What Is a Franchise Disclosure Document (FDD) and Why It Matters

Introduction

Today we’re going to go through the franchise disclosure document. This is the document that every franchise is required to have by the FTC (Federal Trade Commission), and there are numerous states that require registration. We’ve gone through over 10,000 franchise disclosure documents at Vetted Biz, mining and analyzing the data. I’ve personally reviewed over a thousand franchise disclosure documents.

I’m not an attorney; I look at it from a business and risk standpoint, so I’m going to focus on that aspect today. You definitely need a franchise attorney if you’re going to buy a franchise or sign a franchise agreement—consider it an insurance policy because it can save you from big costs in the long run.

FDD Categories

The franchise disclosure document is divided into 23 categories, known as items. Typically, the most important items to analyze are items 3, 4, 6, 7, 8, 9, 12, 19, 20, 21, and 23. We’ll go through these categories in today’s video, and include some resources in the show notes on these different items of the franchise disclosure document.

Items 2 – 4

Business Experience, Litigation, and Bankruptcy

These are items 2 to 4. They provide information about the experience of the franchise’s executive team. I also supplement the information in the franchise document with Google, researching the principal CEO and leadership team on the first several pages of search results.

For litigation, franchisors are required to disclose litigation involving the franchise brand, but not everything may be included, so supplement it with a Google search. You can also hire a third-party due diligence firm to perform a more thorough search. Adding keywords like “litigation,” “lawsuit,” or “dispute” alongside the executives’ names or brand name can help identify potential red flags.

Example

An example is the Nestle Toll House Cafe franchise, which was sued by Nestle USA in 2016 over the use of their name and trademark. When you buy into a brand-heavy franchise like this, the ownership of trademarks is crucial. You don’t want to enter a system where trademark ownership can become an issue.

Items 6 – 7

Initial Costs and Ongoing Costs

Items 6 and 7 cover the initial and ongoing costs. You can also check out vettedbiz.com where we mine a lot of the data from these items, including all different types of fees—whether one-time or ongoing.

It’s important to understand how the franchisor makes money. For example, Anytime Fitness has over 2,300 locations in the U.S., and the franchisor earns over $200,000 before you even open up, as you must buy a lot of initial startup equipment directly from them. The same case is with F45, where $250,000—including franchise fees and equipment—goes to them before you even open your gym.

Item 8

Goods and Services

Item 8 covers goods and services and rebates. Are there any rebates? How are you able to procure your goods and services? Franchisors are required to disclose restrictions on purchasing goods or supplies from specific vendors or directly from them, as well as whether they receive rebates. This helps you better understand how the franchisor makes money from you, the franchisee.

Item 9

Legal Requirements

Item 9 contains information on renewal rights, non-compete clauses, confidentiality requirements, termination rights, and legal forum selection provisions. Changes are happening in 2023 regarding non-compete clauses for employees across the U.S., and this could impact franchising.

It’s important to understand renewal rights and transfer rights as these affect resale value. For example, if there is a significant transfer fee or restrictions when selling the franchise, this can reduce the franchise’s value. F45, for instance, keeps the language around transfer fee costs vague, allowing for additional legal and accounting fees which could surpass $10,000.

Item 12

Territory Exclusivity

Item 12 contains details on the exclusivity of the franchisee’s territory. This is one of the key terms open for negotiation in most franchise systems. You can negotiate for rights of first refusal in adjacent territories, which means you have the right to expand without having to buy multiple franchise units upfront.

Item 19

Financial Performance Representations

Item 19 discloses financial performance representations, generally for franchisees operating for over 12 months. Less than 60% of franchisors disclose financials in Item 19, as they are not required to do so by the FTC. About 60% of franchisors disclose gross revenue figures, while only 20-25% include operating costs, EBITDA, and other bottom-line figures. It’s important to get a full picture of financial performance and verify information with existing franchisees.

Item 20

Franchise Outlets

Item 20 discloses the number of franchise outlets, including franchise failures, terminations, non-renewals, and other reasons for ceased operations. Vetted Biz makes it easier by extracting and analyzing this data to see if the franchise system is growing or declining. For example, in 2021, Subway had a net loss of 1,500 restaurants in a single year.

Item 20 is essential for understanding the system’s performance—is it opening more locations than it’s closing?

Item 21

Franchisor’s Financial Statements

Item 21 discloses the income statement, cash flow, and balance sheet of the franchisor for the last few years. It’s important to assess how the franchisor makes money—whether from franchise fees, selling products, or royalties. Ideally, a stable franchisor generates revenue primarily from royalties.

Financial stability is crucial since signing a franchise contract is a long-term commitment of 10, 20, or even 30 years. It’s important for the franchisor to be financially stable to support you throughout the term.

Item 22

Franchise Agreement and Other Documents

Item 22 lists all legal agreements, including the main franchise agreement, lease options, finance agreements, and purchase agreements that may apply.

Conclusion

There you have it—the franchise disclosure document debunked. Remember, you need a franchise attorney to look at the legal aspects. From a risk perspective, I focus on whether the system is making money, growing, or declining, and what you’re getting yourself into. This is true whether you’re opening a new franchise or buying a resale.