What Is a Franchise Disclosure Document?
A franchise disclosure document (“FDD”) is a legal disclosure document that must be given to prospective franchisees by franchisors as part of the pre-sale due diligence process. It contains information necessary for franchisees to consider when deciding whether to make an investment in the franchise—including insight into how the relationship between franchisee and franchisor will be conducted, as well as details about the structure and health of the franchise system. According to the Federal Trade Commission (“FTC”), a franchisor must update its FDD annually or when there is a material change and must provide prospective franchisees with the FDD at least 14 days before it needs to be signed or before any initial money is exchanged.
FDDs are divided into 23 sections (each called “Items”), which lay out various information—including details related to:
Item 1: The background and history of the franchisor and any parents, predecessors, and affiliates;
Item 2: The business experience of the franchisor and its team;
Item 3: Relevant litigation involving the franchise system;
Item 4: Bankruptcies involving franchisor, its predecessors, and its affiliates;
Item 5: Initial fees charged to franchisees, including the franchise fee and any other initial fees;
Item 6: Other fees charged to franchisees, including royalty fees, advertising fees, transfer fees, and the like;
Item 7: The total estimated initial investment a franchisee can expect to incur (franchise/development fees, rent, utilities, insurance, equipment, training fees, etc.), including a table providing a low and high range of costs and estimated working capital needed;
Item 8: Any restrictions on where and from whom franchisees can obtain products and services (along with any ownership or financial relationship between franchisor and required suppliers);
Item 9: Franchisee’s principal obligations under the franchise agreement;
Item 10: Financing options available to franchisees, if applicable;
Item 11: The pre-opening and ongoing assistance franchisor agrees to provide to franchisees, including training programs, advertising, computer systems, etc.;
Item 12: The territory that franchisee will receive, including any geographical restrictions;
Item 13: Franchisee’s rights to use franchisor’s trademarks;
Item 14: Franchisee’s rights to use franchisor’s patents, copyrights, and other intellectual property/proprietary information;
Item 15: Franchisee’s obligation to participate in the actual operation of the franchised business (some franchises require a franchisee to work full-time on their franchise, while other franchise systems may be held as a passive investment);
Item 16: Restrictions on what franchisee may sell (for example, if the franchise is a fast-casual restaurant, the franchisor may only want you to sell its menu items—and not anything you create on your own);
Item 17: Renewal, termination, transfer, and dispute resolution involving the franchise;
Item 18: Disclosure of any public figures associated with the franchise system;
Item 19: Financial performance representations (franchisors are permitted, but not required, to provide information about franchisee earnings; if they do, it will be addressed in Item 19);
Item 20: Outlets and franchisee information disclosing the number of company-owned and franchised outlets in operation during the last three years;
Item 21: Financial statements showing the health of the franchisor (three years’ worth of balance sheets, statements of operations, cash flows, etc.);
Item 22: All contracts and agreements that a franchisee will be expected to sign—including the franchise agreement, development agreements, financing agreements, product supply agreements, guarantees, licensing agreements, and any other material specific to franchisees, to the extent applicable; and
Item 23: Receipts acting as proof that franchisor provided the FDD to the franchisee pursuant to applicable law.
It is important that prospective franchisees review the FDD with an experienced franchise attorney and/or accountant. Likewise, it is essential that franchisors work with a knowledgeable attorney to update their FDD and related material as necessary to remain in compliance with relevant regulations.