Everything to Know About a Franchise Disclosure Document (FDD)
The franchise system can be a beneficial investment for entrepreneurs, but many legal processes need to be completed before one can become a franchisee. One of the many documents prospective franchisees and franchisors need is a franchise disclosure document or FDD.
Don’t have time to read the full article? Here’s a quick summary:
- A Franchise Disclosure Document (FDD) is a document required by the Federal Trade Commission that sets clear guidelines for the franchise relationship.
- The FDD provides prospective franchisees with information about the franchisor, the franchise system, and all the agreements involved in purchasing a franchise.
- It is important for both franchisors and franchisees to pay close attention to their FDD in order to avoid any legal issues down the road.
What is a Franchise Disclosure Document?
In the US, prospective franchisees must undergo pre-sale due diligence. A franchise disclosure agreement is a part of this process legally required by the Federal Trade Commission (FTC). The legal document sets clear guidelines for the franchise relationship.
Franchisors must provide all their prospective franchisee with a Franchise Disclosure before they finalize the sale. Legally, they have 14 days to provide potential franchisees with the franchise disclosure documents due to the Federal Franchise Rule.
The FDD’s issue date is the day the franchisor declares that the FDD is finished and meets federal franchise requirements. Since no government agency examines or registers FDDs, compliance and determining the issue date are self-certified processes.
Within the states that require franchise registration, franchisors must register the FDD with a state examiner, who will approve or refuse registration following a review procedure.
The document provides the franchisee with further information about the franchise, the franchisors, and the agreements involved in the business. Receiving this enables them to decide whether or not the investment is worthwhile for them.
It can be challenging for franchisors to prepare a disclosure agreement on their own, so they should seek the counsel of a seasoned franchise attorney.
What Must be in a Franchise Disclosure Document?
A franchise disclosure agreement contains 23 pieces of information required for a franchise disclosure document, the franchisor franchise agreement, audited financials, and exhibits.
#1 – The Franchisor, Predecessors, and Affiliates
Within item 1, there is information about the history and background of the company. It discloses if the franchisor has any other business, parent companies, affiliates, and how long they’ve been in business. The franchisee also receives a summary of the business that includes information about regulations and business competitors.
#2 Experience with the Business
Item 2 of the FDD provides information about the management team that the franchisor works with. It includes information about the members and gives the prospective franchisee a complete overview of their experience.
In this section, the franchisor must disclose legal information about lawsuits and government-related actions associated with the franchise, franchisor, affiliates, or management team members.
#4 Initial Fees
In this section, the franchisor discloses all the upfront fees the franchisee must pay. The initial franchise fee section discloses information about the factors that influence the amount that the fees will add up to in total.
#6 Additional Fees
Additional fees are associated with the franchise business aside from the initial fees, such as the royalty and ad rate fees. Franchisors must provide the fee’s name, the fee’s total, and the due date, along with any additional remarks they may have.
#7 Estimated Initial Investment
In this section, the franchisor provides a rough estimate of the amount it will cost to open the business and sustain it for the first 90 days in table format. The headings used should be as follows:
- Type of Expenditure
- Method of Payment
- When Payment is Due
- To Whom Payment is Made
There should be a section for notes below the table.
#8 Restrictions on Products and Services
In some cases, legal limits may be in place on the suppliers that franchisees can use. Item 8 outlines the supplies that the franchisee must purchase for the business and the suppliers that the designated suppliers that they should purchase from.
The specifics of the supplies that the franchisee will need to purchase, and they need to state if the supplies can be brought through affiliates of the business.
#9 Franchisee’s Obligations
There are legal obligations that the franchisee must meet. Item 9 outlines these obligations in table format. It involves information about site selection and the franchisee’s obligations after and during the contract.
In this section, the franchisor tells the franchisee the financial terms of their agreement, including payment options, leases, and extended payment terms.
Direct and indirect financing methods must be included, but there may be some confusion over what counts as an indirect method of financing. The FTC Rule provides examples to clear up the confusion.
#11 Assistance, Computer Systems, Advertising, and Training
In this section, the franchisor outlines the assistance they’ll provide the franchisee. Pay close attention to this item as it involves information about who will cover the costs of training new employees and how advertisements get paid for.
Item 12 has information about whether or not the franchisee will receive protected territory. If the franchisee isn’t receiving protected territory, there is a chance they may face competition from other franchisees in the same area.
#13 – Trademarks
When a franchisee purchases a franchise, they gain legal permission to use the brand’s trademark for a set time. We summarize the brand’s trademarks and how they can be used. It also discusses their registration status with the United States Patent and Trademark Office.
#14 – Proprietary Information, Patents, Copyrights
We aim to provide proprietary information about the franchise, such as the patents and copyrights associated with the business.
#15 – Participation In Franchise Agreement
Some franchises such as Chick-Fil-A require the franchisee to be a hands-on operator and if this is the case, you’ll learn about any obligations to participate in the operation of the business.
There are limits on what franchisees can sell in their franchises, and these limits are clearly outlined here. It provides information on what can be sold, where it can be sold, and what suppliers the franchisee can use.
#17 Renewal, Transfer, Termination, and Dispute Resolution
Item 17 discloses and summarises the terms associated with selling, renewing, or terminating the franchise agreement. It also discloses the method that the business uses for the resolution of legal disputes.
#18 Public Figures
The celebrities or public figures involved in the brand’s promotions are disclosed in item 18. The item outlines the nature of the public figure’s association, along with the amount they are paid for using their name and image.
#19 Representation of Financial Performance
Financial performance representations are when a franchisor shares financial data with the public, media, or a prospective franchisee. They are not legally obligated to share this information, but if they choose to do so, it will be item 19.
The public figures’ involved with the management of the franchise and any amount of ownership they may have over the business should also be disclosed in this section, along with any monetary stake they have in the franchisee.
#20 Outlets and Franchisee Information
Item 20 provides information about the outlets that the business opened in the last three years, including their locations and their franchisee’s number. It also has information about the franchises that the brand will open next year and the contact information for franchisees that recently left.
#21 Financial Statements
You should have three years of audited financial statements from the franchisor.
Franchisors get legal leniency if they operate in their first year as a franchise. They may provide an unaudited initial opening balance sheet and a signed document from their accountant that authorizes its inclusion in the FDD.
After a franchised business has been operational for two years, they are considered experienced and will need to have an audited report of its first financial year.
The FDD document contains all the contracts a prospective franchisee must sign. These contracts may include the franchisor’s standard franchise agreement,
a release agreement, a development agreement, a financing agreement, a site selection agreement, and other related agreements.
#23 – Receipts
The final item in the franchise disclosure agreements are receipts that franchisees sign to confirm that they received the document.
What is the Purpose of a Franchise Disclosure Document?
Franchise disclosure agreements are extremely important because it provides the franchisee with the information about the franchise, franchise system, and franchisor that they need to make a decision about purchasing the franchise.
The FDD exists primarily for two purposes: to safeguard prospective purchasers and defend the franchisor from accusations of making false statements. Normally, the document is revised once yearly (when filing) or if there is a significant change to the franchised business.
What is the Difference Between a Franchise Agreement and a Franchise Disclosure Document?
The franchise disclosure document outlines the business relationship between the franchisor and franchisee and provides the franchise with crucial information about the investment they intended to make. Once potential franchisees have fully reviewed the disclosure document, they proceed to the franchisee agreement.
The franchise agreement is the document that legally binds and governs the relationship between the franchisor and the franchisee.
Elements of the financial agreement include:
- A Contract Explanation – an outline of the terms and the franchisor-franchisee relationship
- An Operation Manual- Terms outlined by the franchisor that the franchisee must legally follow.
- Proprietary Statements – An outline of how the franchise will be advertised and promoted and how much the franchisee will need to contribute to the advertising fund.
- Ongoing Site Maintenance – The types of maintenance must be done at the franchisee’s location and when this maintenance should occur.
Simply put, a franchise disclosure document is a precursor to a franchise agreement. It provides the information needed before franchisors and prospective franchisees can take further steps in the purchase of a franchise.
Let’s take a look at some common questions regarding franchise disclosure documents:
What is a franchise disclosure rule?
The Federal Trade Commission has a franchise disclosure rule requiring some selling a franchise in the U.S. must provide the franchisee with all necessary information regarding the franchise in question.
Why is an FDD important?
An FDD is vital for determining if you as a franchisee wish to purchase the franchise in question. You require an extreme analysis of the franchise that only an FDD can provide.
Is a franchise disclosure document binding?
Technically, the FDD is not a binding document. You will use the FDD to determine if you wish to accept the franchise agreement. The franchise agreement is a legally binding document.
Both the franchisor and the franchisee should pay close attention to their franchisee’s disclosure document to ensure that both parties have an accurate mutual understanding of what the other party expects from them and their role.
If a franchisor doesn’t update their FDD document, or the information present isn’t accurate, it could lead to legal issues. Similarly, franchisees who don’t read their disclosure documents will not know the scope of their duties, which could place them in serious trouble.
In the end, a Franchise Disclosure Document is a safeguard for both parties.