Authored Sep 27, 2016, by Attorney Jeffrey M. Goldstein
Pursuant to federal regulations and franchise laws in various states around the country, before selling a
franchise, the franchisor must provide the potential buyer with a Franchise Disclosure Document (or
“FDD”). Each franchisor’s FDD must closely follow a format that includes:
- A Cover Page
- A table of contents
- Specific information broken out into 23 “Items”
- Exhibits (including a copy of the franchisor’s standard franchise agreement)
While understanding your franchise agreement needs to be a top priority, it is also important to critically
assess the information contained in Items 1 through 23. In a series of three articles, we will summarize
what you can (or should) expect to see when you open up your franchisor’s FDD.
Item 1: The Franchisor and Any Parents, Predecessors and Affiliates
What You’ll Find
Along with general business information (like the franchisor’s name and address), Item 1 must contain: a
description of the franchise business, the general market for the franchise system’s products or services,
disclosures regarding the franchisor’s franchising history and whether it operates any company-owned
outlets, and information about competition and industry-specific laws.
Why You Care
While Item 1 disclosures tend to be pretty general, prospective franchisees can uncover some key
information in Item 1. For example, if the franchisor has a prior history in franchising (especially an
unsuccessful one) or if the industry has unique legal requirements, this is certainly something you will
want to know going into your franchise opportunity.
Item 2: Business Experience
What You’ll Find
A five-year employment and business experience summary for each of the franchisor’s owners, officers,
directors, and operations or sales managers.
Why You Care
If you are like most people, part of the reason you are considering a franchise is because you want to
benefit from the franchisor’s experience and expertise. Knowing what the franchisor’s officers and key
personnel have (or haven’t) done in the past can be important to making an informed decision about
whether a particular franchise opportunity is a sound investment.
Item 3: Litigation
What You’ll Find
Disclosures regarding whether the franchisor, any of its related companies or any individual identified in
Item 2 is or has been a party to relevant litigation.
Why You Care
Generally speaking, what you want to see in Item 3 is a “negative disclosure” (in other words, the
franchisor does not have any relevant litigation to disclose). If a franchisor has litigation disclosures in
Item 3, you need to find out more.
Item 4: Bankruptcy
What You’ll Find
Bankruptcy disclosures similar to the litigation disclosures in Item 3.
Why You Care
Similar to litigation disclosures in Item 3, affirmative bankruptcy disclosures in Item 4 are rare. It is
critical that your franchisor have financial stability, so you will certainly want to investigate if a
franchisor discloses a bankruptcy in Item 4.
Item 5: Initial Fees
What You’ll Find
Disclosure of the initial franchise fee, any other initial fees (“fees and payments, or commitments to pay,
for services or goods received from the franchisor or any affiliate before the franchisee’s business
opens”) and whether any of the initial fees are refundable.
Why You Care
These are the initial fees you will need to pay to the franchisor. They should be both reasonable and
justifiable in light of the opportunity being offered.
Item 6: Other Fees
What You’ll Find
A table that discloses the monthly royalty, advertising fund fee, renewal fees, transfer fees, and any
other ongoing or future one-time payments imposed by the franchisor for itself or on behalf of a third
party.
Why You Care
Once again, any fees payable to the franchisor should be firmly supported by the value of the franchise
opportunity. Also note that any transfer or renewal fees (i) can significantly impair your ability to either
get out of or renew your franchise, and (ii) may be negotiable.
Item 7: Estimated Initial Investment
What You’ll Find
A table that discloses training expenses, leasing costs, inventory requirements and any other expenses
you are likely to incur before your franchise opens for business.
Why You Care
Like Items 5 and 6, this could probably go without saying. When it comes to investing in a franchise, the
amount of your investment is obviously a top priority. Note that some franchisors provide more-detailed
(and more-accurate) estimates than others, so you may want to speak with some current franchisees in
order to validate your likely initial investment.
Item 8: Restrictions on Sources of Products and Services
What You’ll Find
In Item 8, franchisors are required to disclose any obligations for franchisees to purchase or lease
necessary products or services either (i) from the franchisor, (ii) from a designated or approved supplier,
or (iii) according to mandatory specifications. This includes:
- Supplies, fixtures and equipment
- Inventory
- Computer hardware or software (including POS systems)
- Real estate
- Any “comparable items related to establishing or operating the franchised business”
Why You Care
Purchasing controls can often mean higher purchasing prices for franchisees. When a franchisor
negotiates a volume rebate with a supplier, this does not necessarily mean that savings get passed on to
the franchisees. In fact, instead it can simply mean that franchisees lose the ability to shop for
competitive pricing.
Item 9: Franchisee’s Obligations
What You’ll Find
Item 9 is comprised of a cross-reference table that identifies where you can find various pieces of
information (like site selection and pre-opening requirements) in the Franchise Disclosure Document
(FDD) and the franchisor’s standard franchise agreement.
Why You Care
If you are not familiar with reviewing FDDs and franchise agreements (and most prospective franchisees
aren’t), you can use the Item 9 table to get an overview of the key legal and business terms that will
apply if you decide to move forward with the opportunity.
Item 10: Financing
What You’ll Find
If a franchisor (or its affiliate) offers financing of the initial franchise fee, construction costs or any other
amounts to be paid to the franchisor, it must disclose the terms of its financing arrangements in Item 10.
You don’t often see Item 10 financing disclosures (because most franchisors don’t offer financing); but,
when you do, they tend to be fairly comprehensive as required by the Federal Trade
Commission’s Franchise Rule.
Why You Care
If you are considering entering into a financing arrangement with your franchisor, you want to make
sure that you are fully aware of the terms and conditions involved. In addition, you should confirm that
the terms of the franchisor’s financing agreement are consistent with the disclosures in the FDD.
Item 11: Franchisor’s Assistance, Advertising, Computer Systems, and Training
What You’ll Find
Item 11 tends to be one of the longest Items in most franchisors’ FDDs. This is because it covers a lot of
information. Mandatory disclosures in Item 11 include: the franchisor’s pre-opening obligations
(including training), site selection assistance and requirements, and the franchisor’s ongoing obligations
during the term of your franchise agreement.
Why You Care
Just about everything disclosed in Item 11 should also be covered in your franchise agreement. While
you should read Item 11 carefully to make sure you understand and are satisfied with the level of
assistance the franchisor offers, you should be particularly careful to ensure that any material
obligations are also clearly outlined in the franchise agreement.
Item 12: Territory
What You’ll Find
In Item 12, the franchisor must disclose the minimum size, conditions and other key terms related to
your franchise territory (assuming one is provided).
Why You Care
In many industries, an exclusive (or, at least protected) territory can be critical to individual franchisees’
success. Your territorial protections should be sufficient to ensure that you will not face undue
competition from the franchisor or other franchisees.
Item 13: Trademarks
What You’ll Find
Item 13 includes information on whether the franchisor’s principal trademarks are (i) registered, and/or
(ii) subject to litigation.
Why You Care
A recognizable trademark can provide tremendous value to a franchise system. Conversely, lack of
trademark protection can easily lead to undesirable consequences for franchisees. Before you buy a
franchise, you want to make sure that the franchisor is taking appropriate steps to protect its
trademarks throughout the term of your franchise agreement.
Item 14: Patents, Copyrights, and Proprietary Information
What You’ll Find
Item 14 includes registration and litigation information regarding any patents, copyrights or other
proprietary information owned by the franchisor.
Why You Care
Most franchisors do not have any patents to disclose, but some will make general disclosures regarding
protection of copyrights, trade secrets and other confidential information. If your franchisor’s FDD
includes any affirmative disclosures in Item 14, you will want to make sure you have a clear
understanding of how these intellectual property rights will affect your franchise operations.
Item 15: Obligation to Participate in the Actual Operation of the Franchise Business
What You’ll Find
Any restrictions the franchisor imposes regarding who can take responsibility for the day-to-day
operation of the franchised business.
Why You Care
While some franchisors do not require their franchisees to have direct involvement in their outlets’ dayto-day operations, others do. If your franchisor requires direct, “on-premises” supervision, this is
certainly something you will want to know (especially if you are looking for a multi-unit opportunity).
Item 16: Restrictions on What the Franchisee May Sell
What You’ll Find
Any requirements to sell only approved goods or services, as well as any requirements to sell all goods
or services authorized for sale at franchised outlets.
Why You Care
If your franchisor limits your inventory or service offerings, this is something that you will need to take
into consideration when evaluating the financial potential of your franchise. Likewise, if your franchisor
requires you to carry all approved products, is this going to leave you paying for inventory that just ends
up going to waste?
Item 17: Renewal, Termination, Transfer, and Dispute Resolution
What You’ll Find
A table that identifies where you can find key terms in your franchise agreement (such as termination
and renewal rights), as well as summaries of each of these key terms.
Why You Care
If you are struggling to find a particular clause while wading through your franchise agreement, you may
find the Item 17 table helpful. While you can read the franchisor’s summaries of the agreement’s terms
for informational purposes, you should not rely on the summaries as a substitute for obtaining
independent legal advice.
Item 18: Public Figures
What You’ll Find
Information on any sponsorship or endorsement deals the franchisor has signed with public figures
(such as actors, musicians or athletes).
Why You Care
Item 18 disclosures are relatively rare. But, if your franchisor has entered into an endorsement or
sponsorship agreement with a public figure, analyzing Item 18 and asking follow-up questions can help
you get a better idea of the value (if any) that the relationship brings to the franchise system.
Item 19: Financial Performance Representations
What You’ll Find
Either (i) a “negative disclosure,” which states that the franchisor does not provide financial
performance representations; or, (ii) a substantiated disclosure of the actual or potential financial
performance of some or all of the system’s company-owned and/or franchised outlets.
Why You Care
If your franchisor provides a financial performance representation (formerly known as an “earnings
claim”), you will probably want to take it with a grain of salt. Most financial performance
representations come with a host of caveats and disclaimers, and they rarely provide reliable insight into
what any one franchisee can expect to earn. That said, it is certainly worthwhile to review any
affirmative disclosures provided in Item 19 and attempt to validate them with current and former
franchisees.
Item 20: Outlets and Franchisee Information
What You’ll Find
Tables (with accompanying footnotes) that provide three years’ worth of data regarding: (i) franchise
openings and closings, (ii) transfers, (iii) terminations and non-renewals, and (iv) company-owned outlet
openings and closings. There is also a fifth table that discloses the franchisor’s projections for new
openings over the coming year.
Why You Care
Prospective franchisees can glean a lot of useful information from Item 20. Pay particular attention to
any major fluctuations as well as the numbers for “Ceased Operations-Other Reasons” – which often
means that a franchisee went out of business due to lack of profitability.
Item 21: Financial Statements
What You’ll Find
Audited financial statements for the franchisor’s last three fiscal years (except for new franchisors,
which are allowed to follow a “phase-in” approach).
Why You Care
When you buy a franchise, you want to know that the franchisor is financially secure. An experienced
accountant will be able to help you make sense of the franchisor’s audited (or unaudited) financials.
Item 22: Contracts
What You’ll Find
A list of the contracts you will be required to sign if you purchase a franchise.
Why You Care
You will want to make sure you have copies of all relevant agreements so that you can provide them to
your attorney for review.
Item 23: Receipts
What You’ll Find
Two copies of a one-page “receipt” that you will be required to sign when you receive the Franchise
Disclosure Document (FDD).
Why You Care
Federal regulations require all franchisors to obtain a signed FDD receipt from each prospective
franchisee. As noted on the receipt page, you must receive the FDD at least 14 calendar days before
signing the franchise agreement or making any payment to the franchisor in order for the franchisor to
remain in compliance (note that some states have different minimum disclosure periods).
With Thanks
To the Author, Attorney Jeffrey M. Goldstein
