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How to Decode a Franchise Disclosure Document and Franchise Agreement

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Difficulty:IntermediateLength:LongLanguages:
This post is part of a series called Buying and Running a Successful Franchise.
How to Evaluate a Franchise Opportunity
Running a Successful Franchise

Here’s the good news: Before you buy a franchise in the U.S., the franchisor is legally required to provide you with detailed information about the business, so that you know exactly what you’re getting into.

The bad news? These documents are typically drafted by lawyers. They often run to hundreds of pages, and the language can be impenetrable.

So the danger is that you treat the Franchise Disclosure Document like the license agreement for some new software. You know you should read it, but there’s just too much of it, and in the end you just click “Agree” and move on.

But a franchise purchase is a big decision, and it pays to do your research thoroughly. So in this tutorial we’ll take you through the key sections of an FDD, and help you find the nuggets of crucial information in there, without getting overwhelmed by all the details. We’ll also look at the franchise agreement that you’ll sign shortly afterwards, and explain what you need to look for. And you’ll learn what sort of outside assistance you may need, and why it’s important.

By the end of this tutorial, you’ll be ready to make the final go/no-go decision on your franchise, and to move ahead with completing the purchase if you decide it’s right for you.

If you still need help finding a franchise or choosing between a few alternatives, check the previous tutorials in our series on buying and running a successful franchise, where we covered all that in depth.

Step 1: What is an FDD?

The Franchise Disclosure Document (FDD) exists for your benefit. The idea is to make sure you have all the information you need to make an informed decision before investing your money.

The Federal Trade Commission requires franchisors to provide an FDD to prospective franchisees at least 14 days before asking them to sign a contract or pay money. You can also request a copy earlier if you want. In fact, it makes sense to do so, because the information can help with much of the research we covered in the previous tutorial on franchise evaluation.

Most of the document gives information about the franchisor and the franchise system you’re buying into, rather than the specific unit you’re thinking of buying. Nevertheless, there’s plenty of useful information in there, as we’ll find out in the next section.

The best way to get hold of the most current FDD is directly from the franchisor. However, if you just want to get an idea of what the document looks like, there are a few free samples available at franchise news website BlueMauMau.org. Or you can purchase FDDs for around $200 at sites like FranData or FranchiseHelp. Just be sure to check the date on the FDD, as many of those available online are from older years, and the information may have changed.

Step 2: The Key Sections, and What They Tell You

When you open up the document, you’ll see the same basic layout in every FDD—the 23 sections are mandated by the regulations. Here are the key things you should be looking for.

A Stable, Healthy and Growing Company

Item one in the FDD gives you some background on the franchisor and any parent companies, predecessors or affiliates. Look for a long history, and if there have been frequent changes of name and ownership. Make sure you understand why. Also pay attention to the discussion of the competitive environment, and make sure you understand the basic business model and its risks.

In Item two, you’ll find out about the key executives and their experience. This may be little more than a list of names and job titles, with the dates they started with the company, but you can use the names to search online for more detailed information.

A couple of items towards the end also give you a good indication of the franchisor’s financial health. In Item 20, you can see how many franchises there are in each state, and how many have opened and closed in the last three years. Look for growth in the overall numbers, and if there are a lot of closures, start asking more questions. This section also gives contact information for current and former franchisees, which is a great way to do more research, as discussed in the previous tutorial.

And Item 21 gives you full financial statements for the franchisor, so that you can see whether the company’s in good health. If you need help decoding these, check out our tutorial on reading an income statement.

Fees That Match Your Budget

Items five to seven give full details of the fees and other start-up costs of the franchise. You should already have researched this, so just make sure it matches what you expect, and falls within your budget. Account for not just the initial fee, but also other setup costs and ongoing royalty and advertising fees, and make sure you can afford it all comfortably, because there’ll likely be other unexpected costs along the way.

A Healthy Bottom Line

You’ve already looked at the company’s financial statements, but what about your own bottom line? Item 19 is a chance for the franchisor to give details of what individual franchisees can expect to make, based on average historical data.

We say “a chance” because giving this information is optional, and only about 30% of franchisors choose to disclose it.

If you do find numbers here, take a skeptical view of what you’re being shown. For one thing, any estimate based on other people’s experience may not apply to you. And the FTC also says that “earnings information can be misleading.” Sometimes the numbers are based on a sample that’s not representative of the whole, for example looking at well-established stores rather than new ones. And sometimes you’ll see revenue numbers, but no discussion of costs or profits. So don’t hesitate to ask for more information.

Restrictions You Can Live With

Item nine talks generally about all of your obligations as a franchisee, and is a very important section to read. This is what you’ll be obliged to do for the next few years of your life, so make sure you’re OK with it.

There are also specific sections for particular items. In Item eight, for example, check out all the restrictions on where you source your products and services. Item 12 specifies what territory you’re operating in, and whether there are restrictions on where you or other franchisees can do business. Item 15 sets out how hands-on you’re expected to be as a manager, and Item 16 lays out the restrictions on what you can sell.

The Help You Need

Now that we’ve covered your obligations, what about the franchisor’s obligations to you? In Item 11 you’ll find out about what assistance the franchisor gives you in terms of training, advertising and other help. With the advertising, try to find out if it will be used for your benefit, or if it’s just a fee that you pay to help the franchisor and other franchisees.

Franchisors sometimes provide special loans or other financing to help franchisees get started. If you think you may need this, check Item 10 for details of what the franchisor offers. 

No Red Flags

Other than these key areas, you’ll want to check out some of the other items to be sure there are no red flags. Item three details any litigation the company or its executives are involved in, for example, and item four discloses any bankruptcy proceedings in the past ten years. Litigation by itself is not a red flag, but if many franchisees are suing the franchisor for alleged fraud, it’s definitely something to worry about.

Acceptable Terms

What happens if you want out before the end of the agreement? How about if you want to extend the contract? Under what circumstances could the franchisor terminate the agreement and eject you from the franchise? What’s the process for resolving disputes? All of that is covered in Item 17, so pay close attention and make sure you accept the terms.

Item 22 sets out all the legal contracts you’ll be expected to sign before buying, including the main franchise agreement, so read those, or have your attorney read them. We’ll look at the franchise agreement more in the next step.

That covers most of the items in the FDD. The few remaining ones list the franchise’s trademarks and other intellectual property and give details of any public figures used in the franchise’s advertising. Then the final item is a receipt you have to sign, confirming that you’ve been provided with the disclosure document on time.

Step 3: The Franchise Agreement

When you’ve digested the FDD and done any other necessary research, it’s time to read the franchise agreement. You’ll find that it contains much of the same information as the FDD, but it’s presented in a different way, and serves a different purpose. Whereas the FDD was an information document, the franchise agreement is a legal contract. Once you sign it and make the payment, you are officially a franchise owner.

Although much of the information seems familiar from the FDD, you still need to read it carefully. Sometimes there are extra details in the agreement itself, and it’s important to make sure you understand what you’re agreeing to.

Key clauses include the following:

  • Hidden or additional fees such as training or territory fees.
  • Provisions under which you can terminate the franchise agreement.
  • Situations that allow the franchisor to terminate the franchise agreement.
  • Requirements that you purchase goods from the franchisor.
  • Ongoing fees for additional training or management.
  • Terms for renewing your franchise agreement.
  • Your ability to transfer the franchise to another party.
  • Provisions that you gross a specific amount of sales.
  • Restrictions on your ability to hire and fire employees.
  • Details of the quality and quantity of service and support you are to receive.

In many cases, the franchisor will tell you that the agreement takes a standard form and is non-negotiable. Large franchises, in particular, don’t want to have different agreements in place with hundreds of different franchisees. So if you can’t agree to some of the clauses, you may have to walk away from the franchise altogether. Or, especially with smaller franchises and with the help of an attorney, you may find you can make some amendments.

Step 4: Get Help

Clearly, when reading a legal agreement of such length and importance, it makes sense to consult a lawyer, preferably a specialist franchise attorney who’s familiar with the ins and outs of franchise agreements.

You can search online or use directories, but because trust is so important, it’s better to get a personal referral if you can. Speak to your existing lawyer, or to friends or other people you trust, and try to get recommendations. If you’ve interviewed franchisees, ask which lawyers they used, and whether they were happy with them.

An accountant or financial advisor may also be useful to help you assess the financial information you’ve been given, and spot any potential problem areas, as well as helping you develop a business plan and choose a franchise that’s right for your own financial situation.

And you can also get help from the government. The FTC regulates franchises in the U.S., and provides support both via its website and by phone (1-877-FTC-HELP). Individual states also have their own rules, and some states give extra rights to franchisees beyond the federal stipulations. So contact your state Attorney General’s office or go online to see what help they provide.

One thing to keep in mind with hiring lawyers and accountants: It’s a very important step, but to keep costs down, it makes sense to do it late in the process, when you’ve already done a lot of your own research and weeded out unsuitable franchises. Fees can be high, so you want to make best use of your attorney’s time.

Next Steps

So now you know how to break down the mass of information provided in a Franchise Disclosure Document. You know the key areas to focus on, and what to look out for. You’ve also seen what’s involved in reading a franchise agreement, and the kind of external assistance you may need.

This tutorial builds on previous ones in our series on buying and running a successful franchise, so make sure you’ve done all the necessary research outlined in those previous tutorials. If you have, then you’re now in a good position to make an informed investment decision.

If you’re confident that you’ve found the right franchise, done all the research, read and understood the FDD, and had an experienced franchise attorney review the franchise agreement, then the next step is to sign the documents, make the payments, and start life as a franchisee. In the final tutorial in our series, we’ll look at the early stages of your business life, and give tips on running a successful franchise.

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