With a franchise, budding entrepreneurs can jump into business ownership by using a larger company’s proven model, thereby skipping the challenges of a brand launch and uncertain operational demands.
On the other hand, given the investments that many franchisors require, how do you know which franchises are true moneymakers? What are the requirements for owning the franchise? And how do you know if a franchisor will fulfill their promises?
To help separate the franchise wheat from the chaff, U.S. law requires franchisors to provide potential franchisees with a “Franchise Disclosure Document” (FDD). Within this due diligence tool, franchisors reveal the legal and financial realities of their franchise. But FDDs are complex documents, so it’s essential to understand the information they provide.
What a Franchise Disclosure Document Is and Why It Matters
The FDD is not a contract. Instead, it is a legal document that identifies the obligations for both parties.
According to the Federal Trade Commission’s “Franchise Rule,” all FDDs must follow the same format: Franchisors must provide 23 categories of information, referred to as “Items.” With these, franchisors must share details about their business history, financial performance and other requirements. They must also include the proposed franchise agreement and related contracts within the FDD.
Federal Disclosure Rules in U.S. Franchising
Under the federal Franchise Rule, a franchisor self-certifies its FDD’s accuracy. Given that, there’s a patchwork of state laws to protect franchisees.
For example, some states mandate that franchisors submit FDDs for agency review.
When Franchisors Must Provide the FDD
Once you’ve submitted an application and the franchisor has agreed to consider you as a franchisee, the franchisor must give it to you at least 14 calendar days before they can ask you to sign a franchise agreement or accept any money from you.
What Information Is Included in an FDD
Broadly speaking, the FDD contains three categories of information.
First, a franchisor identifies basic information about their business, such as their parent company, affiliates and executive leadership. The franchisor should also disclose recent litigation or bankruptcies.
In the next section, the franchisor explains a franchisee’s obligations – everything from a comprehensive list of fees to operational details.
And finally, the franchisor must reveal other aspects of their business that affect a franchise’s operation.
Overview of the 23 Required FDD Disclosure Items
| Item No. | Item Description | What Each Includes |
|---|---|---|
| 1. | Franchisor and Parents, Predecessors and Affiliates | Identification of the franchisor’s parent company and affiliates, history and industry |
| 2. | Business Experience | A roster of company’s directors and executives |
| 3. | Litigation | A list of legal actions (e.g., lawsuits, criminal actions) involving the franchisor and its executives |
| 4. | Bankruptcy | A list of bankruptcy filings made by the franchisor, affiliates, or executives in the previous 10 years |
| 5. | Initial Fees | Identification of fees, or formulas for calculating them, owed to franchisor and payment terms |
| 6. | Other Fees | A list of other fees that a franchisee must pay the franchiser or affiliate |
| 7. | Estimated Initial Investment | A listing of all expenditures required for the franchisee’s initial investment, including fees, assets, inventory and other requirements |
| 8. | Restrictions on Sources of Productions and Services | All requirements for the franchisee to purchase or lease goods or services from the franchisor, affiliates or suppliers |
| 9. | Franchisee’s Obligations | A complete inventory of the franchisee’s responsibilities |
| 10. | Financing | Disclosure of financing arrangements by the franchisor, an agent or affiliates |
| 11. | Franchisor’s Assistance, Advertising, Computer Systems and Training | Identification of franchisees’ financial contribution to advertising; franchisees’ and franchisors’ obligations relating to training, onsite assistance and use of computer systems |
| 12. | Territory | Identification of the franchisee’s territory or location |
| 13. | Trademarks | Disclosure of all trademarks and the status of legal issues impacting their use |
| 14. | Patents, Copyrights and Proprietary Information | Disclosure of all patents and copyrights and along with any litigation or other actions limiting their use |
| 15. | Obligation to Participate in the Actual Operation of the Licensed Business | Requirements for the franchisee to engage in the franchise’s operation |
| 16. | Restrictions on What the Franchisee May Sell | Disclosure of additional requirements relating to the franchisee’s sale of goods and services |
| 17. | Renewal, Termination, Transfer and Dispute Resolution | The basis for renewal, transfer and termination of franchises and processes for resolving any disputes |
| 18. | Public Figures | Identification of any celebrity with a role in the franchise |
| 19. | Financial Performance Representations | All financial performance information including sales, income and profits |
| 20. | Outlets and Franchisee Information | Information relating to franchise growth and turnover with list of current and previous franchisees |
| 21. | Financial Statements | The franchisor’s audited annual financial statements |
| 22. | Contracts | The franchise agreement, lease agreements and all other related contracts |
| 23. | Receipts | Signed acknowledgement by the prospective franchisee confirming their receipt of the required information |
Costs, Fees and Financial Expectations
Franchisors should use Items 5-7 to disclose all fees that a franchisee must pay, as well as the required initial investment paid to the franchisor, an affiliate or a designated supplier. Fees cannot be hidden in agreements or within an operational manual.
Franchisors may adopt a fee schedule based on sales or other factors, but if there is no set amount, the franchisor must explain the formula used to determine any fees.
Even when the information is detailed, there are other concerns to address. For example, the Items may not include any franchisee salary or cover subsequent investments that you must make after the franchise has opened.
When it comes to financial performance, a franchisor must include all relevant information in Item 19. They cannot make verbal or written claims not included in that section.
Franchise Disclosure Document Requirements and Updates
Companies must update the FDD at least once a year, but some update FDDs every quarter.
The information must be accurate and clear – written in plain English rather than business jargon.
On the more technical side, franchisors must prepare an FDD as a single document. It must begin with a cover sheet and general information. It may also include information relating to state-specific laws.
How an FDD Is Prepared and Maintained
While the North American Securities Administrators Association (NASAA) and other associations provide guidelines on FDD preparation, franchisors typically hire attorneys who specialize in franchise law to prepare the FDD and its related agreements.
Franchisors must have accountants prepare audited financial statements, and they often have sales and operational staff contribute information as well.
Annual Compliance and Revisions
All franchisors must update FDDs within 120 days after the end of their fiscal year.
States may include additional requirements for FDD updates. For example, in New York, franchisors must submit a redlined copy, so you can see changes from the previous year.
How to Review and Analyze an FDD Before Investing
While it’s important for you to review the entire FDD, industry experts often recommend beginning with a few key areas – such as the fees and initial investment to determine what revenue you’d need to generate a profit.
It’s also vital to study the franchisee obligations.
The franchisee list is also useful, as past and present franchisees can be an invaluable source of information.
Some Red Flags to Look For
Experts warn that potential franchisees should look out for common red flags such as exorbitant franchise fees, confusing fee structures or formulas. Another cause for concern: if there are differences between the fees identified in Items 5-7 and those in operations manuals or agreements.
Be wary of franchises with a track record of litigation (Item 3) – particularly involving franchisee disputes – or bankruptcy filings.
Vague, ambiguous terms are another warning sign—especially when defining a franchisee’s territories and setting forth the requirements for renewals or terminations.
And significant turnover (Item 20) may also give you pause. It suggests the franchisors are quick to drop franchisees or that franchisees are unhappy.
When to Seek Legal or Financial Advice
Because FDDs involve complicated legal issues and financial data, the Federal Trade Commission (FTC) advises that potential franchisees consider having an attorney and an accountant review an FDD and franchise agreement.
Where to Find Franchise Disclosure Documents
Keep in mind that many companies offering free or low-cost FDDs are actually franchise brokers who may steer you towards particular franchisors.
But there are alternatives. FreeFDDLibrary.com gives registered users one free FDD a week. Similarly, there are subscription services such as Franchimp, which offers free-to-read FDDs. FranData has a large FDD library, but it charges higher fees than many competitors.
State Registration Databases and Public Sources
Indiana, Minnesota and Wisconsin provide FDDs for their states’ franchisors. California has a database for them as well, but many franchisors receive exemptions from inclusion in it. Additionally, NASAA maintains a free database of FDDs.
Requesting the Document from a Franchisor
A franchisor can hand-deliver, mail or fax the FDD to you. Alternatively, they can send it through email, a website or a disc. No matter which way they send it, they will ask you to sign an acknowledgement that you’ve received the document.
Once you’ve done so, that receipt becomes part of the FDD itself.
While that’s a legal formality, realizing that your signature becomes part of the FDD is a potent reminder:
While the FDD may be used as a sales tool, it’s much more than that. It’s a legal document. So take your time with it. Ask questions. Do your research. Interview franchisees. Make sure your goals are aligned with the franchisor’s. Have your lawyer and accountant review it, and don’t just decide based on what responsibilities and obligations you can live with. Look to see what you can thrive with, too.
Because that’s what being an entrepreneur is all about.
This content is provided for informational purposes only and does not constitute legal, tax, financial, or professional advice. Laws and regulations vary by state and individual circumstances and may change over time. Readers should consult a qualified attorney, tax professional, or other licensed professional regarding their specific situation. Nothing herein creates an attorney-client relationship.
