Prospective franchisees who are considering entering into a franchise agreement typically receive a plethora of documentation. One crucial document is the Franchise Disclosure Document (FDD). All franchisors must provide an FDD to prospective franchisees at least 14 days before the franchise agreement is signed or a non-refundable payment is made to the franchisor. But what exactly is an FDD, and what role does it play? More importantly, what key aspects should a prospective franchisee focus on when reviewing it?
What is an FDD and what role does it play?
The Franchise Disclosure Document (FDD) is a prescribed form outlined in the Franchising Code. Its purpose is to assist prospective franchisees in making informed decisions. Franchisors are responsible for creating and updating the FDD annually, except in limited circumstances. Additionally, franchisors must provide their current FDD to new franchisees, as well as to those renewing their franchise agreements or purchasing existing franchised businesses.
What are the dangers of not renewing an FDD?
Fail to review an FDD, you run the risk of missing vital information that could detrimentally impact your franchised business in years to come. If something in the FDD is unclear or raises questions, you should discuss that with your franchisor. Similarly, if you have engaged a lawyer to assist with your review (and we certainly recommend you do!), you should also raise those issues with your lawyer. It is important you understand all of the contents of the FDD before you sign any franchise agreement.
What should you look for in reviewing an FDD?
The FDD encompasses a wealth of information, and navigating through its contents can feel burdensome at times. While we encourage reviewing it in its entirety, there are certain key elements to look at when evaluating an FDD.
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Corporate structure
A franchisor must provide certain details about it and its corporate associates in the FDD. While it is not uncommon for several intertwined entities to operate the franchise, it is important you understand the role each plays. A complex corporate structure can also pose some risk to franchisees. For example, if valuable intellectual property used in the franchise system is owned by an entity other than the franchisor, you should make enquiries to ensure the franchisor’s right to use that intellectual property is safeguarded.
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Business experience
Here, the franchisor must provide details of their business experience, as well as that of each officer of the franchisor. Typically, the experience and qualifications of the CEO and other directors will be set out. This section of the FDD enables you to understand the people behind the brand, and to ensure they have the required skill and experience to support the franchise network.
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Litigation
A franchisor must disclose on the FDD any relevant litigation brought against it or its officers. Where litigation can often be a red flag, any entries in this section should be investigated. For example, if the FDD reveals the Franchisor was sued by a franchisee for breach of contract, you should ask for details as to how the case was resolved, and if there were ever any judicial findings against the franchisor.
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Intellectual Property
Intellectual property is at the heart of every franchise brand. In this section, you should check that all trade marks you will be using are properly registered. If intellectual property is owned by a third party, you should check there are proper arrangements in place to guarantee the franchisor’s ongoing right to use that intellectual property in the network.
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The size of the network and changes to the network
The FDD will outline the size of the network and any changes it has undergone. It provides details on the number of franchises operating in each state, as well as the number of transfers (sales), terminations, and non-renewals. A high rate of terminations might suggest that the franchisor is proactive in ending agreements rather than collaborating with franchisees. Similarly, a high rate of non-renewals could indicate that franchisees found their businesses unviable or chose not to continue within the network. A lack of growth, indicated by the absence of new franchisees, might indicate stagnation on the part of the franchisor and could raise concerns about the franchise’s viability. Any such trends should be thoroughly investigated.
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Exclusivity of Territories
It’s important you understand the level of exclusivity afforded by your franchisor. You may have an exclusive territory, no territory, or a combination of both. This part of the FDD will detail the extent to which any territory is exclusive, but also whether the franchisor themselves can compete with you in the territory, and if the franchisor has the right to change the territory.
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Costs and expenses
Item 14 of the FDD furnishes comprehensive details regarding the fees or expenses associated with operating a franchise. This information is vital for crafting business plans and cash flow projections. It’s important to meticulously review Item 14, flagging any irregularities or discrepancies in the figures provided. Additionally, conducting your own due diligence is essential to ensure a thorough understanding of your financial obligations.
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Unilateral variation rights
If a franchisor has or may change the terms of the franchise agreement, that must be disclosed in the FDD. Any positive response in this section warrants careful scrutiny. Changes such as alterations to territory boundaries or the introduction of new fees could raise concerns. Ideally, franchisees should prefer contracts that remain binding without the possibility of unilateral amendments after they are signed.
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What happens at the end of the franchise
While renewal may seem like a long time away, it is important you understand your renewal rights from the outset. This is particularly the case where you don’t have a right of renewal, but instead renewal is at the option of the franchisor.
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Earnings information
Earnings Information encompasses any documentation or data supplied by the Franchisor, facilitating the assessment of historical or prospective earnings of the franchised business. Many franchisors opt not to furnish earnings information. However, if provided, the franchisor must disclose specific details about the assumptions, research, and other factors underpinning the data. It’s crucial to thoroughly scrutinize earnings information. Consider engaging with your franchisor to gain insights into how the provided information pertains to your proposed business.
Conclusion
The above is not a comprehensive itemisation of everything in the FDD, but some key points that will be relevant to most franchisees. The FDD also contains information about master franchise relationships, marketing funds, and the supply of goods and services (amongst other things).
Keep in mind that you will be required to sign an FDD receipt before entering into a franchise agreement, acknowledging you have been provided with the FDD. This makes it even more important that you actually read the entire document.
If you are considering a franchise opportunity and require assistance reviewing the FDD, Magnolia Legal would love to help. Please contact us for an obligation free initial chat and fixed quote.