The goal of the FTC Rule is to require presale-disclosure designed to forestall material misrepresentations or omissions related to the (1) opportunity being offered for sale (e.g., business experience of officers and directors, length of time the business had been operating); (2) costs (estimation of costs to open and operate the franchise); (3) contractual terms; (4) success of the seller and prior franchisees; and (5) the seller’s financial viability.
Under the FTC Rule, a prospective franchisee must receive the franchisor’s FDD franchise disclosure document at least 14 days before they are asked to sign any contract or pay any money to the franchisor or an affiliate of the franchisor. The prospective franchisee has the right to ask for (and get) a copy of the sample franchise disclosure document once the franchisor has received the prospective franchisee’s application and agreed to consider it. The franchisor may provide a copy of its franchise disclosure documents on paper, via email, through a web page, or on a disc.
The FTC Rule sets forth the required format for the preparation of the Franchise Disclosure Document (FDD). The FDD is comprised of a cover page, index, and 23 individual “Items” (commonly referred to as “disclosures”) that serve to prevent misunderstandings and false assumptions between franchisors and franchisees.
The FDD discloses extensive information about the franchisor and is intended to provide potential franchisee information they can use to make educated decisions. Twenty one of the Items contain information primarily pertaining to the franchisor, but only two of the items contain information pertaining to the performance of the franchise itself– Item 19 is an optional “Earnings Claims, and Item 20 summarizes the number of units and provides the names and contact information of franchisees, current and ex, who may be contacted for information in aby due diligence process conducted by prospective buyers of franchises.
Format of the FDD
An FDD includes 23 Items. The FTC Rule sets forth a specific order that the FDD must follow. Beginning with a cover page and table of contents and continuing with twenty-three specific disclosures, the FDD format does not leave much room for originality.
- Cover Page and Table of Contents
The required cover page serves to inform prospective franchisees that they are receiving a document containing important information regarding the franchise they are considering for investment.
- Item 1 – The Franchisor and Any Parents, Predecessors, and Affiliates
This section provides a description of the company and details the history of the franchisor, including any parent companies, predecessors, or affiliated entities.
- Item 2 –Identity and Business Experience of Key Persons
This section provides biographical and professional information about the franchisors and its officers, directors, and executives.
It provides the experience of the founder and management team, as well as the operational history of the business itself. It details their work experience and backgrounds.
- Item 3 – Litigation History
Covers any and all criminal and civil litigation, both current and past, for the franchisor and its management, going back ten years.
- Item 4 – Bankruptcy
Discloses any bankruptcies, either on the part of the franchisor or its founder.
- Item 5 – Initial Franchise Fee
Details the initial fees associated with becoming a franchisee, including the franchise fee itself, multi-unit fees, and necessary supplies/materials.
- Item 6 – Other Fees
This item outlines ongoing fees, such as the royalty, training fees (if applicable), technology fees, marketing fees, renewal fees, and any other fee required by the franchisor.
- Item 7 – Franchisee’s Estimated Initial Investment
Covers the total initial investment required, combining the initial fees disclosed in Item 5 with estimates of construction/leasehold improvement costs, furniture, fixtures, equipment, signage, computer systems, rent deposits, insurance deposits, professional fees, grand opening expenses…you name it. It’s meant to provide a solid estimate of the total cost of opening a franchise location.
- Item 8 – Restrictions on Sources of Products and Services
Discusses supply sources and ongoing operational items. Covers sourcing restrictions for products and materials. It specifies suppliers from whom a franchisee may purchase goods.
This section includes the restrictions that franchisor has established regarding the source of products or services.
- Item 9 – Franchisee’s Obligations
Being part of a franchise system means playing by the rules. After all, a brand is only as strong as its weakest operator. This section details what a franchisee can and can’t do. It discusses the franchisee’s specific obligations.
This item provides a reference table that indicates where in the franchise agreement franchisees can find the obligations they have agreed to.
- Item 10 – Financing
This item describes the terms and conditions of any financing arrangements offered by the franchisor.
- Item 11 – Obligations of the Franchisor – Franchisor’s Assistance, Advertising, Computer Systems, and Training
Investors purchase franchises because they want to leverage the brand awareness and support of the franchisor in their business. That support and awareness is valuable.
This section details the training, operations, and ongoing assistance that the franchisor will provide to the franchisee.
- Item 12 – Territory
This section provides the description of any exclusive territory and whether territories will be modified.
- Item 13 – Trademarks
This section provides information about the franchisor’s trademarks, service and trade names.
- Item 14 –Patents, Copyrights, and Proprietary Information
This section gives information about how the patents and copyrights can be used by the franchisee.
- Item 15 – Obligation of the Franchisee to Participate in the Actual Operation of the Franchise Business
Details the expectations set forth regarding a franchisee’s ongoing participation in the business, specifically outlining whether and how the franchisee needs to be personally involved.
- Item 16 – Restrictions on what the Franchisee May Sell
This section deals with any restrictions on the goods and services that the franchisee may offer its customers.
- Item 17 – Renewal, Termination, Transfer, and Dispute Resolution
Provides details relating to renewing the franchise, grounds for termination, transfer options, rights and restrictions when a franchisee has disagreements with your franchisor, and dispute resolution.
- Item 18 – Public Figures
If the franchisor uses public figures (celebrities or public persons), the amount the person is paid is revealed in this section.
- Item 19 – Financial Performance Representations
This section serves as the one and only source for financial information about the prior performance of the franchise sites.
Item 19 is not required, but if it isn’t included in the FDD, the franchisor cannot provide earnings information or claims. Each Item 19 is different and can provide any degree of detail the franchisor sees fit.
With limited exceptions, a franchisor and its sales representatives may not make any other representations to a prospective franchisee about the earnings of other franchisees, projected earnings of franchises, or sales information, unless the representations are included in Item 19. Thus, if a franchisor does not include financial data in its FDD, the franchisor would be unable to answer questions regarding a franchisee’s potential income or earnings.
Financial performance representations included in Item 19 may be projections or based on historical results of existing outlets. In practice, the overwhelming majority of financial performance representations present data from existing outlets rather than projections.
Data from subsets of outlets may be used if appropriate disclosures are included that allow the franchisee to understand how representative the subset may be compared to the rest of the outlets in the system. There must be a reasonable basis for all claims made in Item 19 and a franchisor must be able to produce the data that was used to make the representations and to substantiate the claims made.
- Item 20 – Outlets and Franchisee Information
This section provides a list of all existing franchise sites. It provides the locations and contact information of all existing franchises.
- Item 21 – Financial Statements
This disclosure includes audited financial statements audited financial statements for the past three years.
These can be used to evaluate the franchisor’s financial health, history and earnings. The three major financial statement reports are the balance sheet, income statement, and statement of cash flows.
A potential franchisee can find explanatory information about the franchisor in notes to the financial statements.
- Item 22 – Contracts
This item provides all the agreements that the franchisee will be required to sign. These include not only the franchise agreement, but leases, options, financing agreements, and purchase agreements.
- Item 23 –Acknowledgment of Receipt
Prospective franchisees are required to sign a receipt that they received the FDD.