When it comes to buying a franchise, the Franchise Disclosure Document (FDD) is the number one thing to read. It helps you understand the legal and financial commitments you will be making when becoming a franchisee.
The FDD is also where prospective franchisees will find the majority of information they need to know to make an informed decision about a particular franchise offering.
What is a Franchise Disclosure Document?
The Franchise Disclosure Document is a legally-required document that a franchisor gives to prospective franchisees in the U.S. It discloses important information about the franchisor. The Disclosure must be presented in a specific manner consisting of 23 sections of information.
The FDD is required by Section 436 of Title 16, Code of Federal Regulations — known as The Franchise Rule .1 Certain states also have disclosure laws. Disclosure documents can be provided electronically or via paper.
Franchisor disclosure documents must be in plain English. Even so, they tend to be long. For example, Smashburger’s FDD is around 300 pages. Chik-Fil-A’s is over 400 pages.
How Do I Get a Franchise Disclosure Document?
A prospective franchisee gets the official Franchise Disclosure Document from the franchisor.
- The franchisor must provide the Disclosure a minimum of 14 days before prospective franchisees pay money or sign a binding franchise agreement.
- Franchisors must also get potential franchisees to sign a receipt acknowledging they got the Disclosure.
Samples may be available upon reasonable request. Also, FDDs must be filed publicly and are searchable online in certain states: California, Wisconsin, Minnesota and Indiana. 2
The 23 Required Items
Here are the 23 items that the FTC requires in Franchise Disclosure Documents.
1. The Franchisor and any Parents, Predecessors, and Affiliates
This section tells you about the franchisor company and its history, as well as affiliated companies.
2. Business Experience
In this section you will see a summary of the experience that the franchise company management has. At franchise discovery day you will have the opportunity to meet franchise executives. See: Questions to Ask Franchisors.
This section requires disclosure of certain franchise-related lawsuits and governmental actions.
If you see a lot of lawsuits relative to the number of franchisees in the system, buyer beware. All types of businesses get sued. One or two lawsuits isn’t necessarily a problem. If a franchisor sues or gets sued a lot, though, find out why. For example, 20 lawsuits in a small franchise system that has 200 franchisees is excessive. Your attorney can help you understand whether any litigation should be concerning.
Has the franchisor or any of its key leaders been through bankruptcy?
5. Initial Fees
The franchisor must disclose the franchise fee and any other initial fees. Initial fees might include site development fees or fees for reviewing a lease.
6. Other Fees
This discloses recurring or occasional fees, including royalties and advertising fees. Some franchisors get creative with fees for audits, pest control and gift card services. Make sure you plug all the fees into your financial projections.
7. Estimated Initial Investment
This section contains a table of all estimated fees and costs that franchisees can expect to incur. The initial investment is typically expressed as a low and high range. This section also specifies if the payee is the franchisor or a third party such as a landlord.
8. Restrictions on Sources of Products and Services
Are there restrictions on where you can obtain inventory or services? Some franchisors require that you buy supplies from an approved distributor or the franchisor itself.
9. Franchisee’s Obligations
This section provides information on your legal obligations. It also should point out in detail the sections in the franchise agreement where obligations appear.
Pay close attention. For example, franchisees may be obligated to submit monthly sales reports, achieve minimum sale revenue targets, and only use pre-approved marketing materials.
If the franchisor offers financing, leases, extended payment terms or other financial terms, they will be identified in this section. This is critical to know when considering franchise financing.
11. Assistance, Advertising, Computer Systems, and Training
This is one of the most important information items. It outlines any assistance the franchisor agrees to provide, such as site selection. It also outlines ongoing support obligations including training and advertising.
Training: The Federal Trade Commission recommends paying particular attention to training commitments, including:
- Are new employees eligible for training and, if so, at what cost. Who pays?
- How much time is spent on technical training, business management training, and marketing?
- Is support staff available for troubleshooting?
Advertising: The franchisee usually has to pay into an advertising and marketing fund. The FTC recommends a potential franchisee check into such things as:
- Do franchisees have any control over how advertising dollars are spent?
- What percentage goes toward national advertising? What about local?
- Do you need the franchisor’s consent to develop and buy your own advertising?
A franchisee territory is important because it protects against oversaturation and competition that puts your investment at risk. Are you getting an exclusive or protected territory? If not, you may be shocked later to discover other franchisee units opening up nearby.
This information in this item outlines your rights to use the franchisor’s brand names and trademarks.
14. Patents, Copyrights, and Proprietary Information
The information here outlines your rights to use the franchisor’s intellectual property.
15. Obligation to Participate in the Actual Operation of the Franchise Business
This describes any obligation of the franchisee to personally participate in the actual operation of the business. Some franchise opportunities require a franchisee to work full-time in the business.
16. Restrictions on What the Franchisee May Sell
The franchisor will want you to sell only its offerings. This FDD item outlines what a franchisee may sell — or not. For instance, if the franchise is a restaurant, this may mean that you can only sell the franchisor’s menu items. You can’t unilaterally add your own dishes, no matter how tasty.
17. Renewal, Termination, Transfer, and Dispute Resolution
This franchisor item outlines whether your franchise contract is renewable and the circumstances allowing early termination. Dispute resolution is often required through arbitration.
And what if you want to sell? This section outlines any conditions for selling your business.
18. Public Figures
Are public figures involved in the franchise as investors or owners? Does the franchisor uses celebrities to promote the franchise? This should be disclosed.
19. Financial Performance Representations
Franchisors are not required to provide information about how much their franchisees earn — but are permitted to do so. If they choose to provide such information, it will be in franchisee item 19.
According to the International Franchise Association, approximately 30% of franchisors actually include financial performance representations for franchisees. If they do provide financial performance information, what they provide varies:
- 99% of all systems providing financial representations give sales data.
- 49% percent give expense data.
- Far fewer provide a franchisee unit income statement.
20. Outlets and Franchisee Information
Item 20 is very important because it lists statistical information about franchise units in the past three years. It also lists current franchisees and every former franchisee in the past year, along with contact information including addresses and phone numbers.
A savvy prospective franchisee will want to discover what others who invested their own money have to say. Talk with several existing franchisees. They’re likely used to getting calls. Visit at least one in person. See: Questions to Ask Franchisees.
21. Financial Statements
This section contains audited financial statements. Review the audited financial statements to make sure the franchisor is not in trouble.
All contracts you will be asked to sign must be attached to the Disclosure Document. This includes the franchise agreement, leases, options, etc.
You will be asked to sign a receipt so the franchisor has proof that it provided the franchising disclosure document to you. Signing the receipt does not bind you into buying a franchise.
Should I Get Help Reviewing the FDD?
Investing in a franchise is a major commitment. Read through the Franchise Disclosure Document (FDD) point by point. Take your time. Time in this context is your friend.
Some people make the mistake of thinking that franchise disclosure documents can’t be changed, so why hire a franchise attorney? Why engage a franchisee consultant? Here’s why:
- A franchise attorney knows what can go wrong and the red flags to look for. An experienced attorney can advise how to protect yourself — or in rare cases — when to walk away.
- A franchise consultant or advisor can bring years of expertise. He or she helps you understand how a franchise works — and offers invaluable tips on how to buy a franchise.
Remember, franchises usually require a commitment of at least 10 years. Isn’t 10 years worth effort?