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Understanding the Franchise Disclosure Document (FDD): Items 1-8

Understanding the Franchise Disclosure Document (FDD): Items 1-8 (featuring Elle Gerhards of Fox Rothschild)

Transcription:

Amanda: All right, let’s dive into the…and when I say dive, I literally mean it because it’s how many pages, typically? And there’s so much information. But so before we dive into, kind of, all the different items, overall, what should I know about a franchise disclosure document in a nutshell?

Elle: In a nutshell?

Amanda: I know, we could do 100 podcasts on this.

Elle: Yeah, I’ve done many, many webinars on these, but…so not to get too into the weeds, but I think it’s helpful to have, you know, two minutes of background as to what an FDD is and why we have it because there’s a lot of confusion and a lot of understandable confusion once you’re dropped a couple of hundred-page document in front of you.

So, back in the ’50s, ’60s, you know, early ’70s, you had franchise systems who would, you know, make huge promises. Fly-by-night sort of franchise systems that would come in and promise, you know, customers, “Hey, you give me $20,000, $30,000, and I’m going to give you a turnkey business.” And what would happen, you know, you’d be out your $25,000, $30,000, they would disappear into the night. So it really became an issue. And so people didn’t understand what they were getting into, there was no…you know, people were giving away life savings and, you know, turning out with nothing. So California was the first state, not surprisingly, the public of California. And the FTC on the federal level followed suit with enactment of legislation that required a franchise disclosure document be handed out to every prospective franchisee during the offer and sale process of a franchise.

So a franchise disclosure document is really nothing more than a consumer protection mechanism that’s meant to tell a franchisee, “Here is everything you need to know…” not everything but, “pretty much everything we think is material for you that you need to know about this franchise system.” So, things like, you know… And it’s supposed to be in plain English, I want to add that too. So, when you see a franchise disclosure document and then you see the franchise agreements and all the other agreements attached to it in the financial statement, that whole thing is the franchise disclosure document and really, it’s a consumer protection mechanism to allow you the opportunity to say, “Okay, this is what I know. This is who leads the franchise. This is… You know, this is all the information I’m gonna need to know about the costs, and the fees, and my responsibilities, and my obligations.” And it’s all in plain English so that if I want to thumb through it and read it, I’m not, you know, completely overwhelmed by, you know, legal terms. That’s not the contract between you and the franchisor. That’s the franchise agreement, or license agreement, and all the other contracts that are exhibits to the FDD. So the FDD is really, should be an easy way for you to sort of understand what the franchise is all about and the franchise system is all about.

You know, it also is very, very highly…or very structured. So, you know, everything that you have to disclose, it doesn’t matter, you know, if you’re a home health care system, or if you’re a Taco Bell, or a Dunkin’, or, you know, a junk removal service, you’re gonna have to disclose the same types of information in the same format. You know, it’s very regimented. So when you’re out there and you’re comparing different franchise offerings, you’re able to do that, take FDDs and say, “Okay, I can go to item five and see what my initial fees are and what the training fees are gonna be. And I can go to item 12 and look at the territory and see what I’m getting.” So, really, it’s a great opportunity and a great way for you to find out about the franchise offering. Does that make sense?

Amanda: Awesome. Yeah, it makes perfect sense. And the structure sounds like if, you know, you are comparing one against the other it makes a lot easier, really, apples to apples, right, because everything is structured so similarly. Awesome. So let’s dive in. I know there’s 23 items?

Elle: Correct.

Amanda: Okay. We won’t go through all 23 if you’re listening and you’re like, “Oh my goodness, I can’t listen to this for 23 items.” But we are gonna call out some of the more, I don’t wanna say more important ones because they’re all there for a reason and they’re all important, but things to be aware of. So we’ll leave it up to your your expert opinion which ones you want to make our audience and listeners aware of and which ones may be lesser so.

Elle: Great. So, when you say that you reminded me of a disclaimer that our general counsel at Fox Rothschild told me I should probably say, and I did not, in the beginning of the program which is that, you know, this is general legal information. I’m not giving legal advice, and anything that I say now is as of the date of, you know, us recording the podcast and it may change, you know, depending on changes in regulations, or laws, or, you know, what have you. So just let me put that out there.

So as you work through an FDD, and I typically, when I represent someone who’s purchasing a franchise or area development rights, what I do is I get the FDD and the franchise agreement and all the documents and I go through them. And it may take me a couple of hours and I go through it all. And then I set up what typically at a minimum is an hour and a half and typically into the two, two-and-a-half-hour range, and we walk through it all. And, you know, I point out, you know, things that may…you know, I point out all the things that I think a franchisee would want to know, questions that they may want to ask the franchisor, questions I have about the system, that sort of thing. And so an FDD, you know, once you go through it, it is something that if you have legal counsel, you’ll go through it with them.

And when I’m talking to them, and one of the things I look for in a franchise under item two is the people who are managing and operating the franchise system. So in item two, a franchisor is required to list and describe the bio of anybody who has management or oversight responsibility for franchisees. So if you’re looking at an established brand, you know, hopefully, this is a very fulsome section. If you’re looking at more of a growing brand, the things that you want to watch out for is making sure, you know, that there’s ample personnel within the system that are going to be able to be there for, you know, training, support, operations, and oversight. You want to look out for, if there’s been any, even on established brands, you know, a transition in leadership. Is it, you know, steady? Has there been, you know, a turnover? If it’s a brand that’s changing, those types of things, you want to make sure that there is management in place. If you’re a…you know, I have educational franchise systems that have a chief education officer, someone there who’s in charge of those types of things. So you want to make sure that the key persons that are enlisted in that are there to be able to…that are gonna be able to provide the oversight and support and that they’re basically, showing that the franchise system is properly run.

Amanda: And that you got the…well, you’re getting all the support that you’re gonna need.

Elle: Exactly. And then you run into item three, Litigation and item four, Bankruptcy. A franchise system is required to disclose certain types of litigation and their bankruptcies. And this litigation is really litigation, it’s not slip-and-falls. It’s not, you know, sexual-harassment lawsuits. It’s really litigation that goes to the heart of the franchise relationship. Litigation between franchisees and franchisors. And so you’re gonna look at that, and you know what? We live in a litigious society. So, you know, if a brand’s been around for a while, there’s probably gonna be some litigation. What you want to look for is, you know, a large amount of litigation and also litigation where there’s serious accusations from the franchisee against the franchisor and, you know, maybe from multiple different franchisees, or you see a pattern of potential issues. You know, franchisees are going to default. You know, there’s always gonna be some bad eggs there and a franchisor is gonna have to go after them, but, you know, that’s not the litigation, you know, that you have to watch out for. You just, you look for the other types of litigation that may show perhaps, you know, a disconnect or some issues between a franchisor and its franchisees, because really, at the end of the day, you want to make sure that the franchise system that you’re purchasing into and that you’re buying a franchise from, you know, has a good relationship with its franchisees. So that’s really important.

Amanda: So when you say, you know, things to be aware of, a large amount of litigation. So I know that varies, I’m sure, so much from, you know, varying on the size of the brands and all the things that are involved. When you say a large amount, what does that mean? What’s a reasonable amount of litigation that you can say, “Oh, well, this is just kind of normal,” versus something to be aware of?

Elle: I would say, you know what? I, maybe should’ve been more clear with that. I wouldn’t say… I would worry more about the claims in the litigation than the amount. So if you see a number of litigation where the franchisor is perhaps going after franchisees for nonperformance issues, a couple of those, they’re not particularly as worrisome as lawsuits where franchisees are accusing the franchisor of misrepresenting, you know, certain offerings, or not fulfilling its obligations under franchise agreements. Or, you know, accusations I would say about the franchise system that may, you know, give you pause about whether they’re gonna be able to, you know, fulfill their obligations to support and assist you.

Amanda: Right, that’s more clear.

Elle: Thanks.

Amanda: That’s okay.

Elle: Yeah, I would say in any type of, you know… The larger the system, sometimes, perhaps the more litigation you would see. But, you know, there is a shift also towards mediating disputes and mediation, unlike arbitration, does not have to be disclosed in the FDD. So once it’s in the FDD, you know, that means that…and you can look and you can see if the franchise agreement, you know, at least for this time requires mediation, you know, you can understand if a lawsuit has gotten towards, you know, litigation then the mediation process hasn’t worked or else there’s some, you know, serious…

Amanda: Something…

Elle: …something such as like misuse…

Amanda: …bigger at hand.

Elle: …of the confidential information you’re not mediating.

Amanda: Yeah.

Elle: But those things come up.

Amanda: All right, so what are some other things as we work our way through the FDD?

Elle: Okay, so item five, you know, everybody goes to that, it’s the most important. One of the most important parts to a prospective franchisee is the initial franchise fees, right? What are you gonna hand out upfront? And that could seem, you know, really self-explanatory and it’s, “Okay, this is what I’m gonna need to pay.” But the one thing that you wanna think about and look at when you’re looking at initial fees is, are any of them refundable? So, you know, in a lot of cases, once you hand over the initial franchise fee, you know, it’s not refundable under any circumstances. You know, once you…if you can’t find a location, if you don’t pass training, you know, that money, say goodbye, it’s gone.

There are some franchise systems out there that will refund a portion of your franchise fees if you don’t satisfactorily complete initial training, or let’s say you can’t find a suitable location that both you and the franchisor agree to operate the location. They will typically keep, you know, maybe half or more of the fees, and that’s with good reason because they, you know, put the time and expense into vetting you. You know, in some cases, you know, going out to multiple different locations, providing you assistance, trying to find you locations. So it makes sense that they’re going to, you know, retain a portion of those fees. But a question that, you know, I tell you to look at it now because I’ve dealt with enough franchisees who have said, you know, “We can’t agree on a location. I don’t want to move forward. You know, can I get any of my $25,000 or $40,000 back?” So that’s something to look at when you’re looking at item five is, are these completely, you know, fully nonrefundable or would you get a portion of them back?

Amanda: What do you find typically, I mean, as far as being refundable? Are certain fees usually refundable or is it, kind of, I guess it’s gonna vary a lot but do you see any kind of trends in that?

Elle: You know, it depends on the type of franchise system. So, where a franchise may have to…you know, it depends on the type of franchise system. If it’s… You know, if they’re looking for, you know, the location in terms of finding a lease location is extremely important, you’re gonna have a brick-and-mortar location, and you can’t agree on one, then in those cases, a lot of times you may see a refund of initial fee in those regards, same with the training. And I would say it’s more often than not that the franchise fees are not refundable but, you know, it really does depend on, you know, the type of franchise that you’re…you know, type of industry you’re looking to get into.

Amanda: All right, good to know.

Elle: Item six is your ongoing fees. So I think you talked in past podcasts about this, but in addition to, you know, the initial fee, you’re gonna pay your ongoing royalties. But there’s also going to be other fees, like your ad fund fees, potentially, technology fees. There are very few franchise systems now that I see coming up that either, that don’t charge a technology fee or else reserve the right to charge a technology fee. Because, I mean, websites, online presence, computer system, development even, I mean, all the various technology that you may use, web-based platforms, all those various things. I think the study that I just recently read is that more franchise systems than not will charge a technology fee or reserve the right to. So, sometimes that could be, you know, a couple of hundred dollars or more per month. Other types of fees that may come up, there’s plenty of other fees that they may…customer service, you know, sort of, mystery service fees, there’s mystery shopper fees, all those various types of fees, you want to look at those. And you also want to pay attention to the franchisor’s right to increase those fees. So in item six, it’ll tell you, you know, is there a limit to how much that they’re gonna charge you or is it, you know, is it not going to…could it, you know, be…could they charge whatever they want to down the line? And do they reserve those rights? So, you know, pay attention to the various fees that are there and, you know, whether there is any limit to how high they can go.

Amanda: Do you find that they’re typically percentages or are they’re, kind of, flat fees regardless of revenues? Because I know, like, royalty is typically a percentage of revenue, but what do you find with some of the other fees?

Elle: I would find things like your ad fund fees and your royalties are typically revenue-based. Things like your technology fees, you know, a transfer fee, a renewal fee, you know, a mystery shopper fee, those types of things are usually a flat fixed amount. So that’s what I typically see. Because, you know, you should be paying higher amounts on royalties in your ad fund depending on how your business is doing in terms of generating revenue, but, you know, in technology fees and those various types of fees, it’s usually more just flat fee based. But again, they reserve the right to increase them.

Amanda: Right. So my other question, kind of, about the fees, because it could start to feel maybe a little nickel and dimey because we’re talking about, you know, the ad fees, and technology fees, and all this. So at what point is it…? Where is, kind of, the line between normal fees and then where it might start to get a little concerning with some of these things?

Elle: Sure. So, you know, I get that a lot with either my franchise systems where, you know, especially emerging and growing franchise systems where they say, you know, “We’re just incurring, you know, so much out of cost, you know, expenses on this. So, you know, let’s tack on a fee for this and we’re gonna charge the franchisee for this.” And I say the same thing to my franchise system clients. I say, “You don’t want to give the impression that you’re nickel and diming, you know, your franchisees.” And that’s certainly the case in some franchise systems. But I would say, you know, if you’re seeing a lot of additional fees in addition to, you know… Let me back up for a minute. What I would recommend is looking at the fees and seeing if they provide added value to how you’re gonna operate your franchise location. So if you’re getting charged for fees but, you know, it’s for software, or it’s for technology, or it’s for additional training, or it’s for conferences that are really gonna help you operate your unit, great. You know…

Amanda: Right, you’re getting something for it.

Elle: You’re getting something in return for it. If you’re seeing a lot of fees getting tacked on for really, pass-through costs that should be the franchise system’s, you know, just cost of doing business, then, you know, then I would look with a more critical eye on those systems. So, I guess in a nutshell, if you think you’re getting, and this is something to talk to your attorney about, if you think you’re getting something of value out of it, then it’s probably worthwhile. If you think it’s just a, “Well, you know, they’re just trying to find ways to cut their, you know, overhead and expenses,” then that’s when you kinda, you know, look at it a little more closely.

Amanda: Yeah. Do you find, and I guess it kind of goes back to the conversation between an established brand versus a more emerging brand, but negotiation on those fees, do you find they’re pretty set in stone? Or at this point, like in the FDD, can you go back and say, “Hey, well, I feel like this is just a pass-through expense to me.” What’s that conversation look like? Is it even a conversation or are they kind of locked in stone?

Elle: Sure, so…

Amanda: And I may be asking you all the questions you can’t answer because it might be advice, but just let me know if I…

Elle: No, no, it’s okay. So I’m talking, you know, generally on some experiences. So, listen, if you’re buying an established brand, there is virtually no negotiation of…

Amanda: It is what it is.

Elle: …the franchise terms, you know, at all. If you are very highly capitalized, you’re coming in to purchase a large number of units, you know, with a lot of capital, then you may have some leverage in negotiating power there because you’re really, you know, you’re a highly sought after franchise system.

Amanda: Right, you’re bringing something to the table.

Elle: Yeah, yeah. Let’s say you have a history of, you know, operating a 150 McDonald’s in, you know, the Northeast and you decide you want to…and you have a lot of money to invest in a couple of dozen, you know, different new concepts. You may get a deal on those. But for single units, you’re not. For emerging franchise systems, those are franchise systems that, you know, may be under 25 units, under 50 units depending, or who are moving into a new area that they may not have a…you know, where the trademark and the brand may not be as well-known, sometimes you have a little more room to negotiate. What I will typically see is you’re very rarely gonna have a negotiation on the initial fees unless it’s part of a development process where you’re purchasing multiple units because one, you know, because they’ve come up with the initial fee and it’s, you know, in most cases, you know, fair, based on the circumstances. But also because they have to disclose that in the FDD. So you’ll see in item five if they’ve made deals, and franchise systems do not wanna, you know… Why would you wanna announce to the world that you’re making, you know, your deals?

As far as the other fees, what I see more often is a phase-in. So sometimes if you’re a startup franchisor, you may say, you know, “Hey, the ad fund fee, can we have that start after six months?” Or, you know, “You’re not really that well-known in my area yet, so can I apply what I would pay in ad funds to local marketing so I can help build…use my advertising dollars to build up the brand in the area that I am where I’m going to get the most bang for the buck?” Instead of, you know, a lot of franchise systems have, you know, you pay a 6% royalty or a minimum of X. Sometimes for emerging systems, you can get them to potentially negotiate when those minimums are going to come into play. So maybe not at the end of month one or the end of month three, but maybe a year from now is when you have to start paying the minimum. And the rationale there is that, well, you know, “Give me a little time to get up and running before you start hitting me with minimums, and fees, and costs, and stuff like that.” Other fees that you’re gonna need to pay because you utilize the services for operations of your business, yeah, they’re gonna just be set and that’s, you know, fair.

Amanda: Yeah, absolutely. I agree. So speaking of fees, and costs, and all those things, item seven, start-up costs. You know, what’s it gonna take for me to get running here?

Elle: Yeah, so the start-up fees is a chart. You know, you’re gonna have a low and a high on everything that you’re gonna need to pay to get your business up and running. So you’ll see the initial fees. You’ll see, you know, rent deposits and utility deposits, signage, the buildout, and then at the very end, additional costs for a couple of months of operation. The thing too that I… The advice that I would give you as a prospective franchisee is to always estimate that your costs are going to be on the high-end because, you know, would it be great if they come in on the low-end? Absolutely, but I would always look at the column to the right that’s on the high-end. I would also encourage you to pay attention to any language that says, and it likely will, that this doesn’t include a salary draw for your…or a draw for…or distributions for the owners. So, you know, you can expect that. That’s not taking into account, you know, you taking any money out of the franchise, you know, for your own, you know, dividends, distributions, or salaries in that case. But as far as, you know, that chart, you know, really go through it. And if you’re an established brand, if you’re lucky to purchase an established brand, you know, you could probably put a lot of weight that those estimates are fairly accurate or in a ballpark in any geographic region. If you’re looking at purchasing a franchise concept where the people have only been operating, you know, in Georgia and you’re now deciding whether or not to buy a concept to operate in Brooklyn, you know…

Amanda: Right, that’s a very different ballgame.

Elle: Exactly. So you want to take a little bit…more of a critical eye and make sure, you know, that you’re not looking, you know, depending too much on those estimates if you’re buying a franchise system or buying a franchise in a system that’s still sort of, you know, figuring out what those costs may be.

Amanda: Right, yeah. If you have 500 franchisees, you’re gonna have a much closer handle on what those costs are versus some of the newer ones, it makes a lot of sense.

Elle: Yeah, absolutely.

Amanda: Right, so what else should we know? What other items should we be paying attention to?

Elle: Okay, so I’m not getting… Item eight is called Restrictions on Sources of Products and Services. And so this is the section that’s gonna tell you, this is, you know, where you have to buy, you know, maybe you have to source all of your ingredients, or your marketing materials, or your uniforms, or your even, you know, even services that you’re gonna be…you know, pest-control services, you name it. The franchisor can place restrictions and requirements on who they approve, the vendors, the suppliers, and the products and services you have to purchase. You know, think about this in two ways, one, it’s great because a franchise system, if they do have all of these in place, usually can leverage, use their power to leverage better deals. They probably vetted a lot of suppliers and vendors. So, you know, you’re getting hopefully, the best of the best. You know, the other side of that is a franchise system that may not be really developed, may, you know, be requiring vendors and suppliers that…or, you know, certain products that just, you know, don’t make sense for you and, you know, you’re bound to use them. Let me use an example if you don’t mind…

Amanda: Yeah, go on.

Elle: …what I mean by this. So I had a franchisee who owned four units and they were required to supply their ingredients for their menu items through a certain supplier. That supplier, and it worked out well for a long period of time. And then the franchisor moved suppliers because it worked out best for, you know, they got better deals, it worked out best for the system. It did not work out best for her because they would only deliver, like, at the rush…like, instead of the old people or the older vendors, the buyer, the previous one that delivered at a good time, you know, very, very early in the morning before opening or in the middle of the night, you know, these new vendors delivered right at the rush lunch hour at all the time when every, you know, employee was otherwise preoccupied, and it was just… As much as it seems like a little thing, it was really, really problematic for her. So again, you know, this isn’t…it’s not a make-it-or-break-it sort of deciding whether to purchase or not, but just understanding generally what that, you know, the requirements to use approved suppliers, vendors, is going to mean for you, sort of, on a practical level as you operate. There’s a lot of good benefits, but then also pay attention to the things that may not be so beneficial.

Amanda: Absolutely.

Elle: Does that make sense?

Amanda: Yeah, it makes perfect sense. I mean, if we go back to the example of, you know, if you’re buying a brand that’s really solid in Georgia and you’re looking to open in Brooklyn, it kind of goes back to the same thing where there may be a vendor that’s also very prominent in Georgia but maybe not as established in Brooklyn. It’s something you want to be aware of, right, when you’re looking at things like that.