Small business owners who are looking to franchise will need to be intimately familiar with all of the ins and outs associated with a franchise disclosure document, or FDD.
The FDD is essentially a simplified, or layman’s view of a franchise agreement. It details the associated fees, the structure of the franchise relationship, its offerings and basically clarifies how the relationship between franchisee and franchisor will work. It is constructed for both the franchisor and franchisee’s protection, to minimize misunderstandings.
For instance, there is a mandatory 14-day waiting period after a franchisee receives an FDD. During this time, the individual is expected to read the document to educate themselves on the franchise agreement, and have their attorney explain anything they do not understand before the relationship can legally move forward.
There are 23 items in the FDD. In this blog, the first in a five-part series, we will explain items 1-4.
- ITEM 1 The Franchisor: The first item in the FDD provides details on the franchise offering as well as explains who the franchisor is, if they have any subsidiaries or affiliates, and if there is a parent company. Company-owned locations will also be listed. Its purpose is to create an overall snapshot of who the franchisor is, so the franchisee knows who they are getting into business with.
A franchisee might not find this information while doing their own research, or looking at a company’s website. They would get some of the information, but it might not be immediately apparent who the parent company is, or how many affiliates they have, if they have any.
Item 1 also discusses when the company was created, how long it has been in business, etc. It is important for the franchisee to know this information because the investment they will make to buy a franchise is substantial. It is important that they know who they are dealing with and what the history of the company is.
- ITEM 2 Business Experience: This second item lists the officers and directors and their employment history for the last five years. The value here is, a potential franchisee will know who they are going to deal with on an ongoing basis.
- ITEM 3 Litigation: The third item is where a potential franchisee might start to notice red flags. This information details whether or not the franchisor has been sued, how many times, or whether there is or has been any litigation. For instance, whether or not the company leaders have a criminal record would be listed there.
A startup company may not have any litigation listed, but if the company has been around awhile, like Subway, for example, it’s not uncommon for them to have a number of lawsuits under their belt. That’s not necessarily alarming because it’s a big company with tens of thousands of franchisees; they are bound to be sued a few times. If it is a small company, on the other hand, with less than 25 franchisees, and it has been sued a few times, that is a red flag.
- ITEM 4 Bankruptcy: Item 4 is important. If the company or any of the individuals in item 2 filed for bankruptcy in the last 10 years, it has to be disclosed. This is not necessarily a deal breaker for a potential business relationship, but it should be a caution.
If it is a new company there may not be any disclosures. But if they have been franchising for a couple of years, and they have three or more, a potential franchisee might want to think twice about investing. If the franchise has a long list of litigation or state actions you will definitely want to find out what is going on. State actions refer to any violations from any of the 15 registration states for a violation, like selling an unregistered franchise, for example.
Items 3 and 4 are really important. Combined, items 1-4 are the beginning pieces of the FDD that introduce a franchisee to his or her potential franchisor and details what a relationship with them would be like. Watch for the second part in this five-part blog series, where I will review items 5-9.
If you need a franchise attorney or have more questions about a franchise disclosure document, click here.