Understanding The Franchise Disclosure Document

Reading a franchise disclosure document can be overwhelming, whether one is an experienced, multi-unit franchisee or first-time candidate. Made up of 23 sections called “Items,” FDDs provide prospective franchise buyers with a detailed, 200-page analysis of the business ownership opportunity they are considering. To ensure that franchises are giving prospective franchisees the proper amount of information needed to make an educated decision, the Federal Trade Commission (FTC) mandates that the FDD be provided to the prospective franchisee no later than 14 days before any binding documents are signed.

In order to assist in the review process and point out any potential red flags, 1851 Franchise breaks down all 23 sections of the FDD.

Item 1 -- The Franchisor, Affiliates, Parent Company and Predecessors

In this section, candidates will learn the complete history of the franchisor, including basic information such as: the address where the company is headquartered; when they began franchising; if they were known by any other names or changed ownership; a description of the product or service they offer; and regulations related to the business opportunity. This section also mentions any specific laws that pertain to the industry or permits that may need to be acquired to open the business.

Item 2 -- Business Experience and Identity of Leadership

This section simply lists the key executives in the franchise, with specifics about what role they play in the company and their previous experience.

Item 3 -- Litigation

Here, prospects will learn if any executives within the franchise have pending or past lawsuits. Felonies listed include fraud, violations of franchise law, unfair or deceptive practices/misrepresentation and settled civil actions. It is important to note the nature of the complaint and how it was resolved. 

Item 4 -- Bankruptcy

Another legal item, this section specifically notes bankruptcy filings within the past decade by the franchise or any key executive. Remember, bankruptcies are not necessarily a red flag, and it is important to look into them to understand why they were filed and ensure that they are not part of a bigger issue within the franchise. Bankruptcy information can be helpful in assessing the franchisor's financial stability and whether the company is capable of delivering the opportunity it promises.

Item 5 -- Initial Franchise Fee

When it comes to the investment necessary to purchase a franchise, many of the costs must be covered before the doors of the business can open. This section will lay out these initial costs, including franchise fees, non-refundable fees, deposits, inventory fees, equipment fees, signage fees and royalty fees.

Item 6 -- Other Fees and Expenses

In addition to initial costs, there are many ongoing expected costs associated with owning a franchise. This section details ongoing costs such as royalty fees, national ad and marketing fund fees, call center resources, training and audits. Deadlines for these fees will also be disclosed.

Item 7 -- Initial Investment (Estimated)

This section will combine the total of the fees outlined above in order to provide the specific dollar amount needed to invest.

Item 8 -- Restrictions on Sources of Products or Services

In order to maintain the brand’s consistency and quality when it comes to vendor and supplier partnerships, this section will outline where franchisees are able to purchase goods and services. 

Item 9 -- Franchisee Obligations

This section is essentially a table of contents for the FDD which lays out franchisee obligations and where they can be found in the 200-page document.

Item 10 -- Financing

Here the franchisor will explain if they offer any financing programs, such as loans, installment plans or leasing arrangements. It is important to note that financing from a franchise is just like financing from a bank—if a franchisee defaults, the franchise agreement can be terminated.

Item 11 -- Franchisor Obligations

In this section, the FDD breaks down the assistance and training new franchisees are provided to help them get started. This can include information on training, advertising, software, operations, staffing,  and opening and marketing support.

Item 12 -- Territory

The designated territory section details where the candidate will be allowed to operate and solicit customers. In this section, prospects will learn whether each franchise has an assigned, protected territory or not. Most agreements allow candidates to modify their territory when they renew their contract.

Item 13 -- Trademarks

This section lists the trademarks, copyrights, patents and proprietary information the candidate will gain the rights to under the franchise agreement.

Item 14 -- Patents, Copyrights and Proprietary Information

Similar to section 13, this item lays out the patents and copyrights that franchisees gain access to through the FDD, as well as any restrictions.

Item 15 -- Obligation to Participate in the Actual Operation of the Franchised Business

Here, prospective owners will learn the expectations of being a franchise owner, which can vary from franchise to franchise. For example, some brands expect franchisees to manage the day-to-day operations, while others have no issues with franchisees hiring outside assistance. It also will outline whether or not the franchisee can participate in any other business ventures while under contract with the franchisor.

Item 16 -- Restrictions on What the Franchisee Must Sell

As stated in Item 8, franchisors limit what candidates can sell to maintain consistency across all locations. While these restrictions should all be familiar to prospective franchisees, it’s still important to review this section for any unforeseen or confusing limitations.

Item 17 -- Renewal, Termination, Transfer and Dispute Resolution

This section is important for candidates to understand because it explains whether or not their agreement can be renewed or terminated, and what their rights and restrictions are if they have a disagreement with their franchisor. 

Item 18 -- Public Figures

Should the franchise use public figures in their advertising — such as Shaq’s partnership with Papa John’s — the details of their relationship will be listed here. 

Item 19 -- Financial Performance Representations

This is frequently considered the most important section of the FDD, as it outlines the bottom line for many franchisee candidates: profit. However, franchisors are not required to disclose information about potential income or sales. If they do, the law requires they have a reasonable basis for their claims. It is up to each candidate to examine this section very closely and look for the following: figures from corporate stores, average sales and earnings, gross sales, geographic difference and number of years the franchise has been in operation. 

Item 20 -- List of Franchise Outlets

This is a series of tables that contains the number of franchise and company-owned locations, the number of store transfers, the status of franchised and company-owned outlets and the projected number of new franchise outlets. Ideally, the section will document consistent growth. If not, it is important to use the section’s list of existing franchisees (and their contact information) and to reach out to established franchise owners to ask questions.

Item 21 -- Financial Statements

Here, prospective candidates are provided with a review (in most cases three years) of the franchisor’s financial condition, including audited financial statements. This is a great way to understand the overall health of the business—ideally it will show steady growth and income from royalty payments as opposed to franchise sales. 

Item 22 -- Contracts

If a candidate chooses to open a franchise, there are a few contracts they must sign, including the franchise agreement, confidentiality agreements, leases, finance documents, purchase agreements, service agreements, software agreements, bank draft authorizations and promissory notes. This is a prime example of one of the sections that should be reviewed with a franchise lawyer.

Item 23 -- Receipt

Remember, candidates must review the FDD at least 14 days prior to signing a franchise agreement. Both the candidate and the franchisor should sign this receipt to acknowledge that the FDD was received.