If you are going to buy a franchise, federal law requires the franchisor to make certain information available to help you evaluate what you are getting into. This information is provided in a “franchise disclosure document” or FDD.
These documents are supposed to be consumer protection documents, but they are drafted by the franchisor’s attorneys. Often hundreds of pages long, they can be both intimidating and clear as mud. As with any legal document, the business owner should be able to read and understand the business terms, and call in the experts to evaluate the legal terms.
Overall, the FDD has 23 sections that are supposed to disclose key information to the prospective franchisee to help evaluate the investment. Here is an overview of Section 11-23:
11. Franchisor’s assistance, advertising, computer systems and training. Does the franchisor make you use a proprietary cash register or merchant services system? What of your information and proprietary customer information will the franchisor be able to access? What kind of security is in place? What happens if there is a data breach that exploits the system the franchisor makes you use? How are advertising fees spent, and how much is paid to the franchisor rather than passed through for actual advertising?
12. Territory. Many franchise systems limit the number of outlets to make sure each franchisee can be profitable. Other systems require a certain number of franchisees within a certain area to make sure customers don’t have to go too far to purchase the franchised services. Read this section carefully and make sure it makes sense for your business. Sometimes this may be negotiable.
13. Trademarks. Trademarks are brands, product names, logos or other symbols that connect a good or service to the franchisor. If the franchisor does not have federal trademark registrations for its key branding, there is risk that the branding might need to be changed later. This is expensive and almost feels like starting over with a new company.
14. Patents, copyrights and proprietary information. Patents may cover inventions, proprietary processes and software. Copyrights protect works of authorship such as advertising, photographs, software, web sites, and manuals. You want to make sure that the franchise has adequately protected and sees the value in its intellectual property portfolio. If the business model is based on a proprietary invention, system or process, you want to make sure the franchisor has the exclusive rights secured and is not infringing someone else.
15. Obligation to participate. Some franchises require owners to be hands-on managers; others permit absentee owners. Make sure your participation expectation is permitted by the franchisor.
16. Restrictions on what the franchisee may sell. Many franchises do not permit the franchisee to sell anything that is not specifically permitted. This allows the franchisor to ensure the offerings are uniform outlet to outlet. Make sure the product/service offerings are broad enough to have a successful business. You may not be able to offer additional products or services.
17. Renewal, termination, transfer and dispute resolution. This section summarizes how the franchise may be terminated or renewed, and how disputes will be resolved. Make sure you have a right to renew and what financial investments will be required upon renewal. Often, the financial terms are increased at renewal; it is wise to try to negotiate renewal terms at the time of signing the original agreement. Additionally, disputes may have to be brought through arbitration only or in the place chosen by the franchisor.
18. Public figures. If a franchise uses a public figure in its advertising, this section will describe how hands-on the celebrity is.
19. Financial performance representations. A good FDD will disclose what current franchisees earn; many simply state that they choose not to provide the information. Remember your earnings will vary based on royalties, payroll, rent and other costs that vary market to market.
20. Outlets and franchise information. In my opinion, this is one of the most valuable sections, as it shows the number of franchises opened, transferred and closed in the last three years, and lists current and former franchisees. I encourage potential franchisees to call everyone, but especially former franchisees to find out why they left. A large number of transfers may indicate a problem. Watch out for more transfers than new outlets and ask questions.
21. Financial statements. You or your accountant should be able to review the profit-and-loss statements and the balance sheets to determine whether the investment is likely to pay off for you. A good franchise earns its money from royalty fees, and not transfer or sales of existing franchisees.
22. Contracts. This section provides the Franchise Agreement and other contracts you will sign to become a franchisee. The FDD is just the tip of the iceberg of legal documents you should review and understand.
23. Receipt. You will have to submit an actual or electronic signature to the franchisor showing you received the FDD. If there is ever a dispute, the franchisee is presumed to have knowledge of all the facts in the FDD. Because these documents are so voluminous and often hard to understand, this can sometimes come back to haunt a franchisee who was not familiar with all of his obligations. Note, too, that the FDD includes copies of all other documents you will have to sign once you have evaluated the business opportunity and have purchased the franchise. You are deemed to have actual knowledge of what is in the form contracts, too.
In general, watch out for “obligations” of the franchisor that aren’t truly binding. Watch out for subtle qualifying words, such as “may,” “at/in our discretion” or “as needed,” and know that you cannot count on receiving those services. It may seem obvious, but look for franchises that are growing not shrinking and ones that do not have many disgruntled former franchises (whether they are in active litigation or just listed as “former” franchisees.)
