Franchise Disclosure Document : The Basics
Are you someone looking at growing your business and brand, or are you looking at buying a franchise? In either of the cases, you need to have a thorough understanding of the franchising process and all the legal documentation associated with it.
As a business who is looking to invest in buying a franchise it is crucial to understand all about Franchise Disclosure Document (FDD). So without further ado, let's dive into the subject.
What is Franchising?
As a business, buying a franchise is a huge and long-term financial investment. There are many benefits in buying a franchise.
- You get a head start in comparison to others because you are managing a business set-up and selling merchandise or service that already has a brand recognition.
- You do not have to spend time and effort on developing a system or format. The job has already been done by the franchisor.
- The franchisor also provides you with the required training and does hand holding in the initial days.
However, a franchisee needs to be committed and follow the guidelines set by the franchisor. Any mode of business has certain legalities and paperwork involved. A Franchise Disclosure Document (FDD) is the foundation of getting into a franchise model. People are often skeptical about getting involved in FDD as it involves a lot of documentation, is a lengthy process and has a certain level of complexity. Let us understand what FDD is.
What is a Franchise Disclosure Document (FDD)?
The FDD was earlier known as Uniform Franchising Office Circular (UFOC) and was created by the Federal Trade Commission (FTC) in 1979. There were some updates done by the FTC in the year 2007 and it was renamed as the Franchise Disclosure Document (FDD). The purpose of FDD is to disclose specific “essential information” to the potential franchisee by the franchisor at least two weeks prior to signing the contract. The franchisor is liable to mention information pertaining to the below 23 items in their FDD:
- The Franchisor
- Business experience
- Initial Fees
- Other fees
- Initial investment
- Restrictions on sourcing of products and services
- Franchisee’s obligations
- Franchisor’s assistance, training, computer system’s and advertising
- Patents, Copyright and Proprietary information
- Commitment to participate in the operations of the franchise business
- Restrictions on what the franchisee can sell
- Details on renewal, termination, transfer and dispute resolution
- Public figures
- Financial performance reports
- Other outlets and franchise information
- Financial statements
We will discuss each of these points later here.
Features of Franchise Disclosure Document (FDD)
- It is a legal disclosure document
- Seller presents it as a pre-disclosure document to the buyer of franchises
- It is governed by The Federal Trade Commission Rule of 1979
- It has 23 sections in it, that provides all the information
The Franchise Disclosure Document (FDD) is a legal agreement provided by the franchisor to the buyer. This document states several aspects of a particular franchise.
Why is FDD Required?
FDD is required to provide the franchisee (buyer) with all the due diligence information related to the business. As per FTC the franchisors need to file the FDD annually and make it available for the buyer. FDD is like a report card about the franchisor’s organizational health. The purpose is to provide the prospective franchisee with ample information so that he can take a well-informed decision.
The franchisor must provide FDD to the franchisee at least 14 days prior to signing the formal contract. This is as per a mandate by the FTC. The FDD does not require federal approval. However, some states require that the FDD document is registered with the local legal authorities.
FDD: Key terms
It is the company selling the Franchise to a buyer. Also known as the “Home Office” or “Parent Office” they are the entity that created the franchise.
This is the person who is buying the Franchise. They could be the owner of a local unit. The Franchisee pays a Franchise Fee for operation to the franchisor.
This is the legal document signed between the franchisor and franchisee. It is a legal binding agreement between the franchise and its parent company. It outlines every minute detail how much royalty money is to be paid, kind of advertising materials are allowed etc.
A franchise is a business method whereby the owner of a company sells or licenses its rights to operate. The licensee, known as the franchisee, opens up other outlets for their products and services by paying an agreed fee to the franchisor.
The Franchisee Fee is a fee that the Franchisor requests from their franchisees. This payment helps to pay for training and support services on behalf of the franchise in order to help keep up with industry standards, as well as ongoing assistance when needed by either party. The option ranges between 4% -10%, and are usually paid weekly or monthly depending on what works best for both parties involved
You need to have a legal entity in place before you can start selling franchises. That's why it makes sense for most people with ideas but not capital to work with Franchise developers. They have the required experience and expertise that will help get your business up and running as quickly and efficiently as possible.
In order to legally sell Franchises, you must have in place all the necessary documentation, plans etc. This is where the knowledge and expertise Franchise Developer comes into play.
- The FDD is like a bible for both franchisors and franchisees. The information helps both parties to evaluate whether to enter into a business relationship or not.
- The FTC has made this document mandatory for all franchises in order to provide clarity on how the business relationship will be
- It is always desirable to review the FDD with an attorney once you have done your own due diligence.
What are the 23 disclosure sections in a FDD?
We discussed earlier, what a FDD is. FDD gives you an insight on the company history, fees involved, rules and regulations, details about other franchisees in the system, and many other aspects. Educating yourself on these 23 essential components will help you make a more informed choice.
As per FTC (Federal Trade Commission) the franchisor is liable to present the FDD to the franchisee at least 14 days prior to signing the franchise agreement. It is strongly recommended that you go through this personally to make a note of all your doubts before your attorney walks you through the FDD.
This blog will ensure that you are aware of what all your Franchisor is liable to disclose to you in the FDD. However, it is always advisable to get the FDD vetted by your legal advisor. But by making yourself aware, you won’t feel lost in this often long and complex process. So, read on and get yourself educated on the 23 components of FDD.
1. The Franchisor and any Parents, Predecessors, or Affiliates
This 1st item of the FDD talks about the history and background of the franchisor. It gives information about how long the franchisor has been in business. It also discloses if the franchisor has any other business or a predecessor or any other affiliate. It discloses the corporate structure of the franchise system to the franchisee, for example is the franchise system a corporation, partnership or LLC. Does the franchise have a parent company? (is it owned by or part of a larger company)
2. Business experience
This 2nd item talks about the management team of the franchisor. It discloses information about the directors and the chief officers of the company. This helps the franchisee assess the strength and competence of the team that would be supporting him. However, the franchisor is not liable to disclose any information about the brokers who are helping out with the franchise sales process.
The 3rd item discloses information about any litigation history the franchisor may have. It should also disclose information about its directors or principal officers if they have been convicted of legal charges relating to fraud, violation of the franchise laws, charged for unfair trade practice etc. If the franchisor is having any pending legal cases with any existing franchisee the details of the same must be disclosed as well. Also, if the franchisor has sued any of its existing franchisees, the details and reason for such a lawsuit must be disclosed under the item litigation.
The 4th item discloses information about the financial health of the company. The franchisor is liable to disclose if any of its affiliates, parent company or directors or any of the key stakeholders have filed for bankruptcy in the past. They may also choose to provide a background on what led to bankruptcy.
5. Initial Fees
The 5th item discloses information on the fees a franchisee will be required to pay the franchisor for starting the business. This component gives a summary of the one-time fees that the franchisee will have to pay to commence business. One-time fees will cover expenses like, franchise fees and deposit, equipment cost, software cost, training and development cost. It is important to review the details mentioned carefully as most of the money paid at this stage is non-refundable.
6. Other fees
The 6th item discloses information on all other recurring fees that a franchisee is required to pay to the franchisor throughout the terms of the franchise agreement. Other fees include royalty fees, brand development fund, marketing, technology, training, fees for attending conferences, interest on late payments, audit expenses. Please note, most of the components of other fees are non-refundable and recurring and will largely impact your operational costs. Also, to safeguard yourself please read through details like when a particular fee is due, what is the amount, what are late payment charges, any other terms and conditions properly. It is a good idea to have all the fees and conditions associated with it reviewed by a qualified and experienced franchise attorney.
7. Initial investment
The 7th item requires the franchisors to clearly define the potential franchisee’s estimated initial investment to open a franchise. The franchisor may also choose to disclose information on funds that will be additionally required in the initial 90 days. This estimated initial investment talks about the costs that a franchisee may incur in establishing and opening a new franchised location. Though not prescribed by law, the list typically includes the initial franchise fees, training fees, equipment expenses, property costs (lease/owned), initial inventory costs, reserve capital requirements, and any other expenses that are required to get a franchised location started or in business. A franchisee should do a proper due diligence of all these costs.
8. Restrictions on sourcing of products and services
The 8th item discloses details about a franchisor's relation with its authorized suppliers. The franchisor clearly states the franchisee’s obligation to source goods or services from its authorized suppliers. The section talks in detail about the franchisor's product or service and his designated, exclusive suppliers. Understanding this is important for you as a franchisee from an operational perspective. It gives you an insight into the supply chain and determines the costs involved in procuring these goods or services from the authorized supplier to your franchise location.
9. Franchisee’s obligations
The 9th item talks about the franchisee’s obligations as per the franchise agreement. This is usually represented in a tabular format. The table comprises a summary of all the legal obligations of the franchisee starting from site selection and opening to the obligations upon termination of the franchise agreement. The section talks in detail about the franchisees legal rights, confidentiality rights and requirements, non-compete requirements, forum selection options and termination rights.
The 10th item is related to the 5th and 6th item. Here, the franchisor is obligated to disclose whether or not the franchise system can offer a financing model to the franchisee for payment of initial fees and other fees. Financing model means that the franchisor allows the franchisee to pay the initial and other fees over a period of time rather than in one shot. In such a scenario, the rate of interest if any and the terms and conditions of payment must be fully disclosed under financing in the FDD.
The 11th item discloses details about the territory a franchisee will receive. It discloses details like whether a franchisee is being awarded a protected territory or whether he will be competing with other franchisees and distribution channels in his territory. It also specifies if in future the franchisee has an option or not to relocate to another location. It also specifies whether or not he can pursue any other business as well.
12. Franchisor’s assistance, training, computer system’s and advertising
In the 12th item the franchisor is obliged to disclose details on the support and training he would be giving to the franchisee. It should essentially include details regarding the training, advertising and sales support the franchisee will receive both prior to starting the business and after the business is up and running. The section should typically include a full disclosure of the training schedule that the franchisor planned. The section should also describe the operating manual and information on mandatory requirements like number of computer systems required, software to be used, point of sale (POS) system to be used etc. It should clearly be disclosed whether the franchisor will be assisting with the technical infrastructure or it has to be procured by the franchisee.
One of the most lucrative features of a franchise model is that the franchisee gets to use the trademark of the franchisor. The 13th item discloses information about the trademark or trademarks of the franchisor. It is mandatory for the franchisor to disclose the legal protection status of the trademark. It should also clearly state whether or not the trademark is registered with the United States Patent and Trademark office. If there has been any litigation in the past regarding the use of a trademark or there is any pending litigation, such information should be disclosed. It should clearly state how the franchisee can use the trademark.
14. Patents, Copyright and Proprietary information
The 14th item is a disclosure about the intellectual property of a franchise. The franchisor needs to specify information about any rights or license to a copyright or patent it has. It should also disclose details on any pending patents or copyrights the franchise has applied for.
15. Commitment to participate in the operations of the franchise business
The 15th item discloses the scope of franchisees obligation in the day to day operations of the franchised business. The franchisor should clearly state whether or not the franchisee is expected to be present at the location to manage the day to day operations. If not, the franchisor must specify what skills, training and certification should a manager that is being hired for day to day operations possess. It should also specify the restrictions if any. For example, some franchisors may have a policy against hiring a direct competitor employee. Any such clause must be mentioned in this item of the FDD.
16. Restrictions on what the franchisee can sell
The 16th item will disclose a summary or list of what products or services is a franchisee allowed to sell. It will also mention details of the suppliers from where the goods and services can be sold and also a list of places or enterprises to whom a franchisee is allowed to sell the franchisor's products and services. This section highlights how much control a franchisor has over what and how a franchisee can sell.
17. Details on renewal, termination, transfer and dispute resolution
The 17th item summarises the legal rights of the franchisee in context of franchise renewal, transfer of franchise, termination of a franchise etc. It also mentions about the non-compete obligations of the franchisee (during the association with the franchisor and also after the association has been terminated). The franchisor is also liable to clearly mention how to resolve disputes. He may choose to settle disputes out of court through arbitration or in the court of law. The preferred option must be clearly specified by the franchisor in item 17 of the FDD.
18. Public figures
The 18th item will disclose details about any public figures associated with the franchise. Public figure here refers to a sports celebrity, movie artist, political figure, philanthropist etc. The franchisor is liable to disclose the capacity in which a celebrity is associated with the franchise. Is the concerned person hired by the franchisor for advertising and promoting the brand, is the public figure getting any profit share, has he made some investment in the franchisor company. The details of the agreement between the franchisor and public figure must be clearly mentioned.
19. Financial performance reports
The 19th item discloses whether or not a franchisor is making any Financial Performance Representations. This will typically contain past financial performance and projected financial performance of other franchised outlets. However, such representations are not a guarantee of your franchised business having a similar financial performance. It is a good practice to get these representations verified by an experienced financial attorney.
20. Other outlets and franchise information
The 20th item in the FDD is a table disclosing details of other franchisees and corporate-owned outlets of the franchisor over the past three years. The table gives details of the total number of owned outlets and franchisees that were opened, closed, transferred or terminated in the last three years. The table also contains names, address and contact numbers of all these outlets and franchisees. For the protection of your interest as a franchisee it is a good practice to connect and take feedback from those that have already had a similar business association with the franchisor.
21. Financial statements
The 21st item in the FDD discloses audited financial statements of the franchisor. Past two years financial statements should be included. It must also include the franchisor’s parent and affiliate companies (if any) audited financial statement. The prospective franchisee must review these statements thoroughly as it provides insight of the franchisor’s financial health.
The 22nd item discloses the list of all contracts and agreements that a franchisee is expected to sign to commence business. The copies of all contracts and agreements are attached in this section, including the Franchise agreement.
The 23rd item refers to the last two pages of an FDD. These are the acknowledgement receipts. Both documents are exactly the same. The franchisee signs and returns one copy of the acknowledgement to the franchisor as a confirmation of receiving the FDD. In today’s technology driven world, many have migrated to electronic signatures.
Having understood the 23 components of the FDD, there are a few things you should keep in mind. You should be confident and clear about all the information furnished to you by the franchisor in the FDD. Get your FDD document reviewed by your franchise attorney.
Know your Rights
As a franchisee you don’t have to agree to all the terms and conditions laid down by the franchisor. You can always negotiate on terms you are not comfortable with. The purpose of FDD before signing the Franchise Agreement, is for you to be informed about what kind of terms you will be working with. If you are not comfortable about a certain clause or you feel it is not in the best interest of your business, negotiate on it with the franchisor. The FDD is a good starting point to have a discussion with the franchisor.
How can FDD help you understand the history of the franchisor?
The items 1,2,3,4 and 20 namely the franchisor, business experience, litigation, bankruptcy and other outlets and franchise information will give you an in-depth insight into the background and history of the franchisor.
How can FDD help you in estimating the investment involved in acquiring the franchise?
The items 5,6 and 7 namely initial fees, other fees and initial investment provide a detailed break-up of the kind of investment involved.
How does FDD help in assessing the kind of support I can get from the franchisor?
Detailed study of items 8,11,12,14 and 17 talk about sourcing of products and services, territory, franchisor’s support in training and advertising, patents and trademark usage help you assess how supportive the franchisor is.
How can a FDD help me assess my obligations as a franchisee?
A study of items 8, 9 and 15 specially the section highlighting the commitment expected from the franchisee in day to day operations will help a great deal in assessing your obligations as a franchisee.
Lastly, item 19 is the only section in the FDD that can help you assess the financial viability of the franchisee.
Though FDD is a long and a complex document and often not the most exciting part of the process, it is the most important aspect of the process. It is imperative for you as a franchisee to review it thoroughly to make an informed choice.
FAQ’s on Franchise Disclosure Document
1. What is a Franchise Disclosure Document or FDD?
A Franchise Disclosure Document also known as FDD is a legal document which must be disclosed by the franchisor to a prospective franchisee before a franchise agreement is to be signed. The document comprises 23 sections or items in which the franchisor makes a disclosure to the franchisee on important aspects like basic information about the franchisor, the business opportunity that is being presented for sale to the franchisee, the fees being charged by the franchisor to the franchisee, the legal modalities and relationship between the franchisor and franchisee and some other information.
2. When should a franchisor disclose the FDD to the franchisee?
The Federal Trade Commission or the FTC has a mandate that the franchisor needs to disclose the FDD to a potential franchisee at least 14 days or 2 weeks prior to signing the franchise agreement and collecting initial payment. The 14 days period is counted from the day the franchisee signs the acknowledgement and returns it to the franchisee. The acknowledgement is a part of section 23, “receipts” of the FDD.
3. Does an FDD have to be updated? If yes, how frequently should an FDD be updated?
The FDD must be issued and updated every year, within 120 days of the franchisor's fiscal year end. However, if there is any major change in the information disclosed to potential franchisee, then the FDD must be updated immediately or quarterly so that the franchisee is not misled with any wrong information.
4. Is it mandatory to renew FDD registration?
Yes, the states which require FDD to be registered, there the franchisor must renew FDD registration annually within 120 days of the franchisors financial year end. The state examiners need time to review the renewal application, hence, the franchisor must ensure that the renewal request is submitted well in time before the 120 days deadline expires. If the franchisor fails to do so, it may result in the initial registration expiring before the renewal and the franchisor is at a risk of “going dark” in that state.
5. Can a franchisor choose not to include audited financial statements in FDD?
Including the audited financial statement will depend on how long the franchisor has been operating the business. If the franchisor is new to offering franchises and the company has been in existence only for a year, the franchisor may choose not to include audited financial statements in FDD. However, If they have never offered franchises before, then once they launch and reach $5 million in franchise sales revenue, they will be required to issue an audited balance sheet for at least one year preceding their latest financial year even if it's unaudited when first issued. Once the business has worked on a franchise model for more than 2 years, they will need to provide audited financial statement of parent and any other affiliated company for the previous 2 years. However, the rules regarding including audited financial statements differ for old business. Franchisors who offer more than 50 different products with 10 years of history can skip including audited financial statements in FDD.
6. Is it possible to make amendments in FDD if the franchisee and franchisor have had some negotiations after disclosure of FDD and before signing the Franchise Agreement?
After the franchisor has shared the FDD with the franchisee, the franchisee may negotiate on a few sections or items. For the convenience of the franchisee the franchisor may agree to make a few changes. However, those negotiated changes must reflect in the Franchise agreement. The franchisor need not make any amends in the FDD.
7. Can a franchisee get business information from FDD?
A franchisee is presented the FDD in the initial stages of the franchise sales process. One of the 23 sections in the FDD has a disclosure on the business information. So yes, a franchisee can get the business information from a FDD.
8. What is the difference between a FDD and a Franchise Agreement?
The FDD is written to define the relationship between the franchisor and the prospective franchisee. The aim of the FDD is to provide franchisee the information to understand the franchisor and his business offering. FDD helps the prospective franchisee decide whether the offered business proposition is viable or not. There is still no legal relationship established between the franchisor and the franchisee. Both the parties do not have any legal or financial obligation towards each other.
A Franchise Agreement on the other hand is a legal document. It binds the franchisor and the franchisee in a legal business relationship.
9. Is it mandatory to get the FDD reviewed from an attorney specializing in Franchise contracts?
FDD is a very long and complex document. It is also crucial for you as a franchisee to have a complete understanding of each and every component of the FDD. It contains information which may have long term implications. Though it is not mandatory to get FDD reviewed from an attorney, it is advisable to do so in order to safeguard your own business interest.
10. When should an FDD be issued?
The franchisor can issue the FDD document once it has completed all the compliance requirements as defined by federal franchise laws. However, the franchisor needs to self-certify whether all compliances have been met and then determine an issuance. This is because of the absence of a federal agency that reviews and registers FDDs. If the state you are operating in has FDD registration laws in place you may need to register with a state examiner who will review your FDD and grant registration.