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Thursday, October 17, 2013

FDD Fundamentals: Item 1

Generally, Item 1 is all about the franchisor. The information includes all of the franchisor’s affiliates and related companies, e.g., companies that own it, companies it owns, companies owned by the principles of the franchisor, and companies that are partially owned by a principle of the franchisor that provide goods or services to franchisees.

The Franchisee’s Perspective:
Item 1 performs two functions: first, it requires the franchisor to disclose true information about itself and the second follows from that if the information is misleading, then the franchisee could sue for damages or recession of the franchise agreement. Item 1 requires that the franchisor disclose information in three general categories. First, it must disclose information about itself. This includes the franchisor’s name, business address, and its business experience. It is important to note that “franchisor” here includes any predecessor (person who previously owned the franchise and sold it to the current franchisor) or affiliate (an associated business entity controlled by, controlling, or in common control with the franchisor) of the franchisor. Second, it must provide the name and address of its non-affiliate parent entities (for example a holding or shell company) and its agent for service of process. Third, it must describe the business opportunity it offers. This description includes a general description of the market and competition for the products or services offered and any laws or regulations that are specific to the franchise business industry.

Thus, as the franchisee, this item is very important. You can be reasonably confident in this information because there are potentially significant repercussions for the franchisor if it is misleading. However, it is important to remember that the FDD should not be your only source of information about the franchisor. You should use the FDD as a starting point for additional research. Additionally, there are several red flags to watch for in Item 1. First, if the information regarding the franchisor’s business is very vague or overly general as this could indicate that the franchisor lacks a real understanding of what it is offering, or that the franchisor believes the franchise would not be appealing if the details were fully spelled out and disclosed. Second, you will want to look at the predecessors, parents, affiliates and business experience of the franchisor. You will want to investigate the circumstances surrounding any potential transfer of the franchise business and you will want to look into management of the franchise to see their business histories. If the franchisor has a checkered business past, you may want to reconsider purchasing a franchise from them. It is important to remember that while you are legally considered an independent business owner, the franchisor will exercise significant control over your business and you will want to be sure that you trust them, and can work well with them.

Third, if you decide to consider purchasing a franchise you should compare the information in the FDD with the other information the franchisor gives you. If there appears to be conflicts between the information in the FDD with what the franchisor is telling you, this is a red flag. Finally, if franchise business is subject to significant governmental regulation, you will want to be aware how this may increase the cost to operate the franchise business and increase the potential liability for the franchise business. For example, some franchises offering business opportunities in the health care industry are subject to significant regulations including regulations on storing and sharing patient information, doctor self-referral laws, licensing requirements, employment requirements, and fee sharing.

The Franchisor’s Perspective:
            For franchisors, it is important to remember that the FDD can serve two important functions. It protects the franchisor from liability should a franchisee try to sue the franchisor and it also conveys information about your franchise business. If you comply with the regulations and make appropriate disclosures then it can protect the franchisor from future liability, but if your disclosures are not sufficient or you do not comply with state and federal regulations then it can result in significant liability down the road.

The franchisor needs to balance two interests: the need to provide sufficient, accurate information such that a franchisee cannot claim he was materially misled, and the interest to present an attractive franchise offering. However, it is important to remember that although the FDD does convey information about your franchise to prospective franchisees, its primary purpose is not advertisement but disclosure. Individuals who are looking at your FDD are already interested in your business concept, and (despite what was recommended above) the fact of the matter is that most franchisees who receive your FDD will not read the entire thing, and even if they do, it is unlikely to change their mind. Accordingly, the most important thing is to make sure the information in the FDD is correct and that no information required by federal or state law is omitted.

            Therefore, comparing the franchisor and franchisee perspective of Item 1 gives additional insight into how each party can use Item 1. On the one hand, the franchisee can see that while the information is likely correct, it may not be very detailed and the franchisee should use the information in Item 1 as jumping off point for additional research. On the other hand, the franchisor should keep in mind that although the FDD conveys information about your business to prospective franchisees, its primary function is disclosure. It is important to be careful to include only true information and not leave out any required information.