The Franchise Disclosure Document (FDD)

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The most important document that is a part of your franchising journey is the Franchise Disclosure Document (FDD). The FDD was put in place by the Federal Trade Commission Rule. The FTC Rule states that all franchisors must develop an FDD and provide it to all potential buyers.

FDD’s provide validated information from the company to make a well-informed decision. The FDD is the foundation for any franchise agreements to comply with franchise laws and regulations. There are 23 sections “items” to the FDD that outline specific questions and details regarding the company.

Breaking up the FDD by item makes reading the document easier, especially when you know what you are looking for in each section.

Item 1 – Franchisor: Within this item, the franchisor must disclose corporate information about the history of the company, any affiliates, and parent companies of the franchisor.

Item 2 – Business Experience: This item gives information about the franchisors’ management team and the operational history of the business.

Item 3 – Litigation: Item 3 discloses any litigation that previously or currently involves the franchisor, the parent company, predecessors, and/or individual management members listed in Item 2.

Item 4 – Bankruptcy: This item discloses any bankruptcy by the franchisor, founder, or management members.

Item 5 – Initial Fees: Within this item, the franchisor must disclose all upfront franchise fees that the franchisee must pay before opening the franchise location. This item commonly includes initial fees and other upfront fees such as fees for opening inventory and equipment.

Item 6 – Other Fees: This item discloses all other fees the franchisee must pay during the terms of the franchise agreement. This includes ongoing royalties, brand development funds, marketing, technology, training, renewal, and any other fee the franchisor requires.

Item 7 – Est. Initial Investment: The franchisor must include low to high estimates of potential costs for a franchise to establish and open. The estimate will include build-out costs to reserve capital for the first three months. This is meant to show an entire estimate of all costs.

Item 8 – Restrictions on sources of products or services: This item discloses the products and supplies the franchisee must buy from the franchisor and ongoing operational items. The franchisor must also disclose in the section the revenue and rebates the franchisor earned from selling source restricted supplies and products to other franchisees.

Item 9 – Franchisee obligations: Item 9 discloses all obligations as a franchisee under the franchise agreement. This includes all legal obligations and obligations upon terminating the franchise agreement.

Item 10 – Financing: Within this item, the franchisor discloses whether or not the franchisor offers financing to initial fees to be paid by the franchisor or in connection with the franchised business.

Item 11 – Franchisor’s Assistance, Advert, Systems, Training: This discloses and details the assistance the franchisor gives the franchisee including advertising requirements, training, and technological resources the franchisee will be required to utilize.

Item 12 – Territory: Item 12 defines whether the territory is protected, how the territory will be determined, and if the franchisor reserves rights to operate within the franchisee’s territories.

Item 13 – Trademarks: Within this item, the franchisor will disclose information about the trademarks of the franchise systems. Whether or not they are registered with the United States Patent and Trademark Office, registration status, and if there have been trademark conflicts or disputes.

Item 14 – Patents, Copyrights and Property Information: This item details information about any patents, copyrights, and other proprietary information related to the franchise system.

Item 15 – Obligation to participate in day-to-day operations: The franchisor discloses what obligations, if any, the franchisee must have in day-to-day operations of the franchised business including if they must work in the franchised business on a full-time basis.

Item 16 – Restrictions on what can be sold by franchisee: Disclosed in this item is the franchisor’s control on what a franchisee may or may not sell.

Item 17 – Renewal, termination, transfer & dispute resolution: Within this item, the franchisor must disclose the legal rights and obligations related to the renewal, termination, and transfer of the franchised business. This must also include a summary of legal disputes that are resolved between the franchisor and franchisee.

Item 18 – Public figures: The franchisor discloses in this item if any public figures or celebrities are hired to promote the franchise system.

Item 19 – Financial performance representatives: Item 19 is where the franchisor discloses whether or not it is making any financial performance representations. This means if the franchisor provides information about sales or a specific level or range of actual or potential sales, income, gross profits, or net profits.

Item 20 – Outlets and franchisee information: Within this item, the franchisor must disclose the franchise and corporate outlets over the last three years and a projection of future openings in the next year.

Item 21 – Financial Statements: Item 21 discloses copies of the franchisor’s financial statements.

Item 22 – Contracts: This item includes all the contracts that the franchisee must sign for the franchisor.

Item 23 – Receipts: The franchisor must include two copies of the receipt page. The franchisee must sign the receipt to prove proper disclosure and delivery of the FDD.

The FDD must be disclosed 14 days before signing the franchise agreement. The 14 day waiting period only starts on the day that the franchisee signs the FDD and does not count the day the last day that the franchisee signs the franchise agreement. Altogether it is a 16 day period if you count the first and last day. There is also a small seven-day waiting period that can be included in the 14 days if the franchisor knows the specifics for the franchisee, such as their specific territory. The franchisor can send the fully completed franchise agreement to the franchisee to sign, along with the FDD.

While the FDD provides an ample amount of information about your franchise what it won’t include is the feedback of other franchise owners. This is a vital piece of knowledge that you should research before signing any agreements.

Reviewing an FDD

If you are looking at purchasing a franchise, you will be provided with a Franchise Disclosure Document (FDD) by the franchisor, as required under the Federal Trade Commission’s Franchise Rule.  It’s a huge thick document, but you should really try to read it given that you are about to invest a lot of money and a chunk of your life in a business, and the FDD contains a lot of very helpful information.

Here are some of the things that are most critical for you to read and understand:

1. The Franchise Agreement is the contract that will govern your relationship with the franchisor.  It is critical.   It is attached as an exhibit to the FDD.   Read it.   Yes, it is long and boring.   Read it anyway.   
2. Item 12 – Territory – if the franchise system calls for some kind of territory or exclusive marketing area, make sure that you understand how this will be determined and that you are comfortable with the process.
3. Item 19 – Financial Performance Representations – the law does not require that the franchisor provide any, but if they do, read them carefully.   Make sure that you understand what they represent, and if possible, create a pro forma using this information, start-up cost information from Item 7, and information you gather from speaking with existing franchisees so that you can understand what you might expect from a cash burn perspective and long-term profitability.
4. Item 20 – Outlets and Franchisees – how many franchisees have been terminated or left the system in the last 2-3 years?   Is it a suspiciously large percentage?  Call at least 5-10 franchisees listed in the exhibit to Item 20 and ask them if they’d buy the franchise again, and why.
5. Item 21 – Financial Statements – is the franchisor financially sound?  Do they have enough capital to survive, especially if they are a newer or smaller system?   If you don’t understand financial statements, review these with an accountant or an attorney.
6. Item 17 – Summary of Franchise Agreement terms – make sure that you understand how renewal, transfer and termination will work.   Make sure you read and understand any covenants not to compete.  Dispute resolution – understand how and where disputes will be resolved.   
7. Items 5-7 – Fees and Initial Investment – I encourage you to create a pro forma profit and loss statement for the first two years of operations using the data in these three items.   If you don’t know how to do that, ask an accountant.  Again, this will tell you how much cash you need to start your business and give you some idea of when the business may start breaking even (and therefore how much capital you need to get you to that point).   Assume that things may not go as well as you hope and provide for that risk.  The most common reason that small business fail is lack of adequate capital.
8. Item 3 – Litigation – In a big chain, expect there to be some, but a significant number of cases or lots of cases of the same type are cause for concern and warrant looking into.   You can often access court records (but not arbitration records) online.
9. Personal Guarantee by Your Spouse – many systems will say this is required.   If your spouse is not going to be involved in the operation of the business, push back on this and see if the franchisor will waive this requirement so long as your spouse agrees to abide by any covenants not to compete and to protect confidential information.  I recommend stating (if it is true) that your spouse is an independent person and that you cannot force them to sign a financial guarantee of your business.
10. Liquidated Damages Upon Termination – understand what money you may owe the franchisor if you breach the contract and the franchise agreement is terminated.  Many contracts provide either a formula for determining damages upon early termination, or specifically that you will owe royalties (and possibly other fees) for the remainder of the contract term.   Usually, it is preferable to have a liquidated damages provision which normally limits the amount you’d owe.
11. Buy-out Rights of Franchisor – On rare occasions, franchise agreements provide the franchisor with the right to buy your business from you at a pre-set multiple of your business’ earnings.  This could be disastrous to you if this is triggered at the wrong time and could force you to sell your business before you hoped to exit it.   Be very, very wary of these provisions, and if they exist, speak with an attorney.  They frequently can be negotiated out.

Source: Michael Rosenthal is a partner in the Atlanta office of Taylor English Duma LLP. The majority of his practice is devoted to Franchise Law matters. Michael has been in practice since 1980. He is an active member of the American Bar Association’s Forum on Franchising and the Georgia Bar’s Franchise and Distribution Law Section.

Federal Trade Commission (Posted 5/24/23 by Lesley Fair):
Franchise Fundamentals: Taking a deep dive into the Franchise Disclosure Document

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Gain a deeper understanding of the Franchise Disclosure Document and things to look for from the Federal Trade Commission as you read the FDD.