The 23 Items Your Franchise Disclosure Document Must Include Although an experienced franchise attorney can help you craft a complete document, as the franchisor, it helps to know what your document should outline.
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This article has been updated as of December 2022 by Entrepreneur Staff and includes additional explanations for select FDD sections from Amanda D. Dempsey, franchise attorney with Saxton & Stump, LLC.
The following excerpt is from Mark Siebert's book, Franchise Your Business. Buy it now from the Entrepreneur Bookstore.
Mark Siebert delivers the ultimate how-to guide to employing one of the greatest growth strategies ever – franchising. Siebert shares decades of experience, insights and practical advice to help grow your business exponentially through franchising while avoiding the pitfalls. In this edited excerpt, the author discusses the key components of the franchise disclosure document and explains why certain items are included.
After choosing to franchise your business, you'll need to provide your prospective franchisees with a franchise disclosure document (FDD) 14 calendar days before taking any fees or signing any contracts with them (or upon their reasonable request). Because you don't count the actual day you provide the FDD or the day it's signed, you're actually able to sign on Day 16. There's no need to file this document with any federal agency: Simply present the document to your prospect, and the countdown begins.
The original purpose of the FDD dates back to the days when fast-talking franchise salespeople would play fast and loose with the truth, resulting in a number of franchisees who would invest their life savings into franchises that would ultimately fail. In order to protect these "consumers," the FTC promulgated the rule to inform franchise buyers more fully about the investment they were considering.
In essence, the FDD is just that. It's a document that is drafted in a prescribed format to provide your prospective franchisee with the information they need to make an informed decision. And although the quality and contents of these documents vary, each FDD is required to contain the following sections in this order:
1. The Franchisor and Any Parents, Predecessors and Affiliates
2. Business Experience
5. Initial Fees
6. Other Fees
7. Estimated Initial Investment
8. Restrictions on Sources of Products and Services
9. Franchisee's Obligations
11. Franchisor's Assistance, Advertising, Computer Systems and Training
14. Patents, Copyrights and Proprietary Information
15. Obligation to Participate in the Actual Operation of the Franchise Business
16. Restrictions on What the Franchisee May Sell
17. Renewal, Termination, Transfer and Dispute Resolution
18. Public Figures
19. Financial Performance Representations
20. Outlets and Franchisee Information
21. Financial Statements
The exact content and format of each of these required disclosure items is specified in detail within the text of the FTC Rule. For review by franchisors and franchisees alike, additional context and explanations for some of the most important sections of the FDD are provided below by Amanda D. Dempsey, franchise attorney with Saxton & Stump, LLC:
Items 1 and 2 of the FDD provide prospects with detailed information about the franchisor, predecessors or parent companies, if any, and the key executives and management team that franchisees will be integrating with throughout the franchise relationship. Items 3 and 4 provide the litigation and bankruptcy history of these same entities. The initial four items provide prospects with important information about the background, experience and history of the franchisor it is considering entering into a franchise relationship with.
Items 5-6: Initial Fees and Other Fees
As a franchisor, you must disclose in these two sections any fees you'll be charging your franchisees. Hidden or undisclosed fees can be a source of disputes, so you'll want to be careful here. Item 5 requires you to disclose initial fees, fees that a franchisee will be required to pay to the franchisor before the opening of its franchised business, and Item 6 requires you to disclose ongoing fees, fees that a franchisee will be required to pay to franchisor during the term of the franchise agreement. Hidden or undisclosed fees can be a source of disputes, so you'll want to be as comprehensive as possible.
Item 7: Estimated Initial Investment
You'll need to provide your prospective franchisees with an estimate of their initial investment (often showing a low and high range), including an estimate that will cover their needed working capital. Be sure your range is realistic, as underestimating the high end of the range can also be a source of future disputes.
Item 8: Restrictions on Sources of Products and Services
As a franchisor, you can sell goods and/or services to your franchisees, as long as you disclose that you (or an affiliated entity) are making money on the sales. You'll also need to disclose the amount of revenue you're deriving from any required purchases (including rebates from unaffiliated vendors). Again, the rule here is to be sure you fully disclose all forms of revenue you generate through sales to franchisees.
Item 12: Territory
You're not obligated to provide your franchisees with an exclusive or protected territory, but if you choose to do so, you'll need to disclose it here. You'll need to carefully consider several potential business conflicts and reservations of rights in this section should you choose to grant a territory.
Item 13-14: Trademarks, Patents and Intellectual Property
Items 13 and 14 describe the trademarks, patents and other intellectual property that you license to franchisees when they enter into a franchise agreement. The trademark and other brand identifiers that are licensed to a franchisee are core assets of a franchise system and information regarding the intellectual property that franchisees will be permitted to use. The restrictions on that use are described in Items 13 and 14.
Item 19: Financial Performance Representations
You're not obligated to provide your franchisees with any information on sales, earnings or expenses (other than those outlined above). But if you choose to do so, franchisors are permitted to provide prospective franchisees with information about the financial performance of their existing franchisees and company-owned outlets in Item 19 of the FDD. All such information must have a reasonable basis, in fact. Although you're welcome to discuss any information on these elements with your franchisees after they've signed the franchise agreement, before the sale of a franchise, you'll only be allowed to discuss what you've included in your financial performance representation (FPR), along with appropriate supporting data. These FPRs don't have to be in the form of income statements and don't need to be prepared in accordance with GAAP, so there's a good deal of flexibility as to what you can choose to disclose. But the bottom line is, if you plan to provide information that can help a prospective franchisee derive an income statement, it needs to be included in Item 19.
Item 20: Outlets and Franchisee Information
You must provide a table that will summarize, among other things, the number of franchises that were opened, terminated, closed and transferred over the past three years. You'll also be required to provide contact information for all the franchisees in your system along with the contact information of franchisees that left the system (for any reason) in the past fiscal year.
Item 21: Financial Statements
You'll need to provide three years of audited financial statements (balance sheets, statements of operations, owner's equity and cash flows) as part of your FDD. Because most franchisors create a new business entity when they begin franchising, the FTC has developed a "phase-in" rule that allows a startup franchisor to provide an unaudited balance sheet in the first year of franchising and an audited one in the second year. Note: Some states haven't adopted this rule. Moreover, if the franchisor is a subsidiary of an existing entity (or has obligations guaranteed by another entity), you may need to provide audited financial statements of the existing entity. Be sure to get legal advice on this issue before setting up your franchising business.
Item 22: Contracts
You'll also need to provide your prospects with any contracts they'll need to sign. These will certainly include your franchise agreement and may also include financing agreements, product supply agreements, personal guarantees, software licensing agreements and many other contracts that may be specific to your situation.
Item 23: Receipts
The final section is a receipt page for your prospect to sign so you can document when they received the FDD. The FTC requires that franchisors provide prospects with at least fourteen (14) days to review the FDD and all applicable documents before they sign a franchise agreement or provide the franchisor with any payment, including deposits. The date listed on the receipt is the date that begins the waiting period. In summary, your FDD will review the business decisions contained in your contractual relationship with your franchisees and provide them with additional information about you and the franchise that will aid them in making their decision. There are hundreds of issues that must be addressed, and the decisions behind those issues will ultimately dictate the franchisor's success. The FDD, and the underlying franchise contract, are complex legal documents that should only be prepared by an experienced franchise attorney.
Legal Implications of the FDD for Both Sides
The FDD is a crucially important document, both for the franchisor and the franchisee. Franchisors must adhere to the legal structure of required disclosures in each item section, which franchisees will then take into account when considering potential franchise ownership with the brand. For franchisors, it's a comprehensive reference guide, compiled for the benefit of prospective candidates.
Both franchisors and prospective franchisees are highly advised to seek professional guidance with FDDs. "Compliance with the FTC format is a legal requirement," Dempsey says. Both franchisors and prospective franchisees are highly advised to seek professional guidance with FDDs. Dempsey continues, "Professional advisors, including franchise attorneys, accountants and business advisors can assist franchisors in navigating the process of drafting an FDD that is both accurate and compliant with the FTC Rule, and can be quite instrumental for prospects who are gathering information necessary to make an informed investment decision."
Related: 7 Things Not to Miss in the FDD