How to Decode a Franchise Disclosure Document and Franchise Agreement

Here’s the

good news: Before you buy a franchise in the U.S., the franchisor is legally

required to provide you with detailed information about the business, so that

you know exactly what you’re getting into.

The bad

news? These documents are typically drafted by lawyers. They often run to

hundreds of pages, and the language can be impenetrable.

So the

danger is that you treat the Franchise Disclosure Document like the license

agreement for some new software. You know you should read it, but there’s just too much of it, and in the end you

just click “Agree” and move on.

But a

franchise purchase is a big decision, and it pays to do your research

thoroughly. So in this tutorial we’ll take you through the key sections of an

FDD, and help you find the nuggets of crucial information in there, without

getting overwhelmed by all the details. We’ll also look at the franchise

agreement that you’ll sign shortly afterwards, and explain what you need to

look for. And you’ll learn what sort of outside assistance you may need, and

why it’s important.

By the end

of this tutorial, you’ll be ready to make the final go/no-go decision on your

franchise, and to move ahead with completing the purchase if you decide it’s

right for you.

If you

still need help finding a franchise or choosing between a few alternatives,

check the previous tutorials in our series on buying and running a successful

franchise, where we covered all that in depth.

Step 1: What is an FDD?

The

Franchise Disclosure Document (FDD) exists for your benefit. The idea is to

make sure you have all the information you need to make an informed decision

before investing your money.

The Federal

Trade Commission requires franchisors to provide an FDD to prospective

franchisees at least 14 days before asking them to sign a contract or pay

money. You can also request a copy earlier if you want. In fact, it makes sense

to do so, because the information can help with much of the research we covered

in the previous tutorial on franchise evaluation.

Most of the

document gives information about the franchisor and the franchise system you’re

buying into, rather than the specific unit you’re thinking of buying.

Nevertheless, there’s plenty of useful information in there, as we’ll find out

in the next section.

The best

way to get hold of the most current FDD is directly from the franchisor.

However, if you just want to get an idea of what the document looks like, there

are a few free samples available at franchise news website BlueMauMau.org.

Or you can purchase FDDs for around $200 at sites like FranData or FranchiseHelp. Just be sure to

check the date on the FDD, as many of those available online are from older

years, and the information may have changed.

Step 2: The Key Sections,

and What They Tell You

When you

open up the document, you’ll see the same basic layout in every FDD—the 23

sections are mandated by the regulations. Here are the key things you should be

looking for.

A Stable, Healthy and

Growing Company

Item one in

the FDD gives you some background on the franchisor and any parent companies,

predecessors or affiliates. Look for a long history, and if there have been

frequent changes of name and ownership. Make sure you understand why. Also pay

attention to the discussion of the competitive environment, and make sure you

understand the basic business model and its risks.

In Item two,

you’ll find out about the key executives and their experience. This may be

little more than a list of names and job titles, with the dates they started

with the company, but you can use the names to search online for more detailed

information.

A couple of

items towards the end also give you a good indication of the franchisor’s

financial health. In Item 20, you can see how many franchises there are in each

state, and how many have opened and closed in the last three years. Look for

growth in the overall numbers, and if there are a lot of closures, start asking

more questions. This section also gives contact information for current and

former franchisees, which is a great way to do more research, as discussed in

the previous tutorial.

And Item 21

gives you full financial statements for the franchisor, so that you can see

whether the company’s in good health. If you need help decoding these, check out our tutorial on reading

an income statement.

Fees That Match Your

Budget

Items five to seven give full details of the fees and other start-up costs of the franchise. You

should already have researched this, so just make sure it matches what you

expect, and falls within your budget. Account for not just the initial fee, but

also other setup costs and ongoing royalty and advertising fees, and make sure

you can afford it all comfortably, because there’ll likely be other unexpected

costs along the way.

A Healthy Bottom Line

You’ve

already looked at the company’s financial statements, but what about your own

bottom line? Item 19 is a chance for the franchisor to give details of what

individual franchisees can expect to make, based on average historical data.

We say “a

chance” because giving this information is optional, and only about

30% of franchisors choose to disclose it.

If you do

find numbers here, take a skeptical view of what you’re being shown. For one

thing, any estimate based on other people’s experience may not apply to you.

And the FTC also says that “earnings information can be misleading.” Sometimes

the numbers are based on a sample that’s not representative of the whole, for

example looking at well-established stores rather than new ones. And sometimes

you’ll see revenue numbers, but no discussion of costs or profits. So don’t

hesitate to ask for more information.

Restrictions You Can Live

With

Item nine talks generally about all of your obligations as a franchisee, and is a very

important section to read. This is what you’ll be obliged to do for the next

few years of your life, so make sure you’re OK with it.

There are

also specific sections for particular items. In Item eight, for example, check out

all the restrictions on where you source your products and services. Item 12

specifies what territory you’re operating in, and whether there are

restrictions on where you or other franchisees can do business. Item 15 sets

out how hands-on you’re expected to be as a manager, and Item 16 lays out the

restrictions on what you can sell.

The Help You Need

Now that

we’ve covered your obligations, what about the franchisor’s obligations to you?

In Item 11 you’ll find out about what assistance the franchisor gives you in

terms of training, advertising and other help. With the advertising, try to

find out if it will be used for your benefit, or if it’s just a fee that you

pay to help the franchisor and other franchisees.

Franchisors

sometimes provide special loans or other financing to help franchisees get

started. If you think you may need this, check Item 10 for details of what the

franchisor offers.

No Red Flags

Other than

these key areas, you’ll want to check out some of the other items to be sure

there are no red flags. Item three details any litigation the company or its

executives are involved in, for example, and item four discloses any bankruptcy

proceedings in the past ten years. Litigation by itself is not a red flag, but

if many franchisees are suing the franchisor for alleged fraud, it’s definitely

something to worry about.

Acceptable Terms

What

happens if you want out before the end of the agreement? How about if you want

to extend the contract? Under what circumstances could the franchisor terminate

the agreement and eject you from the franchise? What’s the process for

resolving disputes? All of that is covered in Item 17, so pay close attention

and make sure you accept the terms.

Item 22

sets out all the legal contracts you’ll be expected to sign before buying,

including the main franchise agreement, so read those, or have your attorney

read them. We’ll look at the franchise agreement more in the next step.

That covers

most of the items in the FDD. The few remaining ones list the franchise’s

trademarks and other intellectual property and give details of any public

figures used in the franchise’s advertising. Then the final item is a receipt

you have to sign, confirming that you’ve been provided with the disclosure

document on time.

Step 3: The Franchise

Agreement

When you’ve

digested the FDD and done any other necessary research, it’s time to read the

franchise agreement. You’ll find that it contains much of the same information

as the FDD, but it’s presented in a different way, and serves a different

purpose. Whereas the FDD was an information document, the franchise agreement

is a legal contract. Once you sign it and make the payment, you are officially

a franchise owner.

Although

much of the information seems familiar from the FDD, you still need to read it

carefully. Sometimes there are extra details in the agreement itself, and it’s

important to make sure you understand what you’re agreeing to.

Key clauses

include the

following:

• Hidden or additional fees such as
  
  training or territory fees.


• Provisions under which you can
  
  terminate the franchise agreement.


• Situations that allow the franchisor
  
  to terminate the franchise agreement.


• Requirements that you purchase goods
  
  from the franchisor.


• Ongoing fees for additional training
  
  or management.


• Terms for renewing your franchise
  
  agreement.


• Your ability to transfer the
  
  franchise to another party.


• Provisions that you gross a specific
  
  amount of sales.


• Restrictions on your ability to hire
  
  and fire employees.


• Details of the quality and quantity
  
  of service and support you are to receive.

In many

cases, the franchisor will tell you that the agreement takes a standard form

and is non-negotiable. Large franchises, in particular, don’t want to have

different agreements in place with hundreds of different franchisees. So if you

can’t agree to some of the clauses, you may have to walk away from the

franchise altogether. Or, especially with smaller franchises and with the help

of an attorney, you may find you can make some amendments.

Step 4: Get Help

Clearly,

when reading a legal agreement of such length and importance, it makes sense to

consult a lawyer, preferably a specialist franchise attorney who’s familiar

with the ins and outs of franchise agreements.

You can

search online or use directories, but because trust is so important, it’s

better to get a personal referral if you can. Speak to your existing lawyer, or

to friends or other people you trust, and try to get recommendations. If you’ve

interviewed franchisees, ask which lawyers they used, and whether they were

happy with them.

An

accountant or financial advisor may also be useful to help you assess the

financial information you’ve been given, and spot any potential problem areas, as

well as helping you develop a business plan and choose a franchise that’s right

for your own financial situation.

And you can

also get help from the government. The FTC regulates franchises in the U.S.,

and provides support both via its website and by phone (1-877-FTC-HELP).

Individual states also have their own rules, and some states give extra rights

to franchisees beyond the federal stipulations. So contact your state Attorney

General’s office or go online to see what help they provide.

One thing

to keep in mind with hiring lawyers and accountants: It’s a very important

step, but to keep costs down, it makes sense to do it late in the process, when

you’ve already done a lot of your own research and weeded out unsuitable

franchises. Fees can be high, so you want to make best use of your attorney’s

time.

Next Steps

So now you

know how to break down the mass of information provided in a Franchise

Disclosure Document. You know the key areas to focus on, and what to look out

for. You’ve also seen what’s involved in reading a franchise agreement, and the

kind of external assistance you may need.

This

tutorial builds on previous ones in our series on buying and running a

successful franchise, so make sure you’ve done all the

necessary research outlined in those previous tutorials. If you have, then

you’re now in a good position to make an informed investment decision.

If you’re

confident that you’ve found the right franchise, done all the research, read

and understood the FDD, and had an experienced franchise attorney review the

franchise agreement, then the next step is to sign the documents, make the

payments, and start life as a franchisee. In the final tutorial in our series,

we’ll look at the early stages of your business life, and give tips on running

a successful franchise.

The post How to Decode a Franchise Disclosure Document and Franchise Agreement appeared first on DICKLEUNG DESIGN 2014.