Understanding the Franchise Disclosure Document (FDD): Items 9-23 (featuring Elle Gerhards of Fox Rothschild)
Amanda: So, moving into we talked about, you know, we kind of mentioned it when we talked about litigation, you know, and all the other pieces. What am I responsible for as a franchisee? What is the franchisor responsible for? So, talk a little bit about Item 9. What are things that I should be aware? What’s required of me as a franchisee?
Elle: Yes. So, Item 9 is gonna be that chart that’s gonna tell you what the portions in the franchise agreement that are going to outline, what training is required of you, what payments you’re supposed to be making, the deadlines for a lot of things because there are deadlines for signing a lease, opening a location, getting up and running. And if you don’t meet those deadlines, and, you know, a lot of franchise systems would give you a little grace period, and they will work with you. I don’t wanna say I never, but I rarely deal with franchisors or franchisees where if both of the parties are working diligently to try to get the franchise open and running, that a franchise systems is, “Oh, no, no. You’re out.” But those are the types of things. You know, you wanna go to those provisions and the franchise agreement that are cross-referenced very easily for you so you can understand, you know, what your obligations as a franchisee are gonna be.
And then that also come into, you know, skipping a little bit about financing in the item. But the financing, I guess we’ve had a couple of talks about that. If the franchisor finances any portion of any fees, or anything that you need, you may not see it in the initial fees, but you may see it in, you know, equipment or initial inventory that you’re gonna have to purchase. All the terms are gonna be outlined there in the FDD. But really important is also Item 11. I think it’s probably one of the densest portions of the franchise disclosure document, but also really, really important for providing you with information that you need because it’s going to outline not, you know, the other sections outline what you’re responsible for as a franchisee. This section is gonna talk to you in the beginning about, “Okay. What is the franchisor going to provide for you before opening and then after opening?” And these are things like, you know, you’re gonna obviously get an operations manual and worrying. I don’t think I ever read any FDDs or represent any franchise clients where there’s not an operations manual. You’re gonna have an operations manual. Maybe a landing page on their website, you know, initial advertising materials that you can reprint, forms, maybe, you know, your email address, those sorts of things. You may get some, you know, the list of approved suppliers. And then you talk about the ongoing assistance that the franchisor can provide to you, and then the training.
And they’ll go into a long discussion in information and disclosures about the training that you’re going to get. And is there a continuing training? Is there ongoing training? Are there conventions you can attend? Are the trainers really well-versed in what they’re training you on? All of that stuff will be disclosed in Item 11 so you’ll be able to, again, if you don’t have experience particularly in an industry or in an area, and you’re comparing similar units in addition to comparing fees and all the other things, you’re gonna be able to see what type of support you’re gonna get at least on a contractual basis. When we talk a little bit later on about contacting franchisees and that sort of thing, we’ll talk about the, you know, whether in reality there is the support. And then it’s going to talk about a lot about advertising and your requirements in terms of, you know, your ad fund, if there is an ad fund, and how that’s operated. And, you know, do you have local marketing requirements? Do you have to have, spend 1% or 2% or certain dollar volume on local advertising in addition to an ad fund, and grand opening advertising? So, the one thing that I would say and that is becoming a very hot-button issue with respect to advertising, and marketing, and promotion is social media.
So, if, you know, look at how your franchise system that you’re looking to get into addresses social media, and see what you’re allowed to, do you know what the process is. So, you know, are you allowed to have your own social media accounts and post your own content about the franchise system? Do you have to get approval? Does the franchise system provide you stock photos that you’re supposed to use and stock information? Are you allowed to deviate from that? If so, under what circumstances? If not, you know, why and can you? And if you have a local advertising requirement, can you apply, especially when you’re service branding, you’re doing, you know, you’re worried about review websites and those sorts of things, you know, can you apply some of your cost that you use for social media towards your local advertising expenditures that are required? Those types of things that you wanna think about, because something that I hear a lot from both the franchisor and the franchisee. You know, I get calls from my franchisor clients all the time saying, you know, “We have our social media policy in place. You know, what standards? What should we be watching out for? What should we be doing?” Franchisors, for the most part, want their franchisees out there and advertising. They just wanna do so in a way that’s gonna protect the brand and the trademark. So, you know, you hope that there’s a middle ground with whatever franchise system you’re involving yourself with where you’re gonna able to market your business as long as you’re in compliance with their standards. You know, you often see issues sometimes when those requirements are too onerous, meaning you need approval in advance or you need to only use their stock images, where the franchisees tend to get a little more annoyed because this is so instantaneous, and social media works best when it’s personal.
So, I mean, I just sat through a webinar that was put on by Yelp, and they were like the stock pictures of the food or service is fine, but people relate more if you get this thumbs up sign of the manager in front of your location. So, those are the types of things, you know, you wanna look at with the FDD. And again, you know, we’re talking about disclosures but then, you know, seeing when you talk to franchisees that we’ll talk about when you’re doing due diligence if, you know, how that actually works in practice. And then, did you have anything?
Amanda: No. Lots of great information in that very, I wanna say a small section you said it was pretty hefty. And it sounds like you would want that to be pretty hefty, right?
Elle: Yes. Yes.
Amanda: Really the theme that I’m starting to notice here, there’s not a whole lot of stones left unturned, right? You should, through that FDD, have a pretty good idea of what you’re potentially getting to, and all these questions that might come up, and what you can and can’t do, and all those things.
Elle: Correct. And, I mean, listen, in practice you have…and a lot of the day-to-day activity is gonna come through the operations manual. Your legal contractual requirements, you know, fees, and compliance obligations, and all that stuff will be in the franchise agreement, and will be disclosed in the FDD. Again, there’s going to be a lot of, you know, day-to-day operational leeway that a franchisor is gonna have to be able to update their operations manual. But, you know, that’s more on the operations business side than it is so much on the legal. And I would say after Item 11, definitely the territory item is a big item that you wanna look closely at territory because a lot of times that is directly impacted. You know, the revenue that you’re gonna generate through your location or outlet is gonna be directly related to the territory that you’re granted. And so, you want to look and see, is that territory exclusive? Do I have a radius or a population, some sort of area where I have exclusive rights to operate my unit, or will I have competition from other outlets and locations?
You know, a big thing is, you know, do I have the opportunity to market my services from my location online? And if so, great, if not, or if there’s limitations on it, what are those limitations? You know, another thing that comes up is reserved venues. So, you may have a location that’s near a college campus or a shopping mall, or an airport, or any host of various types of specialty venues within your territory. Oftentimes, you know, the franchisor is gonna reserve the right to open, you know, a location within those reserved venues. So, sometimes you’ll see a franchisee negotiating a right of first refusal to say, “Hey. I understand that that college, or bus location, or, you know, fair grounds or whatever is a, you know, is I don’t have a right to that, but I would like a right to purchase the rights to open an outlet in there if you go into that region.” The other thing to look at is, you know, will my territory change if I renew my franchise agreement? Do they have the right to change the territory? Sometimes a franchisor quite reasonably will want the right to modify the territory based on big shifts in population, which happens.
Amanda: Especially over the course of an agreement, right? Like, 5, 10, 20 years…
Elle: Ten, 20 years.
Amanda: …things can make a big shift.
Elle: Yes, exactly. So, you know, you really wanna just look at the territory and what you’re getting with that. And the other, the final thing on territory to think about is usually, a franchisor will agree not to open another, let’s say you’re a yoga fitness concept, they’ll agree to not open another yoga fitness concept under that particular brand. But they don’t necessarily limit themselves from opening a yoga concept under a different trademark or brand, or maybe a CrossFit, or a bar, like all the various different. So, you have to understand that there’s the potential that, you know, you may have a competitor within your location or within your territory that just is operating under a, you know, a different brand. So, those are the things that you’ll talk about, you know, you’ll review and talk about with your lawyer so you understand sort of what you’re getting into when you purchase a location.
Amanda: Interesting. I learn something new every time I do one of these.
Elle: You know, well, the next couple of sections really have to do with intellectual property. We’re talking about trademarks, copyrights, and the IP of a franchise system is the crux of their assets, these intangible assets, you know, their methods of operation, their operations manual, their trademark, all these things. All their proprietary information is really, you know, what makes their brand. So, the one thing that you…if you’re dealing with an established system, you know, you’re buying a McDonalds, the rights to McDonalds, like, you’re not as concerned about this section. If you are purchasing an emerging or startup brand, then you wanna make sure that they have a federally registered trademark with the United States Patent and Trademark Office. Every once in a while, you’ll see an emerging system that does not have USPTO approval of their marks, which they, and they’re probably under application to, which is totally, you know, it’s normal if you’re a startup brand and you’re going through that process, and, you know, that’s not something in and of itself to be alarmed about. What you wanna make sure is to think about the fact that if they don’t get a USPTO federal mark, you know, down the line, then you may have to change the name under which you do business. And you may say, “All right. That’s not a big deal.” Well, it is a bid deal if you spend tens of thousands of dollars on signage, and, you know, your business cards and, yeah, [crosstalk 00:14:31] materials.
Amanda: Right, all the collateral, the shores, and all the things that go into that.
Elle: And so, keep that in mind when you’re looking on emerging systems is, you know, do they have that trademark, that federally registered trademark at least for the one brand that, you know, usually the big trademark that they operate business under. Item 19 is probably, if you’re a prospective franchisee and you’re flipping to any pages in the FDD, you’re probably going to Item 19, the Financial Performance Representations. I have probably done enough talks literally on just Financial Performance Representations. Look at them, and this is where a lawyer and a business advisor are going to come in really handy. If you do not have a large background in business, or finance, or whatever. You know, a franchise lawyer, or an advisor, or your CPA, or is gonna be able to break these apart for you and kind of tell you where there might be issues or questions. For our listeners who don’t know what a financial performance representation is, a franchisor has the opportunity to show how its franchise units and company-owned outlets are, their financial performance. So, they can show, you know, the gross revenue, the gross profits, the expenses of all of their franchisees or all of their company-owned outlets for the last year and usually it’s couple of years that they’ll show this information Now, there are literally pages, and pages, and pages of restrictions on how financial performance representations have to be disclosed.
You can’t just disclose your best-performing unit. And I do not wanna get into the weeds with this but there’s so many rules of how you’re supposed to disclose this information and present it so that it’s not misleading to a prospective franchisee. I would say if the franchise system that you’re looking to purchase has a financial performance representations, you know, read them, look through them, understand them, and then do your own when you’re doing your due diligence and you’re really plotting out getting ready, make sure your doing your own proformas, right? Make sure that you’re looking at, “Okay. This is what my lease cost are gonna be for the next five years.These are what my costs are likely to be. These are, you know, my expenses, you know, rent, utilities. I can look at these franchisees and see the average person has spent X amount on these various types of expenses, inventory, labor,” those sorts of things, and then use that information to sort of prepare your own, along with the other information you have, your own proforma so you can see, how you’re likely to do, not how likely but sort of getting an understanding of how you may perform.
You know, you can ask a franchise system, you know, “How much money am I gonna make? Am I gonna be profitable?” They’re not gonna answer that question. But the FPRs are really helpful in kind of gauging how you can do from a financial perspective. And then Item 20 is all your list of, you know, your franchise outlets and company-owned outlets, and how many have been sold, and how many have been transferred, and how many terminations there’s been over the past three years. If there’s been a, you know, high number of terminations or ceasing operations for other reasons, you know, ask why. And a lot of those times, there’s a legitimate reason for this, you know. Franchisees may be in the system for a long period of time, and, you know, the industry may change, the way of having to do business may change, franchisees may have to adapt, and some franchisees that have been in the system for a while may not want to adapt and may not wanna be in the system. Sometimes it’s not a great fit. So, there’s sometimes very good reason why there’s been changes. On the, flip side, if you’re an emerging system and you see that they have sold 40, they’ve previously been operating 6 units in 2017, and in 2018 they sold 40 units. Ask them and cross-reference it with Item 2, and ask them, you know, make sure they have the infrastructure in place to be able to support the opening of 40 new units. And hopefully down the line in three or four years, they’re all open and they’re all operating. But those are the types of things that, you know, you’re gonna look for.
And then, you know, finally, I wanna mention the financial statements. So, a franchise system is required to have audited financials. New franchise systems could phase in unaudited financials, but you’re going to have to have audited financials of the franchise system. And, you know, your franchise attorney will probably look at the footnotes and look at those, and make sure that there’s nothing that speaks to a precarious financial position of the franchisor, you know. And another thing, you know, when we go back to the regulatory scheme, you know, a franchisor is not required to register its franchise disclosure document, file it with any federal agency, or the FTC or anyone. You know, if there’s an issue, someone could file a complaint and they can investigate. But you don’t file and get it approved. States are different. There’s a number of states, pretty much the ones that you would think with, you know, the highly populous and in the more higher regulated states, California, Maryland, Virginia, New York, Illinois, Minnesota actually, Washington, number of states which go a step further than the FTC rule and require you to take the FDD and register it with the state. They review it and they approve it. If you have a franchise system that is potentially, you know, in a financially precarious position, then they may require what are called additional financial assurance requirements. This means that the regulating body in, let’s say, Maryland has decided that, “Ooh. We’re not sure that you could perform all your preopening obligations to the franchisees in Maryland. So, we’re gonna require you defer the collection of fees, or you escrow fees, or you post a bond, so, that way, if you, I don’t know, go bankrupt, skip town, you know, there’s some issue where you can’t fulfill your financial performance obligations, then the money is there or the money hasn’t been expanded to the franchisee and they’re not out.”
If you’re buying a franchise in one of these states where there’s a financial assurance requirement, then you might be in a good place. You could be buying a franchise in Pennsylvania, but there’s additional financial assurance requirements in those other states, and your lawyer, or counsel, or even you reviewing the FDD could say, “Ooh. Okay. Wait a minute. The State of Maryland, or the State of California thought critically enough of the financial position of this franchisor to put these additional requirements on them.” I should keep in the back of mind that there may be some potential, you know, issues there with their finances. And in other cases they’re completely fine and it’s just, you know, that’s just the nature of state regulator sometimes, but definitely think about that.
Amanda: So, even if you are purchasing in a state that’s not a registration state, so Pennsylvania as an example, you can still see what other states have kind of, what limitations or criteria they’ve put on that FDD for that particular franchisor.
Elle: Yeah. In most cases, you’re gonna have the full FDD, and it’s gonna have the exhibits. It’s gonna say, you know, they’re under an impound, or we have to defer our fee in those states, yeah.
Amanda: Okay. Good to know. And it can be a little scary if you’re looking at a state that’s not registered and say, “Well, who’s reviewing this? Who’s got my back in this situation?” But that’s good to know. Again, a good partner, a good attorney, a good business advisor, all those people are gonna be able to help you through that process.
Elle: Yeah. And page one of, well, the state cover page of your franchise disclosure document is gonna have the big, bold like all, you know, capped risk factors, and the state regulators have gotten together to try to make those state risk factors more uniform. But if there’s a state that, registration state that the franchisor is in that has required a franchisee to put on or the franchise system to put on a disclosure, a lot of times, their financial, like, “Our net worth is not,” all these various disclosures, you’re gonna be able to see them, and oftentimes, you know, it used to be in past years that you may have a FDD for Maryland, an FDD for California, and a FDD for other states. Any more now, the general rule of thumb is if a state regulator in one state thought an important enough of a risk factor or, you know, something else in the FDD to disclose, then you should be putting it into your FDD for all states. So, that’s the trend, and that’s what you’re, you know, technically supposed to be doing now.
Amanda: Good to know. Any other key… There’s a lot of information in the FDD by design. We want our consumers to be as informed as possible and make sure that it’s the right fit for everybody, and we talk a lot about questions to ask your franchisor, and it sounds like the FDD is really good at kind of informing those questions, right? You mentioned a couple of times, you know, “If you see X, Y, or Z, not necessarily that it’s a deal breaker, but ask the franchisor, right? When you get into those discovery days, or different conversations, never be afraid to ask the question if something doesn’t seem right or your attorney’s raised some red flag or say, “Hey. This might be something to be aware of,” ask the question. You never wanna go into something blind.
Elle: Yeah. And that’s what I say. You know, a lot of times, this is more of an educational exercise than it is anything else. And it really does help streamline and tailor down, tailor what you wanna be going back for to different. You may go to a discovery day and, you know, you can sit there and listen and learn. You come back. You have the call with the franchise attorney who says, you know, “Let’s walk through the FDD and franchise agreement in, you know, an hour and a half, two-hour, or two and a half hour period. And then here’s a list of, you know, 10 or 12 questions that you now wanna go back, that reviewing this with you has spurred.” So, go back and, you know, one-on-one ask the franchisor these questions. And it also helps with what questions you’re gonna ask franchisees because the franchise disclosure document is going to have a list of current franchisees and contact information and a list of former franchisees. You wanna call those, the people on that list, and not just the ones a wide cross range of franchisees, and talk to them about and ask them questions about how they. Now, understanding that some may be under certain confidentiality provisions and stuff like that, but for the most part, they’re a great source of information.
Amanda: Absolutely. And we talked about, I wanna say Item 11, all the information. I took very poor notes. I’ve been listening so intently. But, you know, all the things that are provided and are those things really true. It talks about like ongoing training and education. Is that something that’s in there, but what does really look like in practice as an example? So, and talking to franchisees is a big help for sure. I think we kind of… So, my next question was some of the warning signs to be aware of in the FDD, and I think we kind of covered them as we went through each one, but I’ll ask you if there’s any parting shots or anything that we didn’t really talk about as it relates to the FDD that you would wanna add, tack on here at the end?
Elle: You know, I don’t think there’s…I think we really did it. I feel like we’ve gone a little more detail than I had even expected into the FDD. But the one thing that I will say is you see a trend now in private equity within franchise systems, and so, if you do look in the FDD or in a franchise in the beginning, particular Item 1, and you see that there has been, that the system has been bought out through a private equity firm, or there is new, sort of transitioning towards that, maybe talk to your lawyer about what are the pros and cons of being in a system that’s owned either full or partially by an outside investment group, and talk to your lawyer about, like I said, the pros and cons, and what that means, and those sorts of things. And I’m trying to think, the only other thing I would say is make sure that your franchise counsel also reviewed the franchise agreement in detail as well as the FDD. Sometimes what you’ll see is something that’s disclosed in the FDD as an obligation of the franchisor, but it’s not actually in the franchise agreement. So, there may be a, you know, a limitation on fees that they’ll charge, or there may be a requirement that they provide, you know, onsite assistance this time in the FDD. But then you go to the franchise agreement, and it’s not in there. So, you just wanna get clarity and make sure because really you’re contractually bound by the terms of the franchise agreement.
Amanda: You’re signing the agreement. You’re not signing the disclosure document.
Elle: Exactly. So, I would say those are just maybe two, you know, final points that I would say with the FDD and the offering.
Amanda: Awesome. That’s a ton of great information. Like I said, I learn more every time we do one of these podcasts, but specifically about all the different items. And I think one of my biggest takeaways here from this is really the importance of a good partner, right? And we’re talking about franchise attorneys, and business advisors, and your financial people and all that are involved here. This is not something that most people, unless you’re kind of a serial entrepreneur, are buying franchises every day. So, it’s important that you’ve got a good solid sounding board people, who do this all the time, they know what they’re talking about. So, don’t underestimate the importance or the power of having somebody who’s been through this before. And we talked about, “Oh, my uncle Jim down the street is a criminal attorney or a criminal lawyer,” but, you know, finding somebody who is specific or who specializes in franchise law fore sure.
Elle: I would definitely say that because at the end of the day, you may be investing hundreds of thousands of dollars into a business. And really, you know, I think it would be penny wise, pound foolish not to maybe spend a couple thousand or less on an attorney or other advisor who can kind of walk you through this process so you know what you’re getting into.
Amanda: Absolutely. This is not a place I would say to cut costs for sure because it’s gonna definitely cost you in the long run. Hopefully, it doesn’t, but it could.