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 franchise disclosure document 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 the franchise agreement must be included in the FDD, but the FDD contains much more.
What is a Franchise Disclosure Document?
The franchise disclosure document is an official document that discloses franchise information to potential franchisees. It should be presented to prospective franchisees at least ten days before the franchisor and the franchises sign the franchise agreement. The franchise disclosure document contains important franchisor details and is meant to help prospective franchisees to evaluate the pros and cons of buying that particular franchise.
This document aims at protecting the franchise from misconceptions due to falsehoods that may be spread by the public about a particular franchisor.
The format of this document was created by North American Securities Administrators Association (NASAA) in the year 1993. It was later approved for use in 1995 by the Federal Trade Commission.
Some of the states that require the franchising companies to employ this format include Washington, Virginia, South Dakota, Rhode Island, North Dakota, New York, Minnesota, Maryland, Indiana, Illinois, and California. These states do not allow the use of the FTC format.
One exception that we must mention: Florida is not a franchise registration state. But, in most other states the application of the franchise disclosure document is the most popular format.
Not considering your industry, the format of this document is the same.
A franchise disclosure document will include:
- Name of the franchise
- The franchise history
- Responsibilities of the franchisor and the franchisor
- The financial agreements
- The support, and training that the franchise is supposed to offer to the prospective franchisee
- Estimates for sales and returns
- Financial statements
- Franchising contracts, and information on restitution, termination, and other related details
All this information is put under three categories: the front cover, the table of contents, and “items.” The items consist of 23 different subsections. Twenty of these items have information that mainly relates to the franchising company. Sadly only about two pages have information that is meant for the franchises that you would want to buy.
Almost all of the items that are included in this document are mandatory, but there are a few items like the one relating to earning claims which may or may not be omitted. However, it is important that everything be clear to the new franchise purchasers. They need to know how much they stand to gain if they buy the franchise opportunity that the document presents.
It is important to note that although the franchise disclosure document is an officially authorized requirement, there has been no authorized institution that analyzed it to ascertain its correctness. This explains why you should seek the services of a legal consultant or a lawyer when you are considering buying a franchise.
23 Items of The Franchise Disclosure Document
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 the number of transfers and closures of franchises as well as the number 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:
- 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.
Under federal law, franchisors are required to deliver the franchise disclosure document (FDD) to each prospective franchisee at least 14 days before the prospective franchisee pays any money or signs an agreement. You can see all information regarding this law on the Federal Trade Commission website.
New York requires franchisors to wait 10 business days, which may be more than 14 days. New York requires earlier disclosure if the franchisor actually meets with the prospect to discuss the sale of a franchise at an earlier date.
If you are a franchisor keep careful records of the dates you deliver the FDD to your prospects. The last two pages of the FDD are duplicate copies of an acknowledgment of receipt. The prospect should sign and date this receipt, and you should keep each signed receipt on file to prove the date of disclosure if necessary.
Franchise Agreement and FDD
Finally, before even one franchise can be sold, the company must prepare a form of the franchise agreement and a franchise disclosure document. The agreement is the contractual basis of the ongoing relationship between the franchisor and the franchisee.
The disclosure document describes the franchise offering in plain language. It includes the franchise agreement, the audited financial statements, and much more. It must comply with the detailed requirements of the Federal Trade Commission’s trade regulation rule on franchising. The franchisor must deliver this disclosure document to each prospective franchisee before the prospective franchisee signs an agreement or pays a fee to the franchisor.
In several states, the franchisor must register its franchise offering before the franchisor can offer or sell franchises in the state. These states include California, Illinois, Maryland, New York, and others. In some states, franchisors must also file franchise sales materials before they are used.
Summary
You must be aware that a franchise disclosure document (FDD) is a mandatory document under the laws of the Federal Trade Commission. Whether you are a franchisor or just want to start a franchise, you need to know every aspect of this business. A lot of educational literature dealing with this type of business is available online, so you should have no trouble finding resources that can help you.
Franchising is a business like any other – you have to become an expert if you want to succeed, and that doesn’t come overnight. Before embarking on this type of business, research the rights, obligations, and specifics that the franchising model carries with it.
This business involves multiple stakeholders, and a franchise disclosure document will give you an insight into the stats of that particular franchisor. Therefore, if you have start-up capital and want to start your own business, franchising is the right choice. Franchising is an easier business model than starting a business from scratch.
The franchise disclosure document will provide you with information on what to expect in the future, and it contains a lot of information that can be key to choosing the right franchisor. So take your time and carefully read the FDD that your potential franchisor will provide to you.