So, you’re thinking of purchasing a low-cost franchise? If you’ve started your research and you got this far—great job! If you’re looking for additional information, we recommend reading about what a franchise is, what to consider before purchasing a low-cost franchise or the advantages of purchasing a franchise. Here, we are going to focus on the fine details you should look out for in a low-cost franchise’s franchise disclosure document (FDD).
What is a Franchise Disclosure Document?
A franchise disclosure document (FDD) is a document required by law to be given to people interested in purchasing a franchise. This legal disclosure applies to low-cost franchises as well as high capital investment types. It contains 23 sections with information essential to potential buyers. The sections include information such as financial health of the franchise, pending litigation, bankruptcies and number of franchises opened and closed.
According to the Federal Trade Commission, franchisors are legally obligated to provide the franchisee with the FDD at least 14 days before a franchise agreement can be signed and any initial money is paid. The franchisee has a right to a copy of the FDD after the franchisor has received a franchise application and agreed to consider it.
Items of the FDD:
Drafted in a set format, the FDD provides you with the information you need to make an informed decision. While the quality and contents of these documents vary, every franchisor’s FDD is required to contain the following items in this order:
Item1: The franchisor and any parents, predecessors, and affiliates: This item outlines how the business was started and what transfers of ownership have taken place. It also tells you the history of the franchise organization, parent corporations and discloses any other businesses in which the franchisor may be involved.
Item 2: Business experience: A listing of all the key individuals, ranging from partners and directors to top executives with management responsibilities for the franchise. It will state the occupation and employer for each person over the past five years.
Item 3: Litigation: Litigation risk is the possibility that legal action will be taken because of an individual's or corporation's actions, inaction, products, services, or other events. This section shows any pending litigation with the franchisor.
Item 4: Bankruptcy: As with litigation, this item discloses information to the prospective franchisee about the financial history of the franchise’s leadership team.
Item 5: Initial fees: A franchisor must disclose fees charged to franchisees.
Item 6: Other fees: This section must also include any other fees. Other fees can include additional fees or ongoing fees such as royalties, marketing fees etc. Any hidden or undisclosed fees can be a source of dispute down the road, so a franchisor must be transparent.
Item 7: Estimated initial investment: The franchisor discloses the low and high range of the initial investment.
Item 8: Restrictions on sources of products and services: Tells you three things about procurement of products and services: 1) which ones you are required to get from the franchisor; 2) the recommended suppliers of goods not provided by the franchisor; and 3) the items that are the obligation of the franchisees to provide for themselves.
Item 9: Franchisee’s obligations: This differs from franchise to franchise; an example can be specifics on how the franchisee must uphold the integrity of the brand in addition to representing it in a positive manner.
Item 10: Financing: This section is to advise the prospective franchisee what funding options are available from the franchisor to fund the business, if any.
Item 11: Franchisor’s assistance, advertising, computer systems, and training - This is a list of the systems the franchisor supplies to assist the franchisee in becoming successful.
Item 12: Territory: While there is no obligation to give a franchisee any range or territory to do business, this is the space to indicate any geographical restrictions a franchisor is putting on the franchisee.
Item 13: Trademarks - All registered trademarks of the franchisor are specified in this item, including all the registration information for those trademarks.
Item 14: Patents, copyrights, and proprietary information - If the franchisor owns rights in patents, copyrights or proprietary information that are material to the franchise, the franchisor will describe these and their relationship to the franchisee in this section. Just as with Item 13, this section will give you an idea the franchisor is well protected.
Item 15: Obligation to participate in the actual operation of the franchise business - This describes how much direct involvement the franchisee is required to have in the actual operation of the business. It may sound unusual to specify how much day-to-day activity is required to run a successful franchise, but because people may have various business interests, they need to know if the franchise company allows passive ownership. This declaration serves the dual purpose of giving the franchisee a realistic expectation while at the same time protecting the franchisor against a claim by a franchisee who may have not been engaged as much as they should have been.
Item 16: Restrictions on what the franchisee may sell - This protects the standards and uniformity of the franchise system. If you plan to buy a business that has a specific type of product or service, chances are likely the restrictions to that product/service will be described clearly in this section. For example, Cruise Planners restriction will specify the intent of the travel agency is to sell travel, and not sell other items or products.
Item 17: Renewal, termination, transfer, and dispute resolution - This section summarizes the provisions of the franchise and other agreements such as dealing with termination, renewal, transfer, dispute resolution and other aspects of the franchise relationship. What’s really helpful about this item is the breakdown in layman’s, easy to understand, terms of all possible outcomes, including any worst-case scenarios.
Item 18: Public figures – You are advised about the business relationship the franchise has with a public figure and prevents confusion about how the franchisee may use the name and other images of the public figure.
Item 19: Financial performance representations: Often considered one of the most important sections, yet not required. The declaration of a Financial Performance Representation gives you an expectation of how much money can be made from the business. On the other hand, if no representation is made, information must be collected through interviewing the existing franchisees. Cruise Planners FDD provides this item clearly in their FDD.
Item 20: Outlets and franchisee information - This information is provided to give you a numerical breakdown of locations and growth or franchise regression trends. This shows the growth of the franchise over time.
Item 21: Financial statements: A franchisor must provide three years of financial statements to the franchisee as part of the financial disclosure document. This includes balance sheets, statements of operations, owner’s equity, and cash flows.
Item 22: Contracts: The franchisor outlines the franchise agreement. It may include financing agreements, product supply agreements, personal guarantees, software licensing agreements, and any other contracts specific to the franchise's situation. This section itself is typically brief, but it contains references to the exhibits that constitute the legal relationship between you and the franchisor.
Item 23 Receipts: This is simply a one-page document the prospective franchisee signs to acknowledge the Franchise Disclosure Document was received. There is no obligation related to this signature page; it is merely an acknowledgement of receipt and a listing of your rights under the FTC.
While the FDD may seem like an abundance of information, it is all essential for you to make an informed decision on whether to purchase the low-cost franchise you are researching. Keep in mind the information provided is directional in nature. Each franchisor will be unique; therefore, you will use your own judgment or consult an attorney as you interpret the specific information found in each franchisor’s disclosure document.