The Franchise Disclosure Document (FDD)
by Mike Martuza
In my previous article "A Brief History of Franchising" I outlined some of the circumstances that led to the regulation of franchises by the federal and several state governments in the 1970s. One of the requirements that came from this regulatory effort was that all franchise companies create and provide to prospective franchise owners a Franchise Disclosure Document (FDD) that covers specific topics.
Before reviewing the actual contents of the FDD there are several important regulations covering its issuance.
1. The franchise company must issue a new FDD at least once per year.
2. The format of the FDD must conform to Federal Trade Commission standards so that every FDD has the same twenty-three topics presented in the same order. (This makes it much easier for a potential franchise owner to compare different concepts.)
3. The FDD must be provided to a prospective franchise owner prior to any negotiations.
4. The FDD must be in the hands of the prospective franchise owner at least 14 days prior to any money changing hands.
These requirements insure that the prospective franchise owner has the most current information and is making a decision based upon the state of the franchise company at that moment.
Franchise Disclosure Documents are about 100-150 pages in length and cover the many issues that arise in the operation of a franchise business. As you go through the investigation process it is important to read through the FDD yourself and make note of everything that you do not understand or want to question. Once you are fairly sure that you would like to go forward with one franchise concept you should have the FDD, the franchise agreement/contract, and the financial statements reviewed by professionals (a franchise lawyer and/or an accountant) before you make a final investment decision.
The items in the FDD are as follows, with my comments italicized:
1. The Franchisor and Any Parents, Predecessors, and Affiliates: This section explains the history of the franchise.
2. Identity and Business Experience of Key Persons: Who is running the franchise and what is their business experience.
3. Litigation History: Many franchise companies have current or past litigation activities listed. This should not be a disqualifier, but you want to read and understand if there is a systemic problem.
4. Bankruptcy: Has the company or any of its key employees filed for bankruptcy.
5. Initial Fees: The amount paid to the franchise company upon signing the franchise contract. Some of the items that may be included are the Franchise Fee, Territory Fee, and Equipment Fee. There may also be a mention, if offered, of discounts off of the Franchise Fee for veterans or minorities.
6. Other Fees and Expenses: A listing of other expenses, either reoccurring or one-time, that a franchise owner may incur during operation of the business. Examples include computers, Internet access, insurance policies and royalties.
7. Franchisee's Estimated Initial Investment: Summary of the Initial Investment and the ongoing costs necessary to operate the business.
8. Restrictions on Sources of Products and Services: If the franchise company requires that you obtain certain products or services from certain vendors they will be listed in this section.
9. Obligations of the Franchisee: Lists your principle obligations as per the franchise agreement and contract.
10. Financing Arrangements: If the franchise company provides financing assistance the details will be outlined in this section - most do not.
11. Obligations of the Franchisor: Lists the franchise company's principle obligations to the franchise owner.
12. Territory: How are territories defined (miles, population, etc) and how large are they.
13. Trademarks: Explanation and restrictions on the use of trademarks, service marks, logos, etc.
14. Patents, Copyrights, and Proprietary Information: Overview of those items owned by the franchise company.
15. Obligation of the Franchisee to Participate in the Actual Operation of the Franchise Business: Details your required involvement in the business as the owner and if you may hire a manager to run the day-to-day operations.
16. Restrictions on Goods and Services Offered by the Franchisee: Outlines what services you must offer while running the business.
17. Renewal, Termination, Repurchase, Modification and/or Transfer of the Franchise Agreement, and Dispute Resolution: Provides information on a variety of topics including contract term, renewal of contract, sale of franchise, etc.
18. Public Figures: Lists any public figures used to promote the franchise.
19. Financial Performance Representations: This is commonly referred to as an earnings claim. In answer to a question like "How much money can I make in this franchise?" the franchise company can only tell you what is published in this section. If the section is left blank, which is a valid option, the franchise company may not quote you any figures. Only about 25% of franchise companies provide information in this section. Whether they do or not, your best source of information will be the other franchise owners. The other franchise owners while not obligated, are usually very helpful.
20. List of Franchise Outlets: Lists the number of opened and closed units over the past three years as well as forward looking statements on expansion. Also includes contact information for each location so that you may contact them during the due diligence process. Having these numbers permits you to determine failure rate for the previous three years.
21. Financial Statements: Audited financials for the franchise company for the previous three fiscal years.
22. Contracts: Sample of the contract you would sign. The contract is signed by all franchisees usually with little or no significant changes. It's very important to understand all the terms of the agreement, as it will help you in determining if the opportunity is right for you.
23. Acknowledgment of Receipt: Upon receiving the FDD the franchise company will ask you to sign, date and return this receipt. It proves that the franchise company provided you with a copy of the FDD.
The FDD is not the only research tool in the due diligence process, but with the help of a franchise attorney as well as your own reading of the FDD, you can develop a good sense of the viability and attractiveness for each franchise opportunity.