Are you considering entering into a franchise agreement but need clarification on franchise disclosure documents (FDDs)? Look no further! This guide will break down the key components of FDDs, including:
- The franchisee’s obligations
- Financial representations
- Franchise fees
Additionally, we’ll cover what an FDD is, the legal requirements for FDDs, and why they are important for both franchisees and franchisors. Read on to gain a better understanding of FDDs so that you may make an informed decision about the investment.
Significance of FDDs
First of all, what are FDDs? Franchise Disclosure Documents (FDDs – and in some jurisdictions referred to as “Circulars”) are legal documents that franchisors by law are required to provide to potential franchisees before any agreement is signed and fees paid.
The FDD outlines important information about the franchise system, including:
- Financial information
- Fees and costs
- Franchisee and franchisor obligations
- The franchise agreement
- Important details about the franchise system
The purpose of the FDD is to enable potential franchisees to make an informed decision about investing in a franchise, and to ensure transparency and fairness in the franchising process.
Why is the Franchise Disclosure Document important?
FDDs are important because they provide prospective franchisees with vital information about the franchisor and the franchise system right-up front.
The FDD typically contains information about the franchisor’s business history, litigation history, initial investment costs, ongoing fees and expenses, training programs, marketing, financial reports and advertising requirements, and other important details related to the franchise system.
Legal requirements for FDDs
By law (overseen by the Federal Trade Commission), all franchisors are required to provide prospective franchisees with an FDD at least 14 days before the parties sign a franchise agreement and pay any the Initial Franchise Fee. Failure to provide an FDD or representing false or misleading information in an FDD can result in legal liability for franchisors.
The FDD must contain the following information:
- Franchisor company background
- Franchise fees and investment costs (up-front and anticipated on-going costs)
- Initial and ongoing training and support
- Designated territory and limit of marketing rights
- Financial performance representations (if provided)
- Franchise agreements (including provisions related to termination and renewal)
- Trademark status
- Franchisor’s obligations to provide ongoing support
- Restrictions on the franchisee’s business operation
- Dispute resolution procedures
- Financial statements
- List of current and former franchisees (with contact information – use it, call as many of them as possible and ask questions – this is the most important due diligence step you may exercise!)
Why FDDs are crucial for both franchisors and franchisees
Franchisors may use the FDD to establish credibility and build trust with potential franchisees, while franchisees rely upon it to evaluate the franchisor’s business system and assess the risks and rewards of investing in this franchise.
By disclosing all relevant information, including the costs, risks, and obligations associated with owning a franchise, FDDs help to ensure that both parties have realistic expectations and are fully aware of the terms and conditions of the franchise agreement.
This process is designed to foster successful franchise partnerships and reduce the likelihood of loss, disputes and litigation.
Specific components of FDDs
What information is included in a franchise agreement?
- Franchisor Information – This section includes details about the franchisor’s history, ownership disclosure documentation, other business legal documents, and management team.
- Initial Fees and Other Costs – Franchisees need to know the total investment required to open a franchise, including the initial franchise fee, royalties, and ongoing expenses.
- Territory Restrictions – Many franchisors restrict franchisees from opening competing businesses within a certain geographic area. Is your Territory exclusive, or are there exceptions to that exclusivity?
- Intellectual Property – Franchisees must agree to use the franchisor’s trademarks, proprietary software, and other intellectual property in accordance with the franchise agreement.
- Renewal and Termination – The FDD outlines the terms under which the franchise agreement may be renewed or terminated. This franchisor and franchisee relationship information is critical.
- Financial Performance Information – Franchisors are required to provide audited financial statements (provided the franchisor has been selling these franchises for at least two years).
- Litigation and Bankruptcy History – This section outlines any past or pending litigation or State enforcement actions involving the franchisor or its key executives. Franchisors are required to disclose certain information about their business experience, including any past bankruptcies, and even crimes.
Conducting due diligence on FDDs
What is due diligence? Due diligence refers to the research and investigation conducted before entering into a business transaction, investment, or contract. It involves gathering detailed and accurate information about the relevant parties, financial performance, legal and regulatory compliance, potential risks, and other factors that are critical to making an informed decision.
Why is due diligence so important? A thorough review will minimize the potential for financial loss and legal exposure, and ensure that you are investing your money and time in a worthwhile franchise venture.
When conducting due diligence on FDDs, there are several important steps to take as part of the due diligence process.
Follow these steps to evaluate the Franchisor’s FDD:
- First, it is essential to carefully determine the required initial investment, as well as ongoing expenses, to determine whether the business is financially feasible for you. Franchisees should also carefully review any territory restrictions and demographics to ensure that they are able to operate (and profit!) the business successfully within their designated area.
- Next, it is important to understand the franchisor’s intellectual property policies and ensure that the franchisee is comfortable with these restrictions. Additionally, franchisees should review the renewal and termination terms during legal due diligence to ensure that they align with their long-term goals for the business.
- Finally, while financial performance information may be provided, it is important to note that this data can be limited or selective.
Role of franchise attorneys
Franchise attorneys play a crucial role in reviewing Franchise Disclosure Documents (FDDs) and aiding financial due diligence.
Their primary responsibility is to ensure that the franchisor has complied with the FTC’s Franchise Rule and state franchise laws.
The franchise attorney reviews the FDD documents and provides legal counsel and due diligence consulting to prospective franchisees regarding the information contained therein.
Attorneys help prospective franchisees understand their legal obligations and the rights and obligations of the franchisor.
Some of the key responsibilities of franchise attorneys in reviewing FDDs include:
- Identifying any legal issues: Franchise attorneys review FDDs to identify any legal issues or discrepancies that may arise between the franchisor and franchisee.
- Ensuring compliance with state and federal laws: Franchise attorneys ensure that the franchisor’s FDD is in compliance with state and federal regulations and all legal requirements to start a franchise. This includes reviewing all required disclosures and ensuring that the document includes all necessary information.
- Advising prospective franchisees: Franchise attorneys provide legal counsel and franchise due diligence to prospective franchisees regarding the potential risks and benefits of investing in a particular franchise.
- Negotiating franchise agreements: Franchise attorneys may negotiate the terms of the franchise agreement and any associated documents on behalf of the franchisee.
- Protecting the interests of the franchisee: Franchise attorneys work to protect the interests of the franchisee and ensure that their rights are protected throughout the franchise relationship.
Additional resources and professionals that can assist in due diligence
Franchise Consultants:
Franchise consultants can provide valuable insight and guidance throughout the franchising process. They can help identify potential franchise opportunities, evaluate franchisor financials, and provide guidance on negotiating contracts.
Accountants:
An accountant can review the franchisor’s financial statements, evaluate the franchisee’s projected financials, and provide tax due diligence and advice.
Industry associations:
Industry associations can provide valuable resources and information about the franchise industry and specific types of franchises.
Existing franchisees:
It is critical that you reach out to existing franchisees to gain insight about their experiences with the Franchisor, and understand the level of support the Franchisor (or is it really the Franchisees?) provides.
By utilizing a team of professionals and conducting thorough due diligence, prospective franchisees can make informed decisions and increase their chances of success in their chosen franchise system.
Seek legal counsel for further guidance
FDDs are lengthy and complex, and Franchisors may use legal jargon or industry terms which may not be easily understood by the inquiring investor. As such, it’s advisable for prospective franchisees to seek the advice of a franchise attorney to review the document and provide clarity about any uncertainties.
Reach out to Kilcommons Law today.
We are here for all of your franchise needs so that you can make informed decisions, mitigate risks and protect your rights through litigation or mediation, if necessary.
© Kilcommons Law, P.C. 2023