Buy a Franchise

Important note: The FDD and the franchise agreement, both important legal documents in franchising, are often mistakenly used interchangeably. The FDD discloses information but does not create a legal obligation. The franchise agreement is a binding legal contract that is signed by both the franchisor and franchisee. It is an agreement to do something (open and operate a franchise) and creates legal obligations. The franchise agreement controls the relationship between the franchisor and franchisee for the term of the franchise.

Item 1: The Franchisor and any Parents, Predecessors and Affiliates
Item 1 provides information about the franchisor and its affiliates, and about the business and any specific laws or regulations for the franchised business.

What to look for: Are there any laws or regulations specific to the franchised business’ industry?

Item 2: Business Experience
Item 2 lists all directors and officers of the franchisor and anyone that has “management responsibility” in the operation or sale of the franchised business. Each of the people listed is required to provide their employment history for the last five years.

What to look for: Does management have adequate experience to lead a successful franchise system? And does the franchisor have adequate staff to support the franchisees?

Item 3: Litigation
Item 3 provides information about certain lawsuits or state orders of the franchisor, its affiliates and anyone listed in Item 2.

What to look for: Has the franchisor or its officers been in litigation or arbitration? Does the franchisor have a history of suing its franchisees?

Item 4: Bankruptcy
Item 4 provides information about any bankruptcies of the franchisor, its affiliates and anyone listed in Item 2. Item 4 includes both personal and business bankruptcies during the last 10 years.

What to look for: Has the franchisor or its officers had any bankruptcies? (Pro tip: some states like Minnesota require bankruptcies to be disclosed for an extra five years. You might find more bankruptcies or other useful information in the state addenda pages in the exhibits.)

Item 5: Initial Fees
Item 5 lists all fees that are paid to the franchisor or its affiliates before the franchised business is open. These generally include initial franchise fees, any territory fees, training fees, software fees and fees for inventory purchases. Item 5 only lists fees paid to the franchisor or its affiliates. Item 7 and Item 8 will list fees paid to third parties.

What to look for: Which fees are paid to the franchisor or its affiliates? Is there an unreasonable markup? Are any of the fees refundable? How do these fees compare to the competition?

Item 6: Other Fees
Item 6 lists all fees that are paid to the franchisor or its affiliates after the franchised business is open. Item 6 fees include royalties, national marketing fees, renewal fees and transfer fees. Certain fees may be included in both Item 5 and Item 6 (for example, if you have to pay for software before the franchised business is open and continue to pay for the software after the franchised business is open, this fee would be listed in both Items).

What to look for: Is the franchise “fee heavy”? Will there be enough money left after all the fees are paid?

Item 7: Estimated Initial Investment
Item 7 provides information on the estimated costs to purchase and open the franchised business. Item 7 contains a table that lists categories of expenses. These expenses typically include fees paid to franchisor (Item 5 fees) and fees paid to third parties (lease payments, equipment and inventory). Franchisors are also required to include one line item describing the costs for the initial period (usually the first three months after opening). Franchisors usually have only one FDD for all 50 states, so Item 7 will have a low and high estimate for each category.

What to look for: Is the initial investment reasonable? Will your investment be more toward the “low” or “high” estimate? Are any of the estimates overly optimistic?

Item 8: Restrictions on Sources of Products and Services
Item 8 provides information on what products and services a franchisee must purchase from approved suppliers. An “approved supplier” means any supplier that the franchisee is permitted to use. Most franchisors also have approved suppliers that the franchisees are required to use (this is also described in Item 8). Item 8 also provides information on whether the franchisor or its affiliates are approved suppliers and if so, what revenue the franchisor receives from the sale of products or services to the franchisees. In addition, Item 8 lists whether the franchisor receives any rebates from approved suppliers (for example, the franchisor may receive $.05 per gallon of cola syrup purchased by franchisees). Item 8 also explains the process for approving new suppliers of products or services (if the franchisee wants to use a different supplier).

What to look for: Are the franchisor or its affiliates the only approved suppliers of any products or services? Does the franchisor keep rebates from suppliers? What percentage of the franchisor’s revenue is from sales of products or services to franchisees?

Item 9: Franchisee’s Obligations
Item 9 contains a table that lists 25 categories of franchisee’s obligations (including training, fees, trademarks, insurance, advertising and renewal) and where these obligations are discussed in the FDD and in the franchise agreement.

Item 10: Financing
Item 10 provides information on any financing that the franchisor may offer or arrange for potential buyers related to the franchised business. For example, some franchisors allow potential buyers to pay the initial franchise fee over the first 6 months instead of all at once. This is considered financing. Other franchisors arrange for lenders to offer certain lending to their potential buyers. If the franchisor does provide or arrange for financing, Item 10 lists this in detail and also describes the terms of the financing, including interest rate, payments and qualifications.

What to look for: Does the franchisor provide financing? If it does, how do the terms compare with market rates?

Item 11: Assistance, Advertising, Computer Systems, and Training
Item 11 is the largest Item in the FDD and covers a lot of information. It lists the franchisor’s obligations to the franchisee before the franchised business is open (i.e. site selection assistance and training) and during the operation of the franchised business (i.e. ongoing support and assistance). Item 11 also describes how long it will take to open the franchised business and has a detailed table describing the initial training program. It also discusses a franchisee’s advertising obligations, including any national advertising/brand fund, and describes the computer system and software that the franchised business uses.

What to look for: What are the franchisor’s pre-opening and continuing obligations? Is the franchisor’s initial training program adequate? Does the franchisor have a robust operations manual? What are your advertising obligations?

Item 12: Territory
Item 12 describes whether the franchised business will have a protected territory and whether it will be “exclusive.” Generally, a protected or exclusive territory gives the franchisee varied types of protection against having the franchisor open another franchised business within this area. If a protected territory is granted, Item 12 usually provides a formula to determine the size of the territory (it can be a radius or a certain population). Item 12 also describes what rights a franchisor reserves (such as the ability to sell products over the Internet).

What to look for: What size territory will you get? Is the territory exclusive? Do you have to maintain a sales quota to keep your territory?

Item 13: Trademarks
Item 13 contains information about the trademarks used for the franchised business. This Item lists the status of the main trademarks used in the franchised business and whether these marks have been registered with the United States Patent and Trademark Office. Item 13 also provides information about any known problems that the franchisor may have with its trademarks (such as an unauthorized use).

What to look for: Does the franchisor own the trademarks? Are all principal trademarks registered? Will the franchisor reimburse you if you are required to change trademarks?

Item 14: Patents, Copyrights, and Proprietary Information
Item 14 contains information about any patents, copyrights and other proprietary information for the franchised business.

What to look for: Does the franchisor own any patents or copyrights?

Item 15: Obligation to Participate in the Actual Operation of the Franchise Business
Item 15 provides information on the franchisee’s required involvement in the business. It describes whether the franchised business is an “owner operator” business or whether a franchisee can hire a manager to run the day-to-day operations of the franchised business.

What to look for: Do you have to personally participate in the business? Can you have a manager? Are you required to give your manager equity in the franchisee entity?

Item 16: Restrictions on What the Franchisee May Sell
Item 16 provides information on what products or services that franchised business will be required and/or permitted to sell. It discusses whether the franchisor can require the franchised business to offer new products or services. Generally, Item 16 will state that a franchised business must offer all products and services that the franchisor requires and that these products or services may change over time.

What to look for: What control does the franchisor have over the goods and services offered by the franchisee? Are there any limitations on the franchisors’ ability to change these goods or services? Can the franchisor set minimum and maximum prices for the products or services?

Item 17: Renewal, Termination, Transfer, and Dispute Resolution
Item 17 contains a table that lists 23 categories of the franchise relationship (including the term, renewal rights, transfer conditions, termination and non-compete information) and where these obligations are discussed in the franchise agreement.

What to look for: Is the term long enough to recoup your investment? What renewal options do you have? How burdensome is the non-compete?

Item 18: Public Figures
Item 18 lists any celebrities or other public figures that will endorse the franchise opportunity. If Michael Jordan was hired to do commercials about how great the franchise opportunity is, he would be listed in Item 18.

What to look for: Item 18 disclosures are rare. If there is a public figure or celebrity involved, does it fit the brand image?

Item 19: Financial Performance Representations
Item 19 is all about the money. This is usually the Item that potential buyers look at first. Item 19 is optional and contains financial information about the performance of franchised businesses. It usually presents a historical look at how existing franchised businesses and franchisor owned businesses have performed. There are certain required elements, but franchisors have some flexibility in the type of information they disclose. Many franchisors choose to only disclose gross sales for simplicity, but others may provide expenses and profit figures.

What to look for: Does the franchisor make a financial performance representation? If so, are all of the franchises profitable? If not, why? If the franchisor has provided information on corporate stores, do they pay the same fees and incur the same expenses that you are required to pay?

Item 20: Outlets and Franchisee Information
Item 20 contains five separate tables summarizing outlet status and history of the franchisee locations and franchisor-owned locations for the last three years. These charts show information like whether there has been an increase or decrease in the numbers of franchisee and franchisor-owned locations, and how many terminations or transfers have occurred. The Item 20 charts give historical details about the franchised system, as well as projections of growth over the next fiscal year. Item 20 also contains a complete list of all current franchisees as well as any former franchisees (from the last fiscal year).

What to look for: How big is the franchise system? How much growth has the franchise system experienced? Are there a lot of terminations/closures? Are there large numbers of non-renewals, potentially suggesting franchisees are dissatisfied?

Item 21: Financial Statements
Item 21 contains the audited financial statements of the franchisor legal entity for the last three years (if the franchisor has not been in business for three years, it will only show either an opening balance sheet or the last 1 or 2 years of audits). A franchisor may be able to use an unaudited balance sheet for its first year. Many people confuse the Item 21 financial statements with the Item 19 financial performance representations. Item 19 is optional and describes the financial performance of the franchisee locations and/or franchisor-owned locations (the actual operating businesses). Item 21 is not optional, and it is the audited financial statements of the franchisor entity – a document prepared by auditors and attached as an exhibit to the FDD.

What to look for: Does the franchisor have adequate financial resources to run the franchise system? If there are notes to the financial statements, are there inconsistencies between the notes and the FDD? Does the Franchisor have a “going concern” in their audit?

Item 22: Contracts
Item 22 will list each contract that a franchisee is required to sign to purchase and operate the franchised business. Each contract will also be included as an exhibit. The franchise agreement will be included here. Other contracts may include a transfer agreement, a personal guaranty and a lease addendum.

What to look for: Is there a personal guaranty? Are there contracts you have to sign in addition to the franchise agreement?

Item 23: Receipts
Item 23 contains two receipt pages that document when the franchisee received the FDD. The franchisee and franchisor each keep a copy.

What to look for: Does the franchisor provide a full 14-day period to review the FDD before signing the franchise agreement or paying any money to the franchisor?