Franchise Your Business

Before you offer a franchise to any potential buyer, you will need an FDD, the “disclosure document.”   You are required to give each potential buyer your FDD before you make the sale.

The United States has a complicated patchwork of state and federal franchise laws, the basic purpose of these laws is to protect the person buying a franchise.  So, these laws are very detailed about the type of information that your FDD needs to include.

The FDD contains 23 “Items” and exhibits.  Whether you are selling hamburgers or dog grooming, each FDD will contain the same 23 Items.   The FDD is usually between 200 and 300 pages and includes the franchise agreement.   The FDD describes how the business works, and operates both as a legal document and as one of your sales and marketing tools.  The franchise agreement is an exhibit to the FDD and is the actual contract that you and the franchisee will sign, agreeing to the specific legal obligations.  The FDD was previously known as the Uniform Franchise Offering Circular (UFOC) (the FDD was born in 2007).

Here is a summary of the 23 Items in an FDD:

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.

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 list their employment history for the last five years.

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

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.

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, 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.

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).

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.  Most potential buyers focus their attention on these items that have all of the expense amounts:  Items 5, 6 and 7, and Item 19 (listed below).

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 described in Item 8 too.  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.  It also 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).

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.

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 programs. 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.

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).

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).

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

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.

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 or not 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.

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.  Most potential buyers don’t spend much time reviewing the charts in Item 9 and Item 17.

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

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.   If you do decide to make an Item 19 disclosure, there are certain required elements, but you do have some flexibility in the type of information you want to disclose.  For example, you can include calculations on gross sales, average ticket price or the net profit of each franchised business.   This is your chance to tell the story of the successes of your franchised business.

Item 20: Outlets and Franchisee Information
Item 20 contains five separate tables summarizing the location 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.   Item 20 also contains a complete list of all current franchisees as well as any former franchisees (from the last fiscal year).

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.

Item 22: Contracts
Item 22 will list each contract that a franchise 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.

Item 23: Receipts
Item 23 contains 2 receipt pages that document when the franchisee received the FDD.  The franchisee and franchisor each keep a copy.