Understanding the Franchise Disclosure Document

February 3, 2022by Brian Walsh

One of the more difficult tasks confronting potential franchisees is navigating and understanding the Franchise Disclosure Document (FDD). The average FDD contains over 200 pages filled with complex sentences, polysyllabic words, and legal boilerplate. It is a document written by lawyers for one purpose: protecting franchisors from future liabilities to franchisees.

According to a 2018 study,  the average sentence contains 25 words. The researchers determined that understanding the document requires the reading equivalent of a master’s degree (20.36 years of study). Consequently, disclosures are “mostly ignored; if noticed, unread; if read, misunderstood; if understood, unused; and if used, often in the wrong way.”

The FDD, while difficult to read and understand, nevertheless provides valuable information that a potential franchisee needs to make a rational decision about investing in the offeror’s franchise. The following is an overview of the FDD with those items considered to be most important by the author identified and explained. Even so, the services of an experienced franchise attorney during the due diligence process are always recommended.

History of the (FDD)
Franchise Disclosure Document

The early years of franchising have been likened to America’s Wild West in the middle 19th century. People were expected to be self-sufficient and protect themselves in a lawless community.

Unscrupulous franchisors and their representatives used emotion, guile, and outright fraud to attract the inexperienced to unproven, get-rich ventures. Due to the growing popularity of franchise ownership and the accompanying abuses, the Federal Trade Commission (FTC) issued its Franchise Rule in 1979, subsequently updated in 2008. The 1979 Rule required franchisors to provide potential franchisees with a Uniform Franchise Offering Circular, renamed in the 2008 legislation as the FDD.

The purpose of the FDD is to ensure that potential franchise buyers have sufficient factual information necessary to make an informed decision about investing in the offeror’s franchise. The FDD is not the franchise agreement, a legally binding legal document that governs the relationship between franchisor and franchisee. FDDs are uniform for all franchisees within a given system, while each franchise agreement is unique to the franchisee signing it. By rule, the franchise agreement is one of the 23 identified disclosures (#22. Contracts) included in the FDD.

The FTC does not approve nor verify the veracity or completeness of the information contained in the FDD, simply requiring certain disclosures to prospective franchisees. However, some states require that the FDD be registered and approved before sales can occur. Other states, including Florida, do not require registration of the FDD but file it with the state before solicitation begins.

23 Required Disclosures

The FDD must be provided to a potential franchisee a minimum of 14 days before paying any money or signing a binding franchise agreement. Franchisors must have a written receipt from the potential franchisee acknowledging receipt of the FDD. A complete list of the required disclosures in the FDD follows:
abc 123

Potential franchisees often complain that reading an FDD is akin to the drudgery of a slog through Finnegan’s Wake by James Joyce or the impossibility of identifying the various Russian characters in The Brothers Karamazov.

The pedantic style of most FDD authors encourages ennui and hides the most critical information in a glut of mundane detail. Even so, potential franchisees should note specific information in the FDD that might matter most in their decision to pursue a franchise agreement. Of the 23 required disclosures above the six in red need careful review.

Critical Information (Do Not Overlook!)

While each of the 23 FDD disclosures is important, those that deal with franchisor/franchisee relations (# 3 and #20), initial and ongoing costs (#5, #6, and #7), and the financial capability of the franchisor to delivers as promised in the franchise agreement (#21) are especially critical to a long-term successful outcome:

Franchisor/Franchise Relations

  • #3. Litigation. This section provides information about legal disputes involving the franchisor. Litigants may include customers, officers, and employees of the franchisor or franchisees. While litigation is not unusual nor always justified, legal actions with franchisees are a red flag. They should be carefully investigated to understand the issues and the impact of the outcomes on franchisees.
  • #20. Outlets and Franchise Information. This disclosure provides information on the number of outlets (franchisees and company-owned) at the beginning and end of each year for the previous three years. Potential franchisees can identify the franchisor’s growth strategy, market concentrations, and unit turnover, possible indicators of underlying issues. This section also provides contact information for current and former franchisees (leaving in the past year). Complete due diligence includes personal conversations with franchisees to verify franchisor information and franchisee satisfaction.

Initial and Ongoing Costs

  • #5. Initial Fees. This disclosure typically focuses on the one-time payment of the franchise fee to the franchisor. Other fees such as site development, lease review, and additional upfront fees may be included. In this disclosure, many franchisors offer payment terms, fees for future units or area development rights, and any discounts applicable to new franchisees.
  • #6. Other Fees. This disclosure provides details on additional fees that a franchisee will pay in the future. Examples include royalty payments (some royalties call for a minimum amount each period), advertising and technology fees, and other extraneous fees that may be applicable in certain circumstances (Late, tuition, consulting, or transfer fees). Some franchisors are unusually creative in describing fees and terms, so caution is warranted when reading the fine print.
  • #7. Estimated Initial Investment. Potential franchisees need to know the potential costs of opening a new franchise. The estimate is necessarily a range due to the number of variables affecting costs such as location, buildout, wage rates, averaging costs, and other local expenses. For example, the expense of opening a 3,000 sq. ft. fast food restaurant in Destin, Florida, is likely to significantly vary from the costs of opening a similar-sized outlet in Chicago, Illinois. Potential franchisees need to verify costs in their location during due diligence.

Financial Capability of Franchisor

  • #21. Financial Statements. Audited financial statements – Income Statement, Balance Sheet, and Cash Flow Statement – of the Franchisor for previous years are customarily provided. If the franchisor is a subsidiary of another company, that company’s financial data will be used. Analysis of the statements suggests the financial strength of the franchisor, its record of growth, and an indication of its ability to deliver on its obligations to franchisees. Thorough and accurate financial analysis requires competency in accounting and finance. If the potential franchisee lacks the necessary expertise, engaging an accountant or attorney to assist is worthwhile.

Final Thoughts

The purchase of a franchise can be a life-changing event. Franchisees risk thousands, if not millions, of dollars to acquire the experience, expertise, and brand of a successful franchise. Understanding the opportunity and its risks is crucial in making the right decision. Remember that the FDD is not the Franchise Agreement. The latter is the document that will govern the relationship with the franchisor.

Remember, the franchise agreement is a legal contract, so don’t sign it before you have satisfactorily worked out any concerns with your franchisor. And determining any issues you may have with a franchise purchase begins with a thorough review of the FDD with expert assistance.

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