What can you learn from a Franchise Disclosure Document (FDD)?
History of the FDD
Until the 1960s, there was little franchising momentum in the United States, with the business model being no more than a novelty in some regions. But after the success of McDonald’s, the franchise industry expanded rapidly. In 1979, the Federal Trade Commission’s Franchise Rule became effective. It required franchisors to provide potential franchisees with a document then referred to as the Uniform Franchise Offering Circular (or uniform franchise disclosure document). In 2008, it was renamed the Franchise Disclosure Document or FDD. Its purpose is to enable prospective franchisees to make an educated and informed decision about whether to purchase a franchise.
The amended Rule requires franchisors to furnish the FDD to prospective franchisees at least 14 days before the prospective franchisee signs a binding agreement or makes any payment in connection with the proposed franchise sale. The signing of any agreement or receipt of payment can take place on the 15th day after delivery of the disclosure document. This ensures that prospective franchisees have at least two weeks to review the disclosures.
The FDD’s content
Prospective franchise owners looking for a successful but trustworthy franchise opportunity can’t start any search without first understanding how crucial the FDD is, and what exactly to look for when they’re in the market for investing in the franchising industry. The initial investment alone demands that you go through a franchise company’s FDD item by item and make sure it covers these basic facts about the franchisor and its franchise network.
History and Experience.
The FDD must include a history of the franchisor’s past activities. This information must address activities of the officers and directors as well as the corporate entity. Examples include business experience and any fairly recent bankruptcy and litigation history.
Financial Factors.
The franchisor must disclose the costs involved in purchasing a unit. This includes initial franchise fees, other startup costs, and an estimated range of the total cost of getting into the business. The FDD must specify additional fees such as the ongoing royalties, marketing, and renewal fees required throughout franchise ownership.
Obligations and Restrictions.
The FDD must set forth the franchisee’s and franchisor’s obligations under the terms of the franchise agreement. It must spell out any restrictions that apply to franchisee behavior.
Other Considerations.
The FDD must include relevant information pertaining to a number of other factors, such as financing programs, territory, trademarks and patents, renewal or transfer provisions, and public figures.
Exhibits.
The company must provide additional materials, including audited financial statements, a list of current and former franchisees and their contact information, contracts, and receipts.
Earnings Claims.
The FTC makes it optional for franchisors to supply information about the earning potential of a typical franchise unit. If the franchisor chooses to make financial performance representations or earnings claims, it must follow stringent requirements with these financial statements.. The data provided must be as accurate and representative as possible. The franchisor must clearly label any assumptions or qualifications.
Individual state requirements
In addition to the federal laws, many states have enacted legislation to further protect franchisees. These laws may mandate additional disclosures or specify rules governing the terms of the franchise agreement.
The following states have franchise registration and disclosure laws that require franchisors to register the franchise before making an offer or sale. A state examiner then reviews the FDD, and in some cases, may designate specific changes or additions that must be made.
- California
- Illinois
- Indiana
- Maryland
- Michigan
- Minnesota
- New York
- North Dakota
- Rhode Island
- South Dakota
- Virginia
- Washington
Hawaii and Wisconsin require franchise registrations before a sale, while Oregon has a state franchise sales law, but does not require franchise registration.
Your Responsibility
The most important point to remember regarding the FDD is your role: to read and understand the material that the franchisor is providing. The FTC requires this information to be clearly stated in this legal document.. That protection won’t make any difference, however, unless you carefully review the material.
On top of that, when considering investing in a franchise, it’s crucial to conduct thorough due diligence beyond just reading the Franchise Disclosure Document (FDD). Here is a list of questions any potential franchisee should ask a franchisor before agreeing to invest:
- Franchisor’s Training and Support:
- What kind of initial training do you provide, and how long does it last?
- Are there any additional costs for ongoing training or support?
- What kind of ongoing support can I expect from the franchisor?
- Operations:
- Can you describe the day-to-day operations for a franchisee in this business?
- How do you ensure operational consistency across all franchise units?
- Franchisee Performance:
- What is the average time it takes for a franchisee to break even?
- (If the earnings potential isn’t already included in the FDD) Could you provide financial performance representations based on actual franchisee numbers?
- Franchisee-Franchisor Relationship:
- Could you provide contact information for current franchisees I can speak with?
- How do you handle conflicts or disputes with franchisees?
- Financial Obligations:
- Under what circumstances can my royalty fees increase?
- Advertising and Marketing:
- Do franchisees have a say in local marketing efforts?
- Territory and Competition:
- What is the policy regarding franchisee territories? Are they exclusive?
- How do you protect franchisees from competition within the system?
- Exit Strategy:
- What are the conditions and process for exiting the franchise agreement?
- Are there any restrictions or fees if I choose to sell my franchise?
- Growth and Development:
- What are your future growth plans for the franchise system?
- How do you intend to innovate and stay competitive in the market?
- History:
- Can you explain any litigation history involving the franchise system or its affiliates?
- What would trigger the termination of a franchise agreement?
- Technology and Systems:
- What technology platforms are used in the business, and is training provided for these systems?
- Are there any technology upgrades or software costs that will be passed on to franchisees?
- Success Metrics:
- How do you measure the success of individual franchise units?
- What are some common reasons for the failure of franchise units?
- Resilience and Challenges:
- How has the franchise adapted to significant market challenges or economic downturns in the past?
- What are the biggest challenges faced by franchisees in this system?
Investing in a franchised business takes a lot of effort on both the franchisor and the candidate, with the FDD being the key to starting your journey. However, how well you travel and how prepared you are for the journey will ultimately depend on your due diligence and the work of your franchise consultant.