Franchise Disclosure Document - Franchise Disclosure Document Requirements

Franchise Disclosure Document Requirements

The document discloses extensive information about the franchisor and the franchise organization which is intended to give the potential franchisee enough information to make educated decisions about their investments. The information is divided into a cover page, table of contents and 23 categories called "Items":

Twenty one of the items contain information primarily pertaining to the franchisor but, unfortunately, only two of the items contain information pertaining to the performance of the franchise, itself, that is being offered for sale. One of these items, Item 19, "Earnings Claims" is an optional disclosure under the FTC Rule and State FDDs even though the performance of the franchise in terms of unit "earnings" are material facts that should be disclosed to new buyers by the seller of the franchise, who profits from the sale.

The other, Item 20, provides a current accounting of the number of units that comprise the systems and reports the terminations and sale-transfers which have been applied to report the total number of units that comprise the system. Item 20 also provides the names and contact information of franchisees, current and ex-franchisees, who may be contacted for information in the due diligence process to be conducted by prospective buyers of the franchises offered for sale. Unfortunately, due diligence conducted with Item 20 references is not always reliable because, of course, these references have no legal duty to disclose the performance statistics of their independent businesses to new buyers of franchises.

• 1. The Franchisor and Any Parents, Predecessors, and Affiliates.

This section tells how long the franchisor has been in business, likely competition, and any special laws that pertain to the industry, like any license or permit requirements. This will help the prospective franchisee understand the costs and risks they are likely to take on if they purchase and operate the franchise.

• 2. Identity and Business Experience of Key Persons.

This section identifies the executives of the franchise system and describes their experience.

• 3. Litigation History.

This section discusses prior litigation—whether the franchisor or any of its executive officers have been convicted of felonies involving fraud, violations of franchise law, or unfair or deceptive practices law, or are subject to any state or federal injunctions involving similar misconduct. It also says whether the franchisor or any of its executives have been held liable for—or settled civil actions involving—the franchise relationship. A number of claims against the franchisor may indicate that it has not performed according to its agreements, or, at the very least, that franchisees have been dissatisfied with its performance.

This section also should say whether the franchisor has sued any of its franchisees during the last year, a disclosure that may indicate common types of problems in the franchise system. For example, a franchisor may sue franchisees for failing to pay royalties, which could indicate that franchisees are unsuccessful, and therefore, unable or unwilling to make their royalty payments.

• 4. Bankruptcy.

This section discloses whether the franchisor or any of its executives have been involved in a recent bankruptcy, information that can help potential franchisees assess the franchisor’s financial stability and whether the company is capable of delivering the support services it promises.

• 5. Initial Franchise Fee.

This section describes the costs involved in starting and operating a franchise, including deposits or franchise fees that may be non-refundable, and costs for initial inventory, signs, equipment, leases, or rentals. It also explains ongoing costs, like royalties and advertising fees.

• 6. Other Fees and Expenses.

Training

This section explains the franchisor’s training and assistance program.

Advertising

This section has information on advertising costs. Franchisees often are required to contribute a percentage of their income to an advertising fund.

• 7. Franchisee's Estimated Initial Investment.
• 8. Restrictions on Sources of Products and Services.

This section tells whether the franchisor limits:

• suppliers from whom a franchisee may purchase goods

• 9. Obligations of the Franchisee.
• 10. Financing Arrangements.
• 11. Obligations of the Franchisor.
• 12. Territory.
• 13. Trademarks.
• 14. Patents, Copyrights, and Proprietary Information.
• 15. Obligation of the Franchisee to Participate in the Actual Operation of the Franchise Business.
• 16. Restrictions on Goods and Services Offered by the Franchisee.
• 17. Renewal, Termination, Repurchase, Modification and/or Transfer of the Franchise Agreement, and Dispute Resolution.

This section spells out the conditions under which the franchisor may end a franchisee’s franchise and a franchisee’s obligations to the franchisor after termination. It also defines the conditions under which a franchisee can renew, sell, or assign the franchise to others.

• 18. Public Figures
• 19. Financial Performance Representations.

Earnings information can be misleading.

Franchisors are not required to disclose information about potential income or sales, but if they do, the law requires that they have a reasonable basis for their claims and that they make the substantiation for their claims.

Franchisors practicing Franchise fraud may have a high number of former franchisees under a Gag order, preventing a potential new franchisee from obtaining a clear picture of financial performance.

Sample Size

The disclosure document should tell the sample size and the number and percentage of franchisees who reported earnings at the level claimed.

Average Incomes

Average figures tell very little about how individual franchisees perform. An average figure may make the overall franchise system look more successful than it is because just a few very successful franchisees can inflate the average.

Gross Sales

These figures don’t really tell about the franchisees’ actual costs or profits. An outlet with a high gross sales revenue on paper may be losing money because of high overhead, rent, and other expenses.

Net Profits

Franchisors often do not have data on net profits of their franchisees.

Geographic Relevance

Earnings may vary with geography. The disclosure document should note geographic or other differences among the group of franchisees whose earnings are reported and a franchisee’s likely location.

Franchisees’ Backgrounds

Franchisees have different skill sets and educational backgrounds. The success of some franchisees doesn’t guarantee success for all.

Reliance on Earnings Claims

Franchisors may ask a franchisee to sign a statement— sometimes presented as a written interview or questionnaire—that asks whether a franchisee received any earnings or financial performance representations during the course of buying a franchise.

• 20. List of Franchise Outlets

This section has very important information about current and former franchisees. Many franchisees in an area may mean more competition for customers. The number of terminated, cancelled, or non-renewed franchises may indicate problems. The sale-transfer columns can obscure churning of units through fire sales to third parties by failed or failing franchisees. Some companies may repurchase failed outlets and list them as company-owned outlets.

Some of the former franchisees may have signed confidentiality agreements that prevent them from speaking. Franchisors practicing Franchise fraud may have a high number of former franchisees under a Gag order.

If a franchisee buys an existing outlet that was reacquired by the franchisor, the franchisor must tell the franchisee who owned and operated the outlet for the last five years. Several owners in a short time may indicate that the location isn’t profitable or that the franchisor hasn’t supported that outlet as promised.

• 21. Financial Statements

The disclosure document gives important information about the company’s financial status, including audited financial statements.

A franchisee can find explanatory information about the franchisor’s financial status in notes to the financial statements.

Investing in a financially unstable franchisor is a significant risk; the company may go out of business or into bankruptcy after a franchisee has invested their money.

A lawyer or an accountant can review the franchisor’s financial statements, audit report, and notes. They can help a franchisee understand whether the franchisor:

• has steady growth
• has a growth plan
• makes most of its income from the sale of franchises (Franchise fraud), or from continuing royalties.
• devotes sufficient funds to support its franchise system

• 22. Contracts
• 23. Acknowledgment of Receipt