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Saturday, February 8, 2014

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.