What is a Franchise Disclosure Document & Why is it Important?

What is a Franchise Disclosure Agreement?

No matter what kind of franchise opportunity you’re considering, all franchisors are required by law to hand out a Franchise Disclosure Document (FDD) at least two weeks ahead of signing time.

In short, the FDD is a master guidebook to the business. Inside, you’ll find a wealth of information about the franchisor and the franchise organization along with the finer details of the opportunity itself.

While these documents are packed with info, it can be a dense read. To the first-time franchise buyer, flipping through page after page of lengthy text and legalese can be daunting.

This guide will help you step through each of the 23 sections or “Items” you’ll find inside. We’ll highlight the key sections to pay close attention to and point out potential FDD red flags to watch out for as well.

Let’s start at the very beginning:

Item 1: The franchise company

In the first Item of the FDD, you’ll find a summary of the company’s history. Look to make sure the following topics are covered here:

  • How long the company has been in business
  • Special laws that affect the industry (if applicable)
  • Licenses or permits needed to run the business
  • Any partner or parent company information

In general, Item 1 performs two functions.

First, it requires the franchisor to disclose valid information about itself. Second, it provides legal recourse for a franchise owner if that information turns out to be misleading.

After reading Item 1, you should have a good general understanding of the organization. If this section is difficult to understand, it’s a good indication that the rest of the document will be similarly challenging. Your franchisor should be able to walk you through it more carefully. A business coach or consultant can also assist in helping you make sense of the information.

Possible Red Flags

  • Vague information
    If the information regarding the franchisor’s business is very vague, it could indicate that the franchisor struggles to understand what they’re offering, or that the opportunity wouldn’t be appealing if the details were fully disclosed.
  • Issues with predecessors, parents, affiliates and business experience
    Look into any business transfers and the business history in general. If the franchisor has had problems in the past, you may want to reconsider. Remember: while you are legally considered an independent business owner, the franchisor could exercise significant control over your business. Make sure you trust and can work well with them.
  • Conflicting information
    If a franchisor tells you one thing, but the FDD says another, bring it to their attention and see how they clarify the mismatch.

Item 2: Executive business experience

Here, you’ll learn important facts about the business and people that lead it. It’s important to get a feel for how executives operate and steer their organization since these are the people you’ll be working with to establish yourself as a franchise owner.

Pay attention to general business backgrounds, experience in managing a franchise system and how long they’ve been with the franchisor.

Possible Red Flags

  • People or predecessors with questionable histories connected to the business
    Keep an eye out for executive teams who are either brand new to franchising, or those who have a history of business failures. If the conditions are concerning, you may want to reconsider franchising with that particular franchisor. LinkedIn is a great resource to find more information about the company’s leadership history.

Item 3: Litigation

This section will give you information about any prior legal troubles the company or its directors have had in the past. Whether it’s a claim from a former franchisee or lawsuit for using a restricted trademark, Item 3 will give you a good picture of the franchisor’s legal standing.

The franchisor must disclose three types of legal action and some regulatory actions.

  • Pending criminal, regulatory, or civil actions involving illegal or deceptive conduct or unfair trade practices.
  • Past convictions, no contest, or guilty pleas within the last ten years resulting from criminal, regulatory, or civil actions alleging illegal, deceptive, or unfair actions or practices.
  • Material civil actions involving any franchise relationship. Additionally, they must disclose currently effective injunctive or restrictive orders brought by a public agency that involve violations of securities, franchise, or trade practices.

Possible Red Flags

  • Possible problems not required to be disclosed
    Item 3 is designed to help you understand how the franchise system is performing and how often lawsuits affect the company. However, it’s important to keep in mind the exceptions to the disclosure rule. It may be important to conduct additional research if there has been a recent change to the franchisor’s principle trademark, or if the franchisor has been selling franchises for a very long time. Contact former and current franchisees and ask for information regarding the franchise system’s performance and culture if this is the case.

Item 4: Bankruptcy

This section simply outlines whether or not the company or its directors are currently in bankruptcy or have been before within the last ten years.

Possible Red Flags

  • If a history of bankruptcy exists, consider the risks
    Keep in mind how each party’s bankruptcy could affect your investment in the franchise and your relationship with the franchisor.

Items 5, 6 & 7: Initial startup fees, investments, and other fees

For the sake of simplicity, it’s easiest to understand these three Items together as they all deal with fees.

Item 5 details the initial fees required to start your own franchise. It should disclose all fees that are paid to the franchisor prior to opening the business. It could also include the cost of any goods or services paid to the franchisor prior to the business opening, training charges, and any other fees paid to the franchisor in this initial state of the franchise relationship.

Item 6 will chart all the additional fees needed before launching your business. These may include royalty and advertising fees among others. It’s important to note that the costs of products and inventory are listed later.

Item 7 will lay out your first three months of fees and expenses as a franchise owner. Typical expenses listed include rent, leasehold improvements, franchise fee, utility charges, and deposits, furniture, fixtures and equipment, vehicles (if required), computers, software, insurance, signs, office supplies and equipment, licenses and permits, legal and accounting fees, working capital, etc.

Possible Red Flags

  • Possible problems not required to be disclosed
    Think of Item 7 as a baseline of expenses, or working capital. Be sure to talk with already-established franchisees to get an idea of how long it typically takes to begin breaking even and generating profit on the investment. Make sure that the cost of the franchise is really a great deal beyond just the up-front franchise fee. Go over everything with a skilled accountant before signing the franchise agreement.

Item 8: Restrictions on product and service sources

Franchisors want to make sure all franchisees are selling products and services that meet company standards. Here, you’ll learn where products are sourced (either from the franchisor itself or a third party).

Possible Red Flags

  • Unfair inventory stocking prices
    Franchisors who source their products from third-party distributors can sometimes charge franchisees unfair prices to stock their inventory. Franchisors that produce their own products like us here at The Groutsmith, have the ability to provide their franchisees with what they need for far lower monthly overhead costs.

Item 9: Franchisee obligations

This a big one you should absolutely be paying extra attention to. Item 9 outlines your contractual obligations as a franchisee. It references other parts of the FDD and the franchise agreement itself, allowing you to understand each of your obligations.

While it might seem tedious to finish all the cross-referencing that is required by this format, it is essential.

Item 10: Financing

This section will let you know of any lending programs or lender deals that exist to help franchisees finance their investments over time.

Remember that even if no financing options may be available through the franchisor itself, there are plenty of ways to finance your investment through other means.

If you’re interested in learning more about financing your franchise, check out our post: The 5 Steps to Getting a Franchise Loan.

Possible Red Flags

  • Beware of the risks
    Borrowing from a franchisor is just like borrowing from a bank. If you default, your franchise agreement may be terminated.

Item 11: Advertising, computer systems, training and other franchisor assistance

Here you’ll find a description of the support and training services offered by the franchisor. This tends to be the longest section of the FDD section. This is where you’ll learn what you get for your franchise fees. You’ll learn about assistance before opening as well as continued assistance. You’ll also learn about the franchisor’s training programs and required franchise systems, like computer point of sale.

Item 12: Territory details

Depending on your business, you may need a protected territory––an area no other franchisees can move into with another location.

Here at The Groutsmith, we believe large, protected territories are key to succeeding in your local market. Click here to learn more about our territory protection and other unique advantages we provide franchisees.

These sections list each trademark and copyright the franchisor has registered.

Virtually all franchisors will clearly outline the complete and proper registration of their logos and trade names. This is one of the first things a franchisor does when setting up their system to franchise.

Possible Red Flags

  • Contested trademarks
    Be careful to look for areas in which the trademark may be contested. If the franchisor does not have the name or logo properly registered, this is a reason to “just say no” to the opportunity.

Item 15: Obligation to participate in business operations

One big worry on the minds of franchisors is whether or not new franchisees are fully invested in their businesses. While some require you, the franchisee, to run the business yourself, others allow you to hire managers to take care of day-to-day operations.

A home-based or service business like ours is usually run by an owner-operator. In a restaurant franchise, that is rarely the case as general managers are typically common.

Item 16: Selling restrictions

This section is pretty straightforward. It’s meant to inform you that you’re only allowed to sell products authorized by the franchisor. If you have a single product franchise, you typically have to buy that product and only that product.

Item 17: Renewal, transfer and termination resolutions

This is a summary of the relationship between franchisor and franchisee. Specifically, it details termination and renewal, and explains the system used to settle disputes if they arise.

“Renewal” refers to the renewal term for the franchise agreement. For some it’s 5, some 10, some 20 years. It depends on what deal the company uses.

Termination refers to what franchisees have to do wrong to force a default notice and a termination. It is usually involuntary. Item 17 essentially talks about all the mishaps that would result in this particular consequence.

Item 18: Public figures

This section is only relevant to the less than 1 percent of franchise opportunities that utilize public figures to advertise products and service.

Item 19: Financial performance representations

Sometimes referred to as “Earnings Information” section of the FDD, this name is actually misleading since franchisors are not required to disclose any information about potential income or sales to potential franchisees. Roughly 30-40% of franchisors choose to do so.

If the franchisor does provide earnings information, the law requires their claims to be backed up with real numbers.

Item 20: List of franchise outlets

This section offers a look into the activities of other franchisees. In particular, it shows the number of franchises that opened, transferred, and closed within the last three years to give you an idea of whether the brand is expanding or shrinking.

In addition, you’ll be given a list of all current and former franchisees. Contact as many of these owners as possible to get a more in-depth perspective on the business.

Item 21: Financial statements

Here you’ll find a list of audited financial records to give you a good idea of the franchisor’s stability. It’s a good idea to carefully go through the profit-and-loss statement and balance sheet in particular.

Depending on your ability to pick apart the numbers, it may help to have an accountant determine whether the ratio of assets to liabilities is positive for the business and how deferred revenue is being accounted for.

Great franchisors clearly show steady growth through franchise sales and royalty earnings.

Items 22 & 23: Contracts and receipts

These last Items provide the contracts and receipts you’ll be required to sign. Don’t sign any contracts until you’ve read through and thoroughly understood each of them. Make copies of these documents and keep them on record.

Final Thoughts

While the FDD may be intimidating and complex, remember that its whole purpose is to give you the information you need to make the right franchising decision.

Here at The Groutsmith, we’ve built our franchisee on-boarding system specifically for first-time business owners and those new to franchising. We work closely with everyone interested in our opportunity to make sure each and every person fully understands our brand, our business and the growth potential its provided time and time again.

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Want to learn more about becoming a franchise owner with a low-cost opportunity anyone can succeed with? Learn more about The Groutsmith, read a real-life success story from a Groutsmith franchise owner projecting $1 million in sales this year, and contact us to get more information and start the conversation.

Looking to learn what it’s like to own a Groutsmith franchise? Get a first-hand look from eight franchisees in our free Q&A guide. Click below to download.

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