How to Read the Franchise Disclosure Document (FDD)
A Crash Course on this Important Franchise Legal Document - for the Layperson.
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Understanding the Franchise Disclosure Document or UFOC - By Robert Edwards
So you are researching buying a franchise. By law the franchisor must send you their FDD (Franchise Disclosure Documents) before you can invest. The FDD has a huge amount of information that will help you make an informed decision.
There is a disclosure waiting period between when you sign for the FDD and when you can actually buy the franchise which is a federally mandated 14 days. So even if you wanted to you can't invest for 14 days after receiving and signing for the Franchise Disclosure Documents. There is also a 7 day period for the franchise agreements - so most franchises will send both at the same time and have the waiting periods run concurrently.
When the franchisor finally agrees to send you the documents You think "Great, I will get everything I need to know in this document" but you receive it and it is a daunting 400 pages long!! You may consider the document is too complex and you put it away maybe to look at it "tomorrow, or worse, to just rely on what you have been told by the franchisor.
Well reading an FDD is actually not that hard, and there is some fantastic information that will really help you learn a lot. Now please make note I always recommend you run the FDD and the agreement by a competent FRANCHISE lawyer. and why I stress franchise lawyer is that a non specialist lawyer who doesn't have experience in these agreements will often consider it to be overly restrictive. They often don't understand the very nature of a franchise is highly regulated right down to how many pickles your employees put on the Big Mac. That's just the nature of franchising
What we are suggesting is once you understand how to read the FDD, you can then determine whether it is even worth your time and money to pay a lawyer to look at it. If the Disclosure Document is not to your liking and you choose not to proceed with the franchise you can save money on a lawyer.
I won't go into any great detail today this will be a crash course on how to quickly hone in on the important parts of an FDD.
The first page will be a general overview of the franchise and investment amounts. Most of this you will already know if you have been working with the franchisor.
The Table of Contents page outlines the 23 items of the FDD. This is a standardized format and every FDD will have exactly the same table of contents and 23 items. Let's go over them one by one.
Item 1. The Franchisor and Any Parents, Predecessors, and Affiliates. This will be a few paragraphs regarding the business, date of incorporation, is it owned or controlled by other entities? Where is it's principle place of business, formal operating name and other details. They will also list details about the franchise, applicable regulations and potential competition. This is great data as it will provide insight into who your competition might be. Don't let the legal type wording scare you off.... the FDD is created in such a way it can be jarring after hearing all the smooth sales talk. The reality is typically somewhere between the sales person and the FDD. So item one - we have learned about the franchise history and some details of the compettion.
Item 2. Business Experience. This will outline all of the people involved in the franchise. very helpful and a small tip - Google the names of the people in the FDD. See what comes up. Did they come from other failed franchises? Have they been involved in lawsuits. Check out their Linkedin profiles. management of a franchise system is very important so you should feel confident in the franchise itself as well as the people running it.
Item 3. Litigation. Has the franchise sued anyone or have they been sued? Its not the end of the world if you see lawsuits. Franchising is a very litigious industry. But - if you see several instances of franchisees suing for reasons of fraud, misrepresentation, or breech of contract you may want to look elsewhere, or at minimum up your due diligence.
Item 4. Bankruptcy. has the franchise or any of its principals been bankrupt. If so they will have to list it.
Item 5. Initial Fees. This is a quick breakdown of what your initial fees are. You will likely already know this.
Item 6. Other Fees. Very important item and look this one over well. This is where all the applicable fees beyond your initial fees will be listed. Your typical fees will include items like Royalty payments, marketing and promotional fees, fees for advertising which may be both local and national, training fees, technology fees, software fees and others. Now buried within the fees will be things like the transfer fee - that's how much you will get charged if you sell your franchise, and a renewal fee, that's how much it will cost you if you renew your license after the term expires. Which is another important point we need to look for - how long is my franchise term? We'll get to that later in the Franchise Disclosure Document. Item 6 will also outline late fee charges and if there are any fines for non compliance - look at these carefully as in some FDD's you can potentially be fined thousands of dollars for infractions as small as putting a wrong ingredient in the food! You can also be fined thousands of dollars for losing the operations manuals. And if you don't pay your fine on time item 6 will outline how much interest the company is going to charge you.
Item 7. Estimated Initial Investment. Another very important item in the FDD. This will provide a high and low range of what your total investment will be for the franchise including franchise fee, training, signage, leasehold improvements, furniture, initial inventory and working capital. You can look at these numbers and estimate how much it will be in your area. If you live in a smaller city your costs will be less, expensive cities your costs will be towards the higher part of the scale. At the bottom is the total range for your estimated costs. Item 7 will also have several paragraphs outlining how the funds are allocated as well as who the funds are payable to.
Item 8. Restrictions on Sources of Products and Services. Another very important item particularly if you are selling food, or buying products from the franchisor. Do you need to buy their cleaning products? Are you required to buy their hamburger meat? Do you need to use their point of sale system? Item 8 of the Franchise Disclosure Document will also indicate if the franchisor is making a profit, and how much profit is made from them selling to franchisees. The point here is that if you are forced to purchase goods or supplies at unrealistically elevated costs, you may not be able to be competitive, especially in industries that already have razor thin margins. Always make sure you are not forced into buying goods from the franchisor at unrealistic prices.
Item 9. Franchisee’s Obligations. Very important. At first glance This appears to be a fairly short section however if you look closely you will, see that it references sections in the actual franchise agreement that covers these obligations in greater detail. This item can be a bit time consuming going back and forth between the franchise agreement and the Franchise Disclosure Document, but its worth knowing exactly what you are expected to do during the life of the contract. There are lots of obligations covered ranging from policies, procedures, customer service requirements, owners actual participation, renewal, advertising and a lot more. make sure you are comfortable with all of these before you sign.
Item 10. Financing. is there any financing available?
Item 11. Franchisors Assistance, Advertising, Computer Systems, and Training. So finally after reading about everything the franchisor is taking - here is what they will do for you. These activities may include site selection, helping you find a location, providing floor plans, lists of suppliers and vendors, training, operations manuals, advertising collateral, etc. This is a fairly important item and also make note of things like their social media policy, website policies, do you need to pay for a website? can you run your own local social media campaigns? If you like doing that you may want a franchise that allows it. Also costs of computers and POS systems are broken down.
ITEM 12. Territory. Very easy and very important. Do you get an exclusive territory and if so what is it? How is it defined? We always suggest our clients compare at least 3-4 franchises to make sure you are getting the lowest royalties, biggest territory and best support. Not all franchises have protected territory and depending on the industry that can actually make sense. Also what are your options for territory expansion if applicable.
ITEM 13. Trademarks. These are the trademarks the company owns. If this is a very new company the trademarks may not actually be yet registered - which could potentially cause issues down the line.
ITEM 14. Patents, Copyrights, and Proprietary Information. Legal speak outlining the extent of control over their proprietary information and your limits of use.
ITEM 15. Obligation to Participate in the Actual Operations of the Franchise Business. This item is particularly important if you are looking for a passive operation business. Some franchises require actual owner involvement in the day to day business. Others allow you to install a designated manager to run your shop. make sure this is in alignment with your business goals.
Item 16. Restrictions on What the Franchisee May Sell. This is quite important and ties back to Item 8. Again you want to be sure that these restrictions are for mutual benefit, not gouging you by forcing overpriced single source goods. McDonald's obviously it makes sense to have standardized food sources to lower costs and maintain consistency, many cleaning franchises have proprietary cleaning materials the manufacture, also good. Other unscrupulous franchises may just use this as a profit center selling products at huge margins to contractually obligated franchisees. Always make sure existing franchisees are happy with the arrangement and undue profits are not being gouged from owners.
Item 17. Renewal, Termination, Transfer, and Dispute Resolution. How long is the term? Most franchise agreements fall between 5 and 20 years. How much does it cost to renew? What is cause for termination or non-renewal? What rights are available to you legally? What happens in the case of breech of contract? What happens in the case of death or disability? Also very important are non compete provisions, can you operate other businesses during the term? If you plan is to keep an existing business or career, is that allowable in the contract?
Item 18. Public Figures. Does the franchisor use any public figures or celebrities to promote the franchise.
Item 19. Financial Performance Representations. This is the item everyone asks about first. How much money can I make with this franchise?" Now not every franchise lists their financial performance. And not every franchise lists these figures in the same way. Franchises have the legal autonomy to use any figures they wish, so make sure you understand if the figures shown are an average of all locations, or a smaller cross section of locations,. For example if a frozen yogurt shop only shows profits from the top 10 stores in Florida, that doesn't provide you with much helpful data opening up in Alaska. Now whether the franchise does or doesn't list numbers its always wise to call a few existing franchisees and get a feel for their financial situation and how long it took them to break even. If franchisees aren't happy about their earnings - they will let you know!
Item 20. List of Outlets and Franchisee Information. This is very important as it will show you for the past 3 years how many franchises were opened ,transferred or closed. If you see huge negative numbers that is not a good sign. Now something you also want to watch for is what is called franchise "churning" in the industry. Instead of letting unprofitable stores close the franchisor just sells the store to an unsuspecting new owner. So that wont show up as a net change in the store opens or closes. Where it will show up is lower down in the "transfers" section. You will also see things like terminations, which if there is a lot will be a red flag, non renewals etc. All very important data.
Item 21. Financial Statements. These are the financial statements not for individual franchisees as in the item 19, but the franchise corporation as a whole. If the companies financials look frail, how will that impact their ability to help you be successful?
Item 22. Contracts. This is an overview of all of the contracts that are included including the franchise agreement and others such as a general release form, state specific agreements, development agreements etc.
And finally Item 23. Receipts. That is what you must return to the franchisor to acknowledge receipt of the Franchise Disclosure Documents. Again, you will have 14 days from the receipt before you can invest so if you have time constraints do this as soon as possible. Digital signatures are also allowable so your franchisor may have sent you a copy via Docusign or a similar service.
Below the Franchise Disclosure Form is the actual franchise agreement itself - if you are happy with the FDD you will want to get a qualified franchise attorney to look this over. And as always we recommend you compare several franchises to make sure you are making the best choice. Feel free to contact us to help you search and research. Our consultations are always free to qualified buyers.