Saturday, February 8, 2014

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.