How To Read A Franchise Disclosure Document

NEW YORK (TheStreet) -- Reading a franchise disclosure document can almost be about as fun as reading an encyclopedia, but new franchisees -- whether they're buying into Hampton Hotel for $13.2 million or Vanguard Cleaning Systems for $8,200 -- would do themselves a great service by paying attention to the details.

Steven Feirman, partner at Nixon Peabody, talked with TheStreet about the importance of getting and carefully reading the legally required franchise disclosure document.
Franchise disclosure document may be no fun, but new franchisees should pay attention anyway.

What is the purpose of a franchise disclosure document?

Feirman: A franchise disclosure document is a federally required, pre-sale prospectus that everyone who purchases a franchise in the U.S. and in many other countries must receive before paying any money or signing any agreements. This disclosure document or prospectus contains specified items -- 23 separate items of disclosure -- that must be provided to a prospective franchisee. It's a federal requirement under the Federal Trade Commission franchise rule.

Also some states have requirements in addition to the disclosures required under federal law. In some states it's necessary to register the FDD prior to it being permitted to use in some states.

What are some universal aspects of the FDD?

Feirman: The franchise agreement is really the key aspect of the FDD, and that's really where a prospective franchisee should focus their efforts. But there are various items in the FDD that give information above and beyond what would be in a typical franchise agreement.

For instance, information about the restrictions on sources of supply and products and services. It also contains information about the company's background, any predecessors, affiliates, business experience of the officers and directors of the franchisor, the litigation history of the officers and directors as well as the litigation history of the company itself. Also, information about trademarks, patents and copyrights that the franchised company has rights to. The FDD also contains three years of audited financial statements of the franchisor, so that is a way to see what kind of financial condition the franchisor is in.

Another item is information about where existing franchisees are located, how many have been terminated, how many have been transferred, how many new ones there are and how many new ones are projected. This is important not only to see whether the franchisee system is growing or how it's growing or contracting, but it also enables the prospective franchisee to contact these existing franchisees prior to investing. That's really one of the most important things that a franchisee can do in evaluating a franchise system.

It's very important because one of the other items in the FDD is called a financial performance representation. And this item is optional. If it does not have a financial performance representation it cannot provide any financial performance information verbally or outside of the FDD. So franchisors that don't include it can't discuss actual or projected sales or revenues of how their franchisees are doing.

What are some reasons a franchisor would leave that out?

Feirman:There are several reasons. One reason is that the franchisor might not have what it considers to be reliable information about how its franchisees are doing in terms of revenue or earnings. In most systems, but not all, the payments to the franchisor -- the royalty -- is based on the revenue of the franchisee. But some franchisors receive payment in other ways.

Another reason could be that the franchisor does not have a good story to tell. The results of the franchisees are variable and they may feel that it's more advantageous to selling the franchises by not providing this information.

Frankly, a majority of franchisors do not provide a financial performance representation. Some franchisors feel that it sets them up as a target legally when they provide this information. That makes it even more important for the prospective to contact existing franchisees.

What would be considered a red flag in the FDD?

Feirman: A big red flag would be the disproportionate number of legal disputes, litigations and arbitrations in relation to the size of the franchise system. Another red flag is a disproportionate number of terminations, cancellations or transfers of existing franchises.

Sounds like a franchisee needs a lawyer to read through all the nuances.

Feirman: A typical franchisee will not understand what they are reading in a franchise disclosure document. While it is drafted in plain English, usually a lawyer is recommended to review the FDD as well as the franchise agreement.

-- Written by Laurie Kulikowski in New York.

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