Editorial · May 25, 2019
Franchise Disclosure Document: How to Read One
A franchise disclosure document, or FDD, is the legal paper a franchisor must give you before you buy a franchise. It has 23 numbered items. You do not need to read them in order, but you should read all of them. This guide shows which ones to study first.
What the document is and when you get it
The Federal Trade Commission runs the Franchise Rule. Under that rule, a franchisor must hand you its FDD at least 14 calendar days before you sign a contract or pay any money. That gap is your time to read, ask questions and get advice. If a seller pushes you to sign sooner, treat that as a warning.
The franchisor may give you the document on paper, by email, on a web page or on a disc. The cover says which formats are on offer. Pick one that is easy for you to study, and keep your own copy.
Sources: FTC, Buying a Franchise: A Consumer Guide; FTC Franchise Rule, 16 CFR Part 436.
Start with the company: Items 1 to 4
Item 1 describes the franchisor, how long it has run the business and who its competitors are. It also names any special laws or licenses the business needs. Item 2 lists the top managers and their work history for the past five years. Look for real experience in running a franchise system, not just a good sales record.
Item 3 covers lawsuits. It tells you if the franchisor or its leaders have been found liable in cases about franchise, fraud or unfair business practices. It also says if the franchisor has sued its own franchisees. A long list of claims can mean franchisees are unhappy. Item 4 covers bankruptcy. If a bankruptcy shows up, check the money statements in Item 21 with extra care.
Sources: FTC Franchise Rule, 16 CFR 436.5; FTC, Buying a Franchise: A Consumer Guide.
Add up the costs: Items 5 to 7, 8 and 11
Items 5, 6 and 7 show what you pay. Item 5 lists the initial fees. Item 6 lists other fees, such as royalties and ad fund payments. Item 7 gives a table of the estimated total you need to open. Do not stop there. Costs like legal and accounting help are not in those items, so add your own estimate. The FTC also notes that it may take more than a year to break even, and some franchises never do.
Item 8 tells you if you must buy goods and services from set suppliers. Item 11 explains the help you get, including training and advertising. Read it to see who pays for training and how long it lasts. Then ask current owners if the training was good enough.
Sources: FTC Franchise Rule, 16 CFR 436.5; FTC, Buying a Franchise: A Consumer Guide.
Know your limits: Items 12 and 17
Item 12 covers your territory. Find out if the franchisor or other owners can sell in your area, including online. If no one is limited, another outlet could take your customers.
Item 17 covers the end of the deal. It says if you can renew, what you must do to qualify, and what happens if the contract ends. It also explains how you can sell the franchise and how disputes are settled. After a contract ends, rules often bar you from running a rival business nearby, and those limits can last up to three years.
Sources: FTC Franchise Rule, 16 CFR 436.5; FTC, Buying a Franchise: A Consumer Guide.
Test the money claims: Items 19, 20 and 21
Item 19 holds any claim about sales or earnings. The rule does not force a franchisor to make one, though most do. If it makes a claim, the claim must be in Item 19. Ask if the numbers are typical for the system or only for a few top outlets. An average can look better than it is when a few big earners pull it up.
Item 20 shows tables of outlets opened, closed and sold. If many nearby outlets closed or changed hands, ask why. It also lists current and former franchisees. Call several of them. The FTC says talking to these owners may be the most reliable way to check what a franchisor tells you. Ask owners who are about one year in, and some who have run the business for five years.
Item 21 holds the franchisor's audited financial statements. If you do not read these well, hire an accountant to explain them. A franchisor in poor shape may not be able to support you.
Sources: FTC Franchise Rule, 16 CFR 436.5; FTC, Buying a Franchise: A Consumer Guide.
A simple plan before you sign
Use the full 14 days. Read all 23 items. Mark each one you do not understand. Call at least five franchisees, and ask what they paid, how long it took to open and whether the franchisor kept its promises. Then have a lawyer who knows franchise law and an accountant read the FDD and the franchise agreement. This is general information, not legal advice.
Sources: FTC, Buying a Franchise: A Consumer Guide.
Sources
- Federal Trade Commission, Disclosure Requirements and Prohibitions Concerning Franchising, 16 CFR Part 436 (ftc.gov and eCFR)
- Federal Trade Commission, Buying a Franchise: A Consumer Guide (consumer.ftc.gov)