FDD Fundamentals: Item 7

Like Items 5 and 6, Item 7 addresses a potential franchisee’s financial considerations when entering into a particular franchise. In fact, the figures from Item 5 are incorporated into Item 7’s totals (Item 6’s figures are separate). Keeping in mind that there is some overlap between Items 5, 6, and 7, Item 7’s purpose is not to indicate the magic number where the franchise will begin to turn a profit, but instead to give the franchisee the information necessary to determine if she has sufficient capital to survive the initial phase of a franchise. This initial phase typically lasts for three-months, however, the franchisor may use a different period(generally when a different period is customary in the franchisor’s industry). Finally, it is important to remember that Item 7 contains only estimated values, may include high and low ranges, and in some instances no concrete numbers at all (e.g., real property costs may be disclosed through a general description of the requirements for the property). Thus, it is important to clearly understand which costs are and are not included in Item 7.

Item 7 includes the franchisor’s estimated amounts for the initial franchise fee; training expenses; real property requirements; equipment, fixtures, construction, and decorating costs; initial inventory costs; security deposits; business licenses; other prepaid expenses(Item 5) and finally “additional funds” required before and during the initial phase of the franchise business. Some of these costs are clear and do not require any estimation, e.g., franchise fees, however, others like the costs associated with real property requirements can be a little misleading because the difference between high and low costs may vary significantly.

However, as implied by Item 7’s title, estimated initial investment, this Item is not intended to disclose all fees. Specifically it likely will not include costs that extend beyond or begin after this initial period. Additionally, there are certain exceptions such as, the franchisee’s salary, which do not necessarily need to be disclosed in Item 7. Some examples of other costs that are likely to be omitted from Item 7’s disclosures include interest and financing costs. However, the fact that Item 7 does not disclose all costs does not mean that the franchisee cannot find additional information. A potential franchisee may get a more complete understanding of the initial and ongoing costs by contacting current and former franchisees. Current and former franchisees understand well the total costs to open and operate the franchise business.

Franchisors and franchisees should remember a few key takeaways with respect to Item 7. Franchisees should first remember that Item 7 does not disclose all the expenses required to open a franchise. Second, the disclosures in Item 7 are only estimates. Third, the costs disclosed in Item 7 cover only the initial phase of the franchise. Thus, before signing a franchise agreement and undergoing the significant expense of leasing, remodeling etc. of a franchise location, it is wise to get additional information regarding all the expenses during the initial term of the franchise, and to have capital reserves greater than the minimum ranges listed in Item 7.

Franchisors, when making your estimates it is important to balance at least two factors: sticker shock and franchisee success. Sufficiently accurate estimates simultaneously promote an appealing offering and the long-term growth and lasting success of your franchise system. Accurate high and low ranges can both appeal to potential investors in varied financial situations, and increase the likelihood that your new franchisees will be able to survive the initial phase of the franchise business. Accordingly, if your costs are inaccurately estimated, and you accept a franchisee with insufficient capital to last through the initial phase, you may be left with only a closed location (that reflects poorly on your brand and will need to be disclosed in future FDDs), and an unhappy potentially litigious former franchisee. In short, Franchisors should always remember that their success is closely tied to the success of their franchisees, and their primary goal should be to promote their franchisees success.

FDD Fundamentals: Items 5 & 6 (Part 2)

The primary purpose of Item 6 is to help the franchisee better understand the capital requirements for operating a particular franchise business. Accordingly, Item 6 generally requires the franchisor to disclose any recurring or occasional fees the franchisee must pay to the franchisor or an affiliate, including fees collected by the franchisor or an affiliate for the benefit of a third party, during the initial term of the franchise agreement. Additionally, Item 6 requires the franchisor to disclose the existence of any purchasing or advertising cooperatives and the franchisor’s participation and control over these cooperatives.

It is important to remember that similar to Item 5, the franchisor is only required to disclose operating fees or payments payable to the franchisor or its affiliates, i.e., the franchisor will not include operating costs imposed by and payable directly to third parties. Accordingly, Items 5 and 6 do not provide a complete picture of the opening and operating costs of the franchise business. And, in some instances, the undisclosed costs can be significant. For example, construction, labor, licensing, etc. are all costs that may not be disclosed in Items 5 or 6, but are likely to be significant.

Additionally, Item 6 requires the franchisor to disclose any purchasing or advertising cooperatives. This disclosure provides two important pieces of information to the franchisee. First, it indicates how much freedom the franchisee will have with respect to advertising and purchasing, and second, it provides additional information about the costs of operating the franchise business. Finally, Item 6 requires the franchisor to disclose the existence of any advertising or purchasing cooperative and the participation and voting power of any franchisor owned (company owned) stores that participate in the cooperatives. Additionally, if the franchisor owned stores have controlling voting power in a particular cooperative, the franchisor must also disclose the required fees associated with that particular cooperative.

However, understanding what information is required to be disclosed in Items 5 and 6 is only part of the battle. It is important for the franchisee and franchisor to understand how this information may affect them. When reading and applying the information in Items 5 and 6 the franchisee will want to remember that although these items provide valuable information about costs and control, they do not provide a complete picture of all the costs involved in starting a franchise business. Additionally, the franchisee should remember that these numbers are not necessarily set in stone. The franchisee can attempt to negotiate these fees and if a range is provided in the FDD , under appropriate circumstances, the franchisee should consider negotiating for fees outside that range.

Accordingly, it is important to consider some general negotiation principles. One key principle, probably the most important thing to remember, is that you have alternatives to entering a franchise agreement with a particular franchisor. There are multiple franchisors in every sector of franchise business For example, Holiday Inn, Marriot Hotels, Best Western etc. are all franchisors selling franchise opportunities in the hospitality sector. Franchisees should look at the various franchisors in a particular sector, compare their initial and ongoing fees, compare their services provided, their success rate etc. and use all this information to determine his or her favorite franchisor systems. When negotiating with these franchisors have this information in mind, and remember that if one of these franchisors unwilling to negotiate, you have other alternatives you are interested in and walking away from this negotiation is a viable option.

The effects of Items 5 and 6 for the franchisor are similar to the effects for the franchisee, but from a very different perspective. Franchisors need to consider several factors when determining whether to negotiate and enter an agreement with a prospective franchisee. First, it will be important to remember that any deviation from your standard agreement will need to be disclosed in subsequent FDDs, and disclosing this agreement may adversely affect your ability to aggressively bargain in the future. Second, it is important to consider your alternatives to selling a franchise to the prospective franchisee. Do you have prospective franchisees beating your door down, or is this franchisee the only person who has been interested in your system for some time? You may want to be more or less flexible depending on the current demand for your franchise offering. However, either way a franchisor should consider the unique addition a franchisee could make to her system, and if you believe a particular franchisee is going to be a great asset to your system you may want to consider negotiating.

Additionally all franchisors should take time to understand their competition. What other systems are competing with you for prospective franchisees? What services are they offering? What fees are they charging? Etc. Understanding the differences between your system and others will help you to explain why your system is different from others. For example, if your fees are a little higher than your competition’s, but you provide additional assistance, have a much higher success rate, or a stronger brand, you can explain this to a franchisee. Conversely, if your franchise system is having difficulty growing it may be partially due to your fees, services etc., and if you know this then you can work to make your franchise offering more attractive to prospective franchisees.

FDD Fundamentals: Items 5 and 6 (Part 1)

Items 5 and 6 both address the fees a franchisee must pay to the franchisor or its affiliates between signing the franchise agreement and the end of the franchise agreement’s initial term. Item 5 discloses the required fees a franchisee must pay before opening the franchise outlet. Item 6 discloses the required fees a franchisee is likely to pay during the initial term of the franchise agreement. Since these two items are so closely related, they will both be addressed in this post.

Item 5 serves a few purposes. First, Item 5 gives the franchisee an idea of the costs she will incur before the franchise business opens. Second, it gives the franchisee an indication of whether the franchisor is willing to negotiate these fees and the range within which the franchisor has negotiated these fees in the past. Finally, it informs the franchisee whether any of these fees are refundable and the requirements or conditions associated with any refund. Each of these purposes merits some additional attention. First, it is important for a franchisee to remember that she will have to pay the franchisor fees even before she opens the franchise business (except some states require the franchisor to escrow, defer, or impound these initial costs until the franchisee’s business opens). Thus, the franchisee should not think it can use the profits from the franchise business to cover these costs. Additionally, it is important to remember that these fees are not all the costs that are involved in opening the franchise business, but only the fees that the franchisee must pay to the franchisor or its affiliates. Thus, the costs provided in Item 5 represent only the fixed costs imposed by the franchisor.

Second, since Item 5 requires the franchisor to disclose the range of initial fees it has charged other franchisees in the past, it opens the door to negotiation of these fees. Additionally, it is important to note that the range listed in Item 5 neither functions as a floor nor a ceiling for negotiation purposes, i.e., the franchisee and franchisor may negotiate terms outside the range provided in Item 5. The freedom to negotiate outside the range in Item 5 has benefits as well as costs for both the franchisor and the franchisee. One benefit for both parties is that the freedom to negotiate outside the range gives the franchisor and franchisee the ability to be creative and look for areas of mutual gain that they may not otherwise consider. However, some costs of this additional flexibility are that the franchisor will have to disclose any deal outside the range in the future and may have more difficulty aggressively bargaining in the future. Franchisees should remember that just because the FTC rule permits the franchisor to negotiate outside any range disclosed in the FDD, this does not imply that the franchisor will negotiate outside that range or at all. Consequently, franchisees shouldn’t have unrealistic expectations for a significant discount based on the range provided in Item 5.

Third, Item 5 also has a requirement that the franchisor disclose whether the Item 5 fees are refundable, and the conditions associated with any possible refund. This is valuable because it provides additional information that the franchisee can use when determining what initial fees and other terms it would like to agree to during negotiations with the franchisor. For example, a franchisee who can receive a refund under certain circumstances may be more willing to commit additional capital up front, for the security that it can receive at least a partial refund under certain circumstances.

FDD Fundamentals: Item 4

Item 4 is a fairly straight forward disclosure requiring the franchisor and any of its related parties (affiliates, parents, predecessors and certain individuals) to disclose a bankruptcy, or similar foreign proceeding, within the last ten years. And while the disclosure appears simple, there are some interesting nuances with respect to each party’s disclosure.

Franchisor

With respect to the franchisor, if it has declared bankruptcy it may indicate an increased potential for a future bankruptcy, and may further indicate that in the past, the franchisor has had problems preforming under its contracts. This is particularly important to a franchisee because the relationship between a franchisee and a franchisor is primarily governed by the franchise agreement.

Parent Company

In addition to the requirement for the franchisor entity, the franchisor’s parent company or companies are required to disclose any bankruptcy. This is because under those bankruptcy proceedings the parent may be required to sell its assets, which, depending on the relationship between the franchisor and the parent, may include the franchise system. Under this scenario, the franchisee will not have input over who purchases the franchise system, and the sale could be to a party inexperienced in franchising or possibly even to a competitor. Despite the fact that the franchisee may not like the new owner, she would likely be bound to work with the new owner under the terms of the original franchise agreement, because most franchise agreements contain assignment provisions that require the franchisee to be bound to the terms of that agreement even if the franchisor sells, transfers, or assigns the franchise system to another party.

Affiliates

The franchisor’s affiliates also need to disclose bankruptcies. One reason for this requirement is to alert franchisees to the possibility that the affiliate may choose to divert funds from the franchise system to cover costs etc. of the affiliate’s bankruptcy. While not a common scenario, this diversion of funds may reduce the franchisor’s ability to provided services to the franchisee. For this reason, the definition of “affiliate” for purposes of Item 4 is more broad than the definition under Item 3, i.e., it includes all affiliates not just those who have sold franchises under the franchisors principle trademark.

Predecessors

The franchisor’s predecessors also must disclose any bankruptcy proceedings under Item 4. The primary purpose for this is to prevent the franchisor from reincorporating or reorganizing under a different name in an attempt to avoid disclosing previous bankruptcies. 

Individuals.

Lastly, any individual person affiliated with the franchisor who has significant management responsibility over the franchise system is required to disclose their relevant bankruptcies as well. Relevant bankruptcies include any personal bankruptcy as well as the bankruptcy of any entity that occurred within one year of her serving as a principle officer or general partner.

For the franchisee, these disclosures have important implications when deciding whether to buy into a particular franchise system. A franchisee should be very attentive of the bankruptcy disclosure section and should keep in mind how each party’s bankruptcy could affect both the franchisee’s investment in the franchise and her relationship with the franchisor. Before declaring bankruptcy or selecting the franchise management team, franchisors should be aware of these disclosure requirements. Additionally, franchisors need to be aware of the various entities and individuals who are required to make Item 4 disclosures. Finally, one common mistake is to assume that the ten-year disclosure requirement automatically ends ten years after the person or entity filed for bankruptcy. However, under the FTC Rule this is not necessarily the case; it is ten years from the date of disposition. 

FDD Fundamentals: Item 3

Item 3 of the FDD requires disclosure of the franchisor’s material legal disputes. Legal disputes include formal lawsuits, arbitrations, and settlement agreements (including some confidential settlement agreements). For the purpose of litigation disclosures, “franchisor” means the franchisor company, any of the individuals with significant management responsibility, affiliates, parents, and predecessors. Similar to Item 2, the policy concerns that gave rise to the original version of Item 3 were concerns with deception, fraud, and unfair commercial practices used in the sale of franchises by franchisors. In drafting the revised franchise rule, the FTC expanded the disclosures to include suits initiated by the franchisor. The purpose for this expansion was to reveal the nature and amount of legal disputes within a franchise system, and to indicate the overall franchise system performance.

This blog post will address the following: (1) who needs to disclose, (2) what needs to be disclosed, and (3) the two types of disclosure.

Who Needs to Disclose

First, the franchisor, its affiliates, its predecessors, parents, or individuals working for the franchisor with significant management responsibility are the parties who need to disclose material legal actions. Parent companies need to disclose their litigation history only when they guarantee the franchisor’s performance or have post-sale obligations. Any affiliate that falls into one of the following three categories will need to make some litigation disclosures. Any affiliate who: (1) guarantees the franchisors performance; (2) offers franchises for sale under the franchisor’s principle trademark; or (3) under certain circumstances, affiliates who have sold franchises in any line of business within the last ten years. Importantly, these different subclasses of affiliates have slightly different disclosure requirements (discussed below).

What Must Be Disclosed

Second, the Franchisor et al. must disclose three types of legal action and some regulatory actions.

       a)  Pending legal actions, these parties must disclose pending criminal, regulatory, or civil actions involving illegal or deceptive conduct or unfair trade practices.

           b) They must disclose any past convictions, no contest, or guilty pleas within the last ten years resulting from criminal, regulatory, or civil actions alleging illegal, deceptive, or unfair actions or practices.

        c) They must disclose material civil actions involving any franchise relationship. Additionally, they must disclose currently effective injunctive or restrictive orders brought by a public agency that involve violations of securities, franchise, or trade practices.

However, as mentioned above, the third class of affiliate, those who have offered or sold a franchise in any line of business, are required to disclose any injunction or restrictive order brought by a public agency. Conversely, franchisors et al., do not need to disclose suits not directly related to the operation of the franchise business. For example, suits only involving suppliers, other third parties, or suits for tort indemnification do not need to be disclosed. These types of lawsuits do not need to be disclosed because, according to the FTC, they are not indicative of the franchise system’s overall performance.

Additionally, under the amended Franchise rule of 2007, franchisors must disclose confidential settlement agreements. However, there are exceptions to this disclosure requirement. First, the franchisor need not disclose any settlement that has a neutral or favorable outcome for the franchisor. These types of disclosures are not required because they would not be deemed “material” under the FTC’s interpretation of Item 3. Second, the Franchisor need not disclose any settlements entered into before it started selling franchises. One reason for this exclusion is that these parties would not have considered franchising during these negotiations, and consequently, it would be unfair to make the party disclose those settlements for franchise disclosure purposes. Finally, any franchisor who operated under the franchise rule – Not the UFOC – need not disclose any settlements it entered into before the new franchise rule became effective on July 1, 2007. One reason for this exclusion is that disclosure of these types of settlements was not previously required.

Two Types of Disclosure

It is important to note that Item 3 permits two classes of disclosure. The first requires quarterly disclosures. Legal actions are material civil actions involving the franchise relationship. Specifically, they typically involve the contractual obligations between franchisee and franchisor that relate to the operations of the franchise business. The second type of Item-3 disclosure requires only annual updates, e.g., franchisor initiated suits. However, a franchisor initiated suit can be moved into the quarterly disclosure group if a franchisee asserts a counterclaim related to the contractual obligations of the franchisor to help operate the franchise business.

Item 3 of the FDD is meant to help the franchisee understand how the franchise system is performing and how often lawsuits occur within the franchise system. However, as the franchisee, it is important to keep in mind the exceptions to the disclosure rule. As with all large investments, it may be important for the franchisee to preform additional research if there has been a recent change to the franchisor’s principle trademark, or if the franchisor has been selling franchises for some time. One way to obtain additional information is to contact former and current franchisees and ask for information regarding the franchise system’s performance and culture.

From the franchisor’s perspective, there are a few important things to remember. First, be sure to disclose all required information involving lawsuits and settlements. Second, understand your business organization, specifically which entities have been involved in settlements or lawsuits that need to be disclosed and whether those entities or individuals fall into a class that needs to disclose. Third, moving forward, you should attempt to prevent problems before they arise. Attempt to avoid situations where a lawsuit or unfavorable settlement is likely to occur. For example, be engaged in your franchisee’s success. Keep in touch with them, and do your best to help them be successful. Successful franchisees are less likely to sue their franchisors. However, if a problem does arise, before immediately initiating a lawsuit, attempt a resolution outside of the courts, and utilize competent legal counsel. 

FDD Fundamentals: Item 2

To begin it is valuable to review some of Item 2’s relevant background; the original rule making commission found that some individuals offering franchises were misleading consumers regarding important facts about the franchise business. For example, how long the business had been operating and the experience of the parties managing the franchise. The FTC concluded that these types of misrepresentations could mislead reasonable consumers, causing them to believe that the franchise offering was a more secure investment than it actually was. Accordingly, they added a rule requiring franchisors to disclose information about their business including names and addresses for the franchise business, any parent companies, and any sellers. Additionally, they had to provide background information for any sellers, officers, and directors.

As the FTC enforced the franchise regulations, it became apparent that franchisors were still misleading consumers by misrepresenting relevant information about the business. Specifically, the franchisors would leave out information about their predecessors (entities or individuals who had previously owned or operated the franchise). Alternatively, franchisors would give the people managing the sales or services titles other than officer or director to avoid disclosing their unappealing backgrounds in the FDD. Consequently, the FTC amended the rule to require franchisors to disclose information about its predecessors and about any party with significant management responsibilities.

It is important to understand that Item 2 contains only work experience for the prior five years. Franchisors are not allowed to place information inside of Item 2 that is considered extraneous or unrelated.

            The Franchisee’s Perspective for Item 2:

There are a few red flags to look for in Item 2 of the FDD. First, if there are predecessors then the franchisee will want to research what happened to them. Did they go bankrupt, suffer significant legal problems, or did they sell the system to investors? If the conditions of the sale were concerning, and if the management is the same then you may want to reconsider franchising with that particular franchisor. Second, you will want to research the individuals who are managing the system. If they lack experience or they have a history of business mismanagement or failure you may want to reconsider franchising with them, because those traits are likely to permeate the entire franchise system. Finally, these red flags can be mitigated or exacerbated depending on the level of franchisor involvement. If the system is complicated, or you are unfamiliar with the underlying business, then these red flags are even more important. If you are inexperienced you will likely need significant help, at least at first, from the individuals managing the franchise.

            The Franchisor’s Perspective:

There are a few concerns that a franchisor should keep in mind when drafting Item 2. First, the FDD is not supposed to contain extraneous information. While you may want to include information about awards or accolades your management staff has received or a particularly impressive work position from more than five years ago, don’t. Registration states may require you to delete this information before they will accept it, and you can share this information with your perspective franchisees in other ways. Second, the exact definition of “management responsibility” is not explicitly defined in the Franchise rule leaving franchisors often to question whether an individual has management responsibility. However, some additional insight can be gained from an examination of the original rule (UFOC), and the commentary preceding the amendment to the franchise rule.

The old rule generally provided that an officer was an individual who had significant management responsibilities for marketing or servicing franchises. The old rule was amended because franchisors were giving these responsibilities to individuals who were not given the title or name of officer or director. To combat this naming problem, the FTC amended the rule to include any individual with significant management responsibilities. The amended rule was not changed to cover additional or different activities, but to cover individuals acting like officers (managing services or sales to franchisees). Ultimately, the rule of thumb for a franchisor is that any individual who actively controls the marketing or servicing of franchisees should be included in Item 2.

Finally, it is important to remember not to include individuals in Item 2 who do not have significant management responsibility. In other words, it may be misleading to include a notable individual who might attract franchisees, but who does not actually participate in the management of the franchise. For example, if Warren Buffet had a small interest in the franchisor, but exercised no control over the franchisors marketing or services it would likely be misleading to include his name in Item 2, and could result in a lawsuit.

Item 2 is an important part of the FDD, and while it may seem strait forward at first blush, there are important nuances that both franchisors and franchisees should both be aware of.