Most Important FDD Issues – Top 12 List
The FDD (Franchise Disclosure Document) can be well over 200 pages for most major companies. With all of that information, where should a prospective franchisee start? In this article, we will address the top 12 items to pay attention to within the FDD. You should read all of the documents and items contained within the FDD and retain counsel of an experienced franchise attorney or a certified public accountant to answer any questions that you have about any of the clauses contained within the FDD.
- Bankruptcy. In Item 3 of the FDD, the franchisor is required to disclose whether any of the officers, directors, managers, or the franchise company itself has filed bankruptcy within the last 10 years. They must disclose this information for the United States Bankruptcy as well as foreign country filings. It is imperative that you pay particular attention to this information. If the franchisor has filed bankruptcy, you need to dig a little deeper. Find out the surrounding information and reasoning for the bankruptcy. Many companies have legitimate reasons for filing a bankruptcy, but some do not. You do not want to be a victim to a “professional bankruptcier” who just accumulates a lot of wealth and then closes the company. You are looking to create a long term business relationship, so make sure the company is solid financially.
- Term of the Agreement. The term of the agreement will be located in Item 17(a) and within the Franchise Agreement itself. First of all, this goes for all of the clauses; make sure that the clause is consistent between the FDD and the Franchise Agreement. The most common term of the Agreement is 10 years. However, this can usually be negotiated for a longer term. If the franchise is a perfect fit for your business skills, it would be a smart decision to have your franchise attorney negotiate a longer term to ensure a longer period before the potential for higher royalties could set in. Remember that most Franchise Agreements will state that at the end of the term, you must sign the “then-current” Franchise Agreement to continue as a franchisee. After a decade it is understandable that costs and fees will have gone up, especially as the brand becomes more infamous.
- Non-Compete Clauses. The non-compete clause will be located within Item 17(q) and Item 17(r) of the FDD and within the Franchise Agreement. Since every Franchise Agreement is compiled differently, we cannot advise as to where it will be within the Agreement, but it most likely will be there somewhere. Non-compete clauses are standard protocol for a franchise. After all, you are licensing the right to use the franchisor’s confidential information, so of course they are going to want to protect it. Most franchisors’ non-compete clauses will impose the restriction on all of the executive board members or parties of the franchisee company and their management employees. The only item that is usually negotiable with this clause is the amount of time after terminating the franchise that the non-compete will be enforced for and the geographical area for the non-compete. Depending on the type of business, standard provisions will include two years and three to five miles from the franchised location. This is to try and protect the franchisee from stealing away current clientele after leaving the franchise. However, for some franchises the area could be much larger. Take for example, a construction company could be for a whole area of a state and still be considered reasonable by courts. Your franchise attorney can assist in giving you guidance as to what would be reasonable to negotiate for the type of franchise you are looking at purchasing.
- Hidden Costs. By hidden costs, I am referring to the costs other than the initial franchise fee and royalty fees. You will find these fees located in Item 6 & 7 in the FDD. Item 6 lists the “Other Fees” while Item 7 gives information on the “Estimated Initial Investment.” Some of the typical fees you will see listed here are lease fees, supplies, inventory, equipment, disposable equipment expenses, and advertising fees. The hidden costs could be contained in Item 9 “Franchisee’s Obligations” or in Item 17 titled “Renewal, Termination, Transfer and Dispute Resolution.” Some of the more common ones would be required upgrades to the trade dress or “overall look” of the franchise or even additional or ongoing training fees. Make sure you look for these potential fees throughout the FDD and the Franchise Agreement.
- Exclusive Territory. The protected territory that will be granted to you if there is one will be discussed in Item 12 of the FDD. This is one of the most negotiable areas of the contract. Make sure that your franchise attorney negotiates the largest possible protected territory for your franchise to ensure that you have an ongoing chance for profitability in the franchise.
- Franchisor’s Obligation to Assist You. This information will be in Item 11 of the FDD. This will probably be the largest Item in the FDD. Within this section, the franchisor must disclose the amount of training they will give you, before and after opening your franchise along with what other services they will provide. Federal law requires that the franchisor state that this is the only assistance they are required to provide. Therefore, if the franchisor is telling you that they will provide more help that what is in writing in this section, make them place that promise in writing. Of course, that advice is actually true for all of the Items disclosed in the FDD; get all promises in writing. You can also negotiate on such items as location or site assistance and the amount of time the franchisor has to approve your proposed site for the franchise.
- Training. This is another area that can be negotiated to some degree by an experienced franchise attorney. Also contained within Item 11, the actual training program is typically set; but other training times can usually be negotiated. Be extremely cognizant of what training you will receive. Remember that this is the franchisor’s business. You need to ensure that they are giving you enough pre-opening training to start successfully, and enough post-opening training to continue running smoothly in the black.
- Franchisor’s Right to Terminate the Agreement. Contained within Item 17 of the FDD you will find a table that reflects how and when the franchisor can terminate your franchise agreement. It is extremely important that you read this section carefully. This is when you could lose your business because of your actions or inactions. Typically you will see that the franchisor can terminate you for “cause.” Then in Item 17(h) will be a laundry list of items that the “cause” cannot be cured. In other words, if these events happen, you are going to be automatically terminated as a franchisee and you will have to close the business. Some of the usual items contained within Item 17(h) are if you file bankruptcy, have an unsatisfied judgment for 90 days; have a levy on a substantial portion of real or personal property; abandonment; trademark misuse; unapproved transfers; conviction of a felony; or two or more repeated curable defaults within a 12 month period, even if cured.Also contained in Item 17 under section (g) will list “causes” that can be cured. This means that if you rectify the situation within the allotted time, usually 30 to 90 days, you will not be terminated. Some of the items typical to Item 17(g) include: Sanitation problems, cessation of business; noncompliance with provisions of the Franchise Agreement and/or Operations Manuals; violation of public health laws; non-payment of fees; non-submission of reports; violation of law by you; breach of any material covenant of any of the agreements; default under the lease; attempted assignment in violation of the Franchise Agreement or any other defaults listed in Franchise Agreement.
- Restrictions on Products and Services. This information will fall under Item 8 of the FDD and will also be in your Franchise Agreement. This section tells you exactly what the franchisor has control over, or requires approval before you can go forward with a lease/purchase. You can see all types of information in this section; however, commonly location, equipment, supplies, records and bookkeeping, specifications and standards, signage, and materials are all on the list. The franchisor must disclose whether or not they receive any kickbacks or rebates from the vendors based upon your sales. They also must disclose if they negotiate purchase arrangements for all franchisees with various suppliers for the mutual benefit of all franchisees, which include price terms.
- Cancelled and Transferred Franchisees. At the end of all the required tables in Item 20 of the FDD, (or perhaps on an exhibit attached to the FDD) you will find a listing of all of the cancelled and terminated franchisees. This list can be worth its time in gold. I would recommend that you call these franchisees first and find out why they were cancelled or terminated. It could be solely their lack of solid business choices, or it could be that there is not enough profit in the business for it to stay growing. A mountain of information can be obtained from ex-franchisees. Remember to take what they say and try to look at it objectively. Of course they are going to have bad news; they failed. But you can avoid their bad luck by being prepared and not making the same mistakes they did in the business. Use their information, and turn it into your better business plan.
- Litigation. Of course all of the items listed on this Top 12 are important, but this one is definitely worth some investigation as well. Item 3 of the FDD, must list all of the litigation that the franchisor has been in within the last 10 years. The franchisor should also have listed when the litigation occurred, who originally filed the litigation, them or the franchisee, and what the outcome of the case was.
- Renewal and Transfer Rights. Back by popular demand is Item 17. There are several sections within Item 17 that deal with renewal and transfer, specifically Item 17(b), (c), (I), (k), (l), and (m). These sections deal with the time frame for your renewal, and what you have to do or accomplish to be eligible for renewal. In the transfer arena there are many items to watch out for, such as: a requirement that you will remain liable even after the transfer; the franchisor’s ability to reject the transfer; an extended amount of approval time for the transfer; or an unreasonable definition of the word “transfer” such as a change in ownership of anything over five percent. An experienced franchise attorney will ensure that you have the franchisor’s approval rights be tied to reasonable objective standards.
Most important tip of all, a tip 13 if you will, is read all of the documents and items contained within the FDD and retain counsel of an experienced franchise attorney. Then ask questions. Find out answer to any and all questions that you have about any of the clauses contained within the FDD or the Franchise Agreements.
Lynne Shelton, Esq., is a Senior Partner over the Franchisor division at Shelton & Power, LLC, a Franchise and Intellectual Property Law Firm; a Certified Franchise Executive; and has been involved in the franchising industry for over 20 years.