide financial performance information in the disclosure document so that the franchisor can discuss earnings openly. For a new franchisor, the disclosure can be based on company-owned outlets. A new franchisor should plan to collect adequate data from its franchisees so that it will be in a position in a short time to disclose financial performance information about its franchisees.
Item 20 is a series of tables that show the numbers of franchises and company outlets over the last three years. It includes breakdowns by state. It shows numbers of transfers and closures of franchises as well as numbers of franchises opened. It also requires a listing of the names, addresses and telephone numbers of all franchisees and those who left the system in the last fiscal year. This listing enables a prospective franchisee to call current and former franchisees to learn more about the system.
Item 21 calls for disclosure of the franchisor’s financial statements. For new franchisors, the audits can often be phased in, although New York requires audited financials from day one. For this reason, many new franchisors set up a separate franchise company and have the opening balance sheet audited. The financials appear as an exhibit to the FDD.
Item 22 requires the franchisor to attach a copy of all proposed agreements relating to the franchise offering.
Item 23 is an acknowledgment of receipt. The franchisor should have each prospect sign and date the acknowledgment of receipt and should keep these on file as evidence of timely disclosure.
Other Franchise Disclosure Document Exhibits
The Exhibits to the FDD also include:
- a list of state administrators
- information regarding any franchisee organizations specific to the franchise system
- the table of contents of the operating manual
The same FDD that is used to comply with the FTC Rule is used to comply with the state disclosure requirements, although some states require some additional state-specific language. These variations are usually relatively minor and are included in an addendum to the franchise disclosure document. In this way, the franchisor can use a single disclosure document throughout the U.S.