UNDERSTANDING THE FRANCHISE DISCLOSURE DOCUMENT

Thu, Sep 22, 2011

UNDERSTANDING THE FRANCHISE DISCLOSURE DOCUMENT

In a recent survey of our readers, many requested that we provide deeper insight into the Franchise Offering Circular that must be provided to each buyer. This document includes several important sections that help a prospect gain a great deal of knowledge about the franchising company. The major portion of the document is a plain-English description of the company offering franchise licenses, the business that will be created, the costs involved and the restrictions placed on the franchisee. In addition, the franchisor’s promises to the licensee are enumerated. The company’s latest Profit & Loss Statements and Balance Sheets are included for the buyer’s review, as is a copy of the actual license agreement that will be signed if the parties agree to join forces.

Reviewing this article should help you choose between franchisors and protect your investment.

Since the Federal Government instituted a set of disclosure laws in 1979, all franchisors have been required to submit a Franchise Disclosure Document to each and every prospective franchise buyer at least 14 days before any contracts are signed or any money changes hands. Today, most franchisors will ask that you complete their Franchisee Qualification (or Application) Form before they give you their Disclosure Document. Any reluctance on their part to give you this document or any pressure they exert to get you to sign it quickly should be viewed as a warning sign.

The Federal law stipulates that copies of all documents that you would be expected to sign during the relationship should be included with a full description of the franchise, the costs, the company offering the franchise and the terms under which you will operate. If financing is involved, a copy of the note you will sign should be included. Some states have added regulations in addition to the Federal Government’s and if you are in one of these states (see the current list at the end of this newsletter) you should have an extra page or two indicating compliance with the state regulations.

A common mistake made by franchise buyers is ignoring the wealth of information that is in an FDD/C. Although the structure of the circular is mandated by law, what it contains (and how the franchise system is run) is far less regulated. If you are buying a franchise, you should gain experience reading these documents, since you will be able to gain “a feel” for the company’s approach to franchising by reading the various sections of the FDD. If there are two or more companies offering a similar franchise, you should endeavor to obtain a circular from each company and compare. Philosophy may be more important than license and royalty fees. A good, long term franchise relationship is almost a partnership and more than just the name must be shared between the franchisor and the franchisees.

Even though FDD’s range from 60 to 175 pages, we strongly encourage you to review several closely so that you can enter into your business relationship with both sides understanding the rules and regulations. We suggest that you have your advisors review this as well and demand that someone from the franchisor answer any questions that may arise.

There are 21 sections in each FDD. These are the headings required by statute:

TABLE OF CONTENTS

1. The Franchisor, and Any Parents, Predecessors and Affiliates

2. Business Experience

3. Litigation

4. Bankruptcy

5. Initial Fees

6. Other Fees

7. Estimated Initial Investment

8. Restrictions on Sources of Products and Services

9. Franchisee’s Obligations

10. Financing

11. Franchisor’s Assistance, Advertising, Computer Systems, and Training

12. Territory

13. Trademarks

14. Patents, Copyrights and Proprietary Information

15. Obligation to Participate in the Actual Operation of the Franchise Business

16. Restrictions of What the Franchise May Sell

17. Renewal, Termination, Transfer and Dispute Resolution

18. Public Figures

19. Financial Performance Representations

20. Outlets and Franchisee Information

21. Financial Statements

22. Contracts

23. Receipt

Exhibits

A. Financial Statements

B. Closing Acknowledgments

C. Schedule of State Agencies

D. Loan Agreement and Addenda

E. Franchise Agreement and Addenda

The Franchise Doctor will cover each of these headings in this and a subsequent Newsletter.

The Cover Page contains a description of the franchise offering and a summary of the costs involved. It must also include warnings of the risks involved that the government deems appropriate. Obviously, you recognize that your investment is not guaranteed. The most important ingredient in your eventual success is YOU. The cover page usually also notes that legal actions between the parties must be filed in the home state of the franchisor. Since most franchisors encourage mediation of any disagreements, and Arbitration after that, they hope that this will ever become an issue.

Section 1. covers The Franchisor and any Parents, Predecessors and Affiliates.This gives you the history of their corporation and their franchising activities. As you’re evaluating joining any company, you should determine if they operate a unit similar to yours–that they don’t just focus on franchising. As the industry changes, those who operate “company stores” will be “on the field of battle,” addressing the issues in their daily operation of the headquarters-owned units–not reacting to calls from franchisees who have encountered problems that will impact the entire industry.

Section 2. gives details regarding the identity and Business Experience of the individuals involved with the Franchisor. The company is asked to reveal the work history of each of their principals and any key employees for the last five years. You should judge the suitability of their background as you would a potential partner. Have they been in this industry for several years (five minimum)? Is there depth? What if one person becomes ill or retires? Who would step in to fill the gap?

Section 3. covers company Litigation. The government requires that they disclose if either the franchisor, its predecessor, any person identified in item 2 or an affiliated company offering franchises under the franchisor’s principal trademark:

A. has an administrative, criminal or material civil action pending against that person or business alleging a violation of a franchise, antitrust or securities law, fraud, unfair or deceptive practices, or comparable allegation;

B. has during the 10 year period immediately before the date of this disclosure document been convicted of a felony or pleaded nolo contendere to a felony charge; or been held liable in a civil action by final judgement or been the subject of a material action involving violation of a franchise, antitrust or securities law, fraud, unfair or deceptive practices or comparable allegation; or

C. is subject to a currently effective injunctive or restrictive order or decree relating to the franchise or under a federal, state or Canadian franchise, securities, antitrust, trade regulation or trade practice law resulting from a concluded or pending action or proceeding brought by a public agency.

Anyone who reads the paper realizes that Americans love to sue people. If there are one or two suits reported per 100 franchisees, that’s probably not a problem. However, if there is page after page of litigation, and all seem to be over similar issues, you should begin to be concerned.

The next Section, 4., discloses any filings under the Bankruptcy laws. Here, they report that:

Neither the Franchisor, its predecessor, nor any of the parties listed in Items 1 or 2 of this offering circular during the 10-year period immediately before the date of this offering circular;

A. filed as a debtor (or had filed against it) a petition to start an action under the U.S. Bankruptcy Code;

B. obtained a discharge of its debts under the bankruptcy code; or

C. was a principal officer of a company or a general partner in a partnership that either filed as a debtor (or had filed against it) a petition to start an action under the U. S. Bankruptcy Code or that obtained a discharge of its debts under the bankruptcy code during or within 1 year after the officer or general partner of the franchisor held this position in the company or partnership.

Again, if someone who is involved in managing the company has had a similar position in the past that led to bankruptcy, you should ask further questions and decide if their explanation is plausible.

In Section 5. the FDD begins to address some very important information: Franchisee’s Initial Fees  Today, Initial Franchise Fees usually range from a low of $10,000 to a high of $35,000. This is usually payable in full at the time of the signing of the license. It allows you to go through headquarters training and open your unit. (A franchisor willing/able to finance a portion of your initial fee is usually a good sign–they’re confident that you’ll succeed and pay the balance over time. However, opening your new venture with too much debt is very dangerous and should be avoided whenever possible.) In retail, restaurant or site-based franchise systems, this fee is usually the same for all franchisees. However, in some systems, (usually service businesses) the franchisor may offer two entry levels, depending on the size of your hometown. Small towns with a population up to a certain size, (let’s use 175,000) will cost less for a Minor Market License. They may sell two such units in towns with populations up to 350,000. In larger cities they may sell Major Market licenses for a higher fee. They may make a commitment that they will never sell more than one license per 350,000 residents and that they will not allow offices to open within a 5-mile radius of each other. Should you wish to open another office in the future, many systems will ask you to pay only a percentage of the license fee in place at that time.

Section 6. discloses Other Fees Here you begin to see some of the unique factors that separate the franchise you are reviewing from others. (Remember, we suggest you review at least three FDD’s before choosing the system you’ll join.) Almost universally, franchisors charge Ongoing Royalties from their franchisees.

They are willing to begin sharing with you their successful system for doing business and give you ongoing consultation and assistance for a low initial licensing fee. No company would sell this knowledge for such a low entry fee if there was no ability to participate in the ongoing success of the new venture. This royalty allows the franchisor, as your “partner,” to receive an ongoing benefit from your success. It ensures their motivation to give you all the assistance you desire. Without a royalty, their license fee would exceed $100,000–so, you could think of these payments as a kind of financing for your purchase (similar to an “earn out” in the purchase of a business).

The great majority of franchisors charge a set percentage of all sales you generate in your business. In retailing, 6% is common, in fast food 4% to 5% are widespread, and some service businesses charge up to 10% of sales. Some franchisors charge a declining royalty fee. You might pay 6% of your gross receipts on the first $250,000 of sales you generate each year; 5% of the gross receipts between $250,001 and $500,000; and 4% of all receipts in excess of $500,000. They recognize that, the lower your revenues, the more help you need from headquarters. The greater your sales, the less you’ll be calling on the franchisor for assistance. Therefore, they lower the effective percentage they charge as your revenues grow. Recognize that this is adjusted monthly based on the sales, year to date. Everyone would pay 6% in January–the goal is to reach the break points as early in the calendar year as possible. Many companies have you calculate the monthly sales and remit by the 10th of the following month. Some ask you to submit weekly reports and they debit your checking account weekly.

Determining the effect of the Royalty Fees on your personal income as a franchise owner is important. If an industry typically provides only a 15% Net Pretax Profit, giving 10% to the franchisor cannot be justified unless they are providing inventory, advertising, or some other benefits at a great discount, unavailable to your independent competitors. On the other hand, some food franchisors are able to provide such great discounts on food, supplies, equipment and construction costs, that their 4 or 5% royalty could almost be considered free!!

Depending on the industry, a great advantage to franchising is the benefit of national advertising and name recognition. Is there anyone in America who doesn’t recognize the names McDonald’s, Burger King, and Wendy’s? This power allows franchisees to build their sales much quicker than an independent and unit sales almost always (99% of the time) exceed the sales of an independent. Still, not all industries require mass advertising. In these cases, you should question the need for a national advertising fund. Most systems charge 2% of sales to fund this program. You will have to spend additional monies in your local area to promote just your unit.

Included in your Initial Franchise Fee are rights for you and your staff to attend headquarters start-up training. Should you decide that you wish to have others attend this training (which is often only for Owners or General Managers) you will be charged for each person who attends this class which runs from 1 to 4 weeks.

If you, or your estate, decide to sell your franchise, someone will have to pay a Transfer Fee to offset the franchisor’s expenses associated with training a new franchisee in the system. You will be building equity in your new business. Some franchisors charge up to 50% of the Initial Franchise Fee being charged new franchisees at the time of the sale. This will cover their costs associated with training the new owners (who receive several seats in training).

When your license expires, (typically after 10, 15 or 20 years) a Renewal Fee will be due. Some companies charge as much as 50% of the original Franchise Fee as a renewal fee. Most feel it doesn’t make sense to charge a good franchisee a significant sum to continue operating within the franchise system.

Since some franchisees have tried to hide revenues to avoid royalties, most franchisors now stipulate that, if they feel that your Royalty Reports are not a true reflection of the Revenues of your franchise, they will try to determine the correct information. If this proves to be insufficient, they reserve the right to have a professional audit conducted and pass the cost of the audit, interest on underpaid royalties and a penalty on to you but only if the audit shows an underpayment of at least some significant percentage of Gross Receipts (3 or 4% is often the deciding value).

[To be completed in the next Blog Post.]

“Opportunities are never lost. The other fellow takes those you miss!”