Franchise Agreement and Franchise Disclosure Document FAQ

Buying a franchise is a popular way to become a business owner. A franchise business allows a franchisee (investor) to operate and run a well-known company (franchisor) in exchange for a franchise fee. The two parties enter into a contractual relationship by signing a franchise agreement.

Before entering a franchise agreement, you must read all the franchise disclosure documents. Read this FindLaw article to know what documents to look for when reviewing the terms of this agreement.

Study the Franchise Disclosure Document

You've found a franchise offer that you like, and you want to invest in it. You like the franchisor's training program offers and business model. By law, the Federal Trade Commission (FTC) has a Franchise Rule requiring the franchisor to provide you with a franchise disclosure document (FDD).

Study the disclosure document. Have an attorney and accountant review it with you, too.

FDD Timeline

Under the FTC's Franchise Rule, you must receive the document at least 14 business days before being asked to sign any contract or pay any money to the franchisor. Some state laws have additional timelines along with the FDD laws. You should read the entire disclosure document. Make sure you understand all the provisions.

Under applicable law, this must be sent to you at least 14 days before you sign a franchise agreement.

Business Background

The FDD identifies the executives of the franchise system and describes their prior experience. Consider not only their general business background but also their experience in managing a franchise system. Also, consider how long they've been with the company. Investing with an inexperienced franchisor may be riskier than investing with an experienced one who has experience doing business in the industry. There should also be contact information for the company and ten previous franchisee owners.

Litigation History

The FDD tells you if the franchisor, or any of its executive officers, has felony convictions involving:

• Franchise law
• Fraud
• Unfair practices
• Deceptive practices
• Previous or current state injunctions
• Previous or current federal injunctions

Civil lawsuits where the franchisor or its executives were liable or settled a case with a franchisee must be included. Many claims or legal documents against the franchisor may show that the company does not abide by its contracts. The support you may want could be lacking. It also shows that other franchisees aren't satisfied with the franchisor's performance.

Some franchisors may try to conceal these legal documents and litigation history. A potential new franchisee may not find these things if a franchise changes its name every six months or removes a troublesome executive from the FDD.

Bankruptcy

The FDD must disclose if the company or any executives filed for bankruptcy. This helps you determine the franchisor's financial stability. Suppose a franchise is insolvent or has a history of bankruptcy. In that case, they likely won't have quality control over their business either. This can serve as a prediction of whether the company is financially capable of delivering the promised support services.

Costs

The disclosure document tells you the start-up and expected costs of owning a franchise.

The following checklist will help you ask about potential costs to you as a franchisee.

• Initial deposit (is it refundable?)
• Initial franchise fee
• Royalty fees or royalty payments
• Continuing royalty payments
• Inventory costs
• Signage cost
• Lease expense (real estate lease or building lease)
• Sublease expense
• Equipment costs
• Business promotion cost for a grand opening
• Occupational license
• Building permits
• Advertising payments, both to local and national advertising funds
• Product or service supply costs
• Training cost
• Professional fees (accountant, lawyer, insurance)
• Insurance
• Expected employee salaries and benefits
• Expected independent contractor wages

Opening a small business, even a franchise, takes months to get up and running. Consider your living and operating expenses for the first year in your total cost estimate. Compare your estimates with other new franchisees' payments. Look at how this compares to other franchise systems.

Restrictions

Your franchisor controls how you operate your business. The FDD lists these restrictions:

• What companies you can buy supplies from
• The type of goods or services you sell in the franchise
• Any age restrictions for customers under applicable law or internal policies of the franchisor
• What your franchise territory is, and if you have exclusive rights to a new location in your area

Understand these restrictions—they limit your ability to use your own judgment when running your franchise.

Terminations

The FDD tells you how the franchise relationship ends. Franchise agreements include each side's obligations. It lists a material breach that could terminate or cancel the deal. Failing to pay royalty fees or leases, becoming insolvent, or filing bankruptcy is a material breach. Disclosing proprietary information like trade secrets usually is, too. It also tells you the conditions under which you can renew, sell, or assign your franchise to other parties.

Training and Other Assistance

The FDD explains the franchisor's training and assistance program.

• Can anyone else get training, or is it just the new franchisee?
• If so, do you have to pay an additional fee for the training?
• How long is training? Do you have to travel out of state, or does the franchise come to you?
• Will the training include business management, marketing, or technical training?
• Does the franchisor develop the training courses, or does a third party handle it?
• Who gives the training, and what is their background?
• Will you get training from time to time once you open? If so, is there an additional fee?
• How does the franchise address problems? Who do you talk to?
• Where is the company's headquarters?
• Are there any support staff near you? How many other franchisees do they interact with in your area?
• Will someone be available to provide more individual assistance to you?

Remember that training and assistance are the primary reasons for investing in the franchise—instead of starting your own business.

Advertising

Every franchise company has an advertising fund. You must pay for it. Usually, this is a percentage of your earnings. You can't opt out of the advertising fund. You must still pay for it even if you disagree with how the national company uses it.

The following checklist will help you assess whether the franchisor's advertising will benefit you.

• How is the advertising fund money used?
• Will the funds pay any other expenses?
• Does the fund pay any administrative costs?
• Can the franchisees control how the funds are spent? Are there any votes?
• What is the advertising campaign history?
• Are there any campaigns in development?
• How much is spent on national advertising? What about ads in your area?
• Will all franchisees pay the same percentage to the fund?
• Do you need the main company's approval of your advertising?
• Will the main company need to approve your social media campaigns?
• Are there rebates or advertising contribution discounts if you conduct your own advertising?

If you don't like how the franchise has campaigned in the past, you should not move forward with your investment into its business model.

Current and Former Franchisees

The FDD provides important information about current and former franchisees. Many franchisees in your area may mean increased competition.

• How many franchisees operate?
• How many terminated their contracts?
• How many did renew?

A large number of terminated, canceled, or non-renewed franchises indicates problems. Be aware that some companies may try to conceal the number of failed franchisees by repurchasing failed outlets and then listing them as company-owned outlets.

If you buy an existing location, know how many owners operated before you. If there were multiple owners in a short period, then that location may not be profitable. It could also mean the franchisor has not supported that outlet with its promised services.

The FDD gives you the contact information of current franchisees and franchisees who have left the system within the last year. Talk to them. This is how you can verify whether what the FDD says is true or not.

The following checklist will help you ask current and former franchisees such questions as:

• How long has the franchisee been open?
• What was their total investment?
• Did they have unexpected costs? What were they?
• When did they start taking a salary?
• How long did it take them to cover operating costs and earn a reasonable income?
• Did they have a business background before opening?
• How do they feel about the franchisor's training?
• What ongoing assistance did the franchisor provide?
• Did they agree with how the advertising fund was used?
• Did they see increased profits from national advertisements?
• Did the franchisor fulfill its contractual obligations?
• Would they invest in another location?

Look outside of the reference list of selected franchisees listed in the FDD. Those on the FDD list may be individuals paid by the franchisor to give a good opinion of the company.

Earnings Potential

You may want to know how much money you can make if you invest in a particular franchise system. Be careful. Earnings projections can be misleading.

Franchisors aren't required to make earnings claims. If they do, the FTC requires franchisors to have a reasonable basis to make that claim. The franchisor must prove that claim to you. This is known as substantiation.

Consider the following in reviewing any earnings claims:

• Income of the average franchise
• Sample size
• Gross sales of the company
• Net profits of the company

The company must give you documents, its basis, and assumptions about how it got that number. Insist on seeing written reports.

What Does a Franchise Agreement Do?

It allows the franchisee to use the franchisor's name and intellectual property in exchange for a fee. Intellectual property includes the license agreement for the brand name, copyrights, and logos. It also includes confidential information like trade secrets and the company's training manuals, operations manuals, and procedures.

The cancellation procedures and timeline to invoke these terms are included, too. For example, it includes what happens when the two sides face legal issues or don't perform their duties under the agreement.

Most franchise agreement templates also include franchise location boundaries, the price of the initial franchise fee, and the governing law for any conflicts. For example, it includes what state law applies. It also typically includes arbitration as the preferred type of dispute resolution instead of court.

Talk to a Franchise Lawyer

There are many considerations to opening a business, especially when signing a contract to be a franchisee. Talk with a franchise lawyer and accountant when you read the FDD and sign the agreement.