How To Develop A Franchise System: Part 9: How Franchising Works


How does franchising work? In this video we look at the mechanics of the franchising system and the requirements of the Franchise Disclosure Document (FDD), which is required by federal law and integral to any franchising system. Find out what you need to provide your franchisees in all 23 items of the the Franchise Disclosure Document, and when it needs to be disclosed to the potential franchisee.

This video also addresses setting franchise fees, common contractual rights and obligations, and the Financial Performance Representation (FPR) that is included as Item 19 in the franchise disclosure document.

Video Transcript

So how does franchising work under the law? You will prepare and file, in the right states, a disclosure document. You’ll provide that disclosure document to prospective franchisees at a certain point in time prior to them signing their franchise agreement. You and the franchisee will sign the franchise agreement. The franchisee will pay you an initial fee which is going to give them the right to use your trademark and your system, your brand. You’re going to provide them information, with training, with support; and once they open the door, it is the franchisee’s responsibility to operate the business subject to compliance with your standards and specific procedures. It is straightforward, and quite frankly not a significant burden; it works quite well. 

The franchise disclosure document applies in all states and territories. The FTC and state laws will govern the offering of a franchise, not the sale of a franchise. The laws are primarily dealing with how do I give somebody this disclosure document, what do I have to do before they become a franchisee primarily. You’ll need the FDD to make an offering; there are no filing requirements at the federal level, and the franchise salespeople are going to be prohibited from making certain disclosures that are not included in this disclosure document. So don’t think that you can violate what’s in the document; those rules are fairly clear, and as long as you understand the rules it’s very difficult to go outside the boundaries.

Remember always that the relationship between the franchisor and the franchisee is contractual. What you have in the written documents is essential; and just because the franchisee wants you to do something, if you’re not putting it in the legal document, you may not have to comply and the franchisee should not be relying upon things that are not in the contract between the parties. 

The disclosure document is prepared in a format that has been established by the Federal Trade Commission, it was revised in 2007, and several states will regulate those documents. It’s comprised of 22 items and a receipt. They are 22 buckets of information that you must provide to a prospective franchisee, and a receipt page that goes along with it. While the items that you need to disclose are bucketed, the information you put in those items is unique to your brand. So you are not needing to follow somebody else’s formula for a franchise system, you just need to provide the information in those 22 items. 

The purpose of that document is to allow a prospective franchisee to make an informed decision. So, what goes into a disclosure document? It really falls into three categories: information about the franchisor; information about the franchise system and the investment necessary to develop a location, a business unit; and information about each party’s rights and obligations under the contract that they’re going to sign.

It’s going to identify the business and the experience of the franchisor, its parent and predecessor companies and affiliates; it’s going to identify the employment history of the officers of the franchise franchisor and directors; generally anybody who makes decisions that affect the franchisee will be disclosed in that document. It’s going to disclose the litigation and bankruptcy history of the franchisor, its parent, its predecessor company, each of the officers, directors, and companies they may have been involved in on occasions; and it’s also going to include audited financial statements about the franchisor for the prior three years. So this is going to give the prospective franchisee information about who are they getting into a relationship with. 

As far as system costs and information, the franchisee, one of the things they want to know is how much am I going to pay you for the rights to be part of your system? How much am I going to pay you in continuing fees? So you’re going to have a section in the disclosure document talking about all the different fees: the initial fee, and the continuing fees, and there are a lot of fees in addition, royalties, so all of those fees will be listed down that you may be charging. 

And remember, as you start to look at fees, fees vary from franchisor to franchisor. Not all fees are flat; fees are based upon territorial rights, populations, a lot of variables. Fees as far as continuing fees could be a fixed percentage, they could also be a fixed fee, they can also go up, they can go down, there’s likely 50 different types of continuing royalties that are used in the United States today.

Other system information that is going to be provided is a list of every franchisee in the system. You’ll have information about the statistics of how many units are opening, how many units are closed, how many units have transferred. There will be information about trademarks, patents, copyrights, and other proprietary information that’s going to be licensed to the franchisee.

You’ll also have contractual rights and obligations. What’s the term, how many years is the franchise, do you have the right to enter into successor agreements, can you transfer the franchise during the term, does the franchisor have rights of first refusal? Can you transfer the business to your children? Are there required purchases; do you have to buy things from the franchisor, can you buy them independently, is the franchisor telling you what companies you must buy from, or are they just setting standards for the products and services you have to buy? What are the fees that the franchisor is going to earn in those areas? There will be discussions about the management of the unit, do you have to manage your own business or do you bring in a manager or an operating principal, what type of services and inspections is the franchisor expecting you to allow them to do during the term?

What are the territorial rights? Are you able to go outside of a certain geographic area to sell your products and services, or are you restricted to a territory around your business, or are you restricted only to the four walls of your business where you can’t sell anything even on the street outside? You need to be very careful about what your territorial rights are, understand the difference between an exclusive territory, a protected territory, understand the issues around carve-outs, even if you’re given a territory what is not available to you. A very common area in franchising is where franchisees may not fully understand territorial rights because they have not read or they have not comprehended what the disclosure documents and the agreements say. 

Also in the franchise agreement you’ll have an Item 19 disclosure. About half of franchisors today provide an Item 19 disclosure, about half don’t. It’s a financial performance representation that used to be known as an earnings claim, and it is the only place where a franchisor is able to tell a prospective franchisee how much their business historically, or from projecting, has done as a company-owned or as a franchise system. It’s a little bit complicated, and it’s going through some variations today with the regulators looking at changing the content of that FPR or Financial Performance Representation, but it is a key place to focus on because one of the questions people generally ask is “How much am I going to make?”

If you do not put in a Financial Performance Representation in writing in your disclosure document, generally, not always, there are some exceptions, but generally you can’t say anything to the prospective franchisee about the operating sales and costs they’ll expect to get in a franchise system. 

The 22 items and the receipt, and we’ll go through them rather quickly, Item 1 is the franchisor, its predecessors and its affiliates. It describes the franchise company and its affiliated companies, the business concept that’s going to be offered, the market for the products and services, known regulations which you know about and are going to tell the franchisee regulations they’re going to have to meet, and it’s also going to tell them something about the competition they’re going to face in the business. Is it a mature industry, is the industry fragmented, things that a franchisee will only be able to get sometimes from the franchisor. 

Item 2 is going to talk about the business experience, the professional experience of the company, its directors, and all of its senior management. Item 3 is going to deal with litigation, and will list specific litigation relevant to the franchise company whether it’s civil or criminal, pending or settled, and it’s going to be going back for a period of time. Item 4 is going to deal with bankruptcy. All of the senior management is going to need to disclose any personal bankruptcy or any corporate bankruptcy for a company in which they were in senior management going back for 10 years.

Item 5 is going to deal with the initial fee, how much is the franchisee needing to pay to become a member of the club. Item 5 will deal with that. Item 6 is a long list of other fees that the franchisee will pay during the relationship, starting with ongoing royalties, advertising fund contributions, training fees, renewal fees or successor fees, transfer fees; many franchisees today may go public down the road if they get large enough. Is there a public offering fee? What type of software fees will there be? Any type of reimbursement of cost, if you are needing to replace your franchisee’s insurance, you want to make sure that the franchisee owes you the money for that premium. So we’ll even have in there things like insurance reimbursement fees.

Item 7 is in a chart format with extensive notes. It’s going to tell the prospective franchisee what their investment will be in opening up a location. It’s broken down by category, by when the money will be paid, and by who they pay the money to. In this cart you’re going to see things like the franchise fee, multi-unit development fee, construction and leasehold costs, professional fees for architects, accountants, lawyers, equipment, furniture and fixtures, security systems, rent deposits, networking, office supplies - it’s a very detailed list - it will run into utility deposits, opening inventory of products, opening inventory of supplies, how much pre-labor do you expect the franchisee to have coming to training, or how much pre-labor do you need to open up the location, to stage the location, what are the costs that go in there, the pre-opening advertising, marketing, brand marketing that will take place to introduce the location to the community. It will also include what type of working capital the franchisee is expected to need. 

So in this type of investment, the franchisee is getting a huge piece of information how much is my investment going to be, in a range of low to high. There will be an extensive amount of notes because none of these figures are going to be absolutely accurate, they’re going to be the franchisor’s best understanding of what their system has done and what they think will happen in the future for its franchisees. There are market condition changes, your location may be a different size, your labor costs in a market which the franchisor has not entered may be higher or lower, rents may be higher or lower, so you’re going to want to make certain that you review the notes to Item 7 very carefully, and make certain that when you’re building an economic model for your business, you know what range of investment you’re likely to have, even though the franchisor has disclosed one set of numbers. 

Item 8 is going to be talking about the restrictions on sources of products and services that the franchisor will require you or will allow you to buy, who you’re going to be buying them from. It will also talk about rebates that the franchisor will earn or profits the franchisor will earn by selling you things, or their affiliates selling you items directly. They’re not going to disclose each item, of course, but they are going to disclose during the year that just passed what percentage of your ongoing expenses generally came from purchases that you are required to buy because of the franchise contract, and how much globally the franchisor made last year on those types of purchases. 

Item 9 talks about your obligations in running the business. It’s a chart which will refer you to information elsewhere in the franchise agreement. Item 10 will talk about financing that the franchisor has made available either directly or indirectly. You’re going to see things about SBA Registry, about leasing programs. It’s an important area to look at because in there the franchisor may be telling you how much capital you can get from third parties, in loans and leasing programs that will reduce your investment from Item 7. 

Item 11 is going to tell you the franchisor’s obligations to you are. Do not ever think that your obligations as a franchisor or the obligations that the franchisor owes you as a franchisee are the same from franchise system to franchise system. The amount of training may be different, the amount of field support may be different; these are not fungible documents and the franchisor’s obligations are not what you heard or what you believe you heard, but what are in the Item 11 disclosures and in the franchise agreement.

Item 12 is going to talk about territory. Whether you’re getting a territory, whether it’s protected, whether it’s exclusive, what type of carve-outs are in there.

Item 13 and Item 14 are going to deal with trademarks, patents, copyrights, and proprietary information which is going to be licensed to you, and the obligations you have about that, the use of that information.

Item 15 is going to talk about your obligations to participate in the actual operation of the business. Some franchisors, many franchisors, expect you to operate the business full-time and on a day-to-day basis. Others that are more interested in multi-unit franchisees, or many that are looking at investor-type franchisees, will allow you to have the business managed on a day-to-day basis by a manager or operating principal. You have to know what you are expected to do before you get into the franchise agreement. And as a franchisor, you want to be able to make certain that your franchisee knows what you expect of a franchisee. 

Item 16 is straightforward, it says to the franchisee what they’re allowed to sell. And clearly what they’re allowed to sell is what the franchisor tells them to sell, so you’re not going to walk into a franchise business and be surprised that they’re selling products which the franchisor has not authorized. You’re also not going to be surprised that items that you expected that franchisee to have the franchisee chose not to carry. Brands are supposed to be consistent, and you’re not supposed to be surprising the customers by not having what they came into the business to buy, if they used to buy those products and services from the business. Item 16 will tell you exactly what you’re going to be offering, and it’s generally what the operating manual or other documents for the franchisor will tell you to do.

Item 17, which a lot of people read through quickly because they consider it boilerplate, is one of the most serious parts of the document. It needs to be crafted by the franchisor carefully, and it needs to be read by prospective franchisees very carefully. It deals with things that happen often when things are not going well between the franchisor and franchisee, the things that are happening at the end of the relationship as well. Do you have the right, at the end of the term of the franchise, to continue in the business? If the agreement does not give you successor terms, on the last day of the 10-year term you sign, the last day of the 20-year term you sign, you may find you no longer have a business. You could have sold it, you could have renegotiated additional terms. So you want to be looking at Item 17 to understand your renewal rights, your termination rights, your transfer rights, and how do you solve disputes? Is it litigation, is it arbitration, is it mediation, what state laws are going to govern the relationship between you and the franchisor, will you be litigating or arbitrating in your home state or will you be going to the franchisor’s home state, all of the terms that deal with the end or the time when things are not going well between the parties, is dealt with in Item 17. It is definitely not boilerplate in a well designed franchise system. 

Item 18 is a holdover from a prior time that’s still there; you don’t see it too often, but it deals with public figures. Is Roy Rogers part of the management of Roy Rogers? Is Kenny Rogers part of the management of Kenny Rogers? What is a public figure; what does Peyton Manning actually do in Papa John’s, other than being a franchisee? If they do have a management role, they’re going to be disclosed under public figures. Very few franchisors today have public figure disclosures.

Item 19 is the Financial Performance Representation. In Item 19, it’s only in there that the franchisor, its agents, its brokers, is able to provide to a potential franchisee information about its profitability, its sales, its income. If it’s not in writing there, you’re not allowed to provide it, with some exceptions dealing with the sale of an existing business. There are numerous ways of constructing an Item 19. It’s not generally required that you provide a P&L Statement, you don’t have to provide gross sales, you don’t have to provide cost information. If you want to, you can provide statistical information; in some industries the statistics about the business are more important than the actual sales of the business because a potential franchisee is generally inexperienced, and they want to know, for the hotel industry, what the reservation rate is - how many rooms will I generally get from the reservation system? They’re less interested in the sales because quite frankly they’ll be able to calculate that out by themselves, although those franchisors may still give sales, they may give average, mean and medium type sales. 

So Item 19 is well constructed, there are a lot of notes, it’s a place where litigation can come from, whether it’s in there or not, so you have to be very careful. Today about 50-odd percent of franchisors are providing an Item 19 disclosure, which is dramatically up from prior to 2007, when only about 25% of franchisors made an Item 19 disclosure. It is the only place that is truly a voluntary disclosure in the disclosure document.

Item 20 lists the franchise outlets. It is a place where the franchisor will list the contact information of every franchisee in the system, and the contact information of the franchisees that have left the system in the past couple of years. It will have charts that will talk about the number of franchisees terminated, transferred or cancelled; it will deal with those that have been renewed, it will tell you about the units that have ceased to operate. It is a series of charts that allow a potential franchisee to understand whether the system is growing or the system is not growing. It is a very important feature because it is from there that the prospective franchisee can make their validation calls, be able to call the franchisees and answer the questions that the franchisor may not be able to answer, or that they didn’t understand when they read the document. It’s also a place where they’ll ask questions that deal with, is the franchise system an honorable place, are people happy, and being happy in a franchise system is not overrated - it’s important for both parties.

Item 21 will be audited financial statements from the franchisor for the past 3 years. Item 22 will be a copy, in blank, of all of the contracts and agreements that a potential franchisee will be required to sign. 

Item 23 is simply a receipt for the disclosure document. It’s important, because that disclosure document has to be in the hands of the potential franchisee at least 14 days prior to the franchisee signing any agreement or giving over a check. The agreements, the contracts, have to be in the franchisee’s hands in substantially the final format, with all of the information filled in, 7 days before the franchisee can sign the contract. Now those two things can run together, the 7 days can run during the 14 days, but if there are material changes that are not in the franchisee’s advantage upon the day of closing, and you make changes to those agreements, the 7 days has to continue to run. So be careful as a franchisor, be careful as a potential franchisee, that you’ve gone through the agreements and made all of the changes, or expect when you’re ready to sign the check, sign the agreement and give over the check, that the franchisor may not be able to close that day and that’s unfortunate because it could have been dealt with in advance.

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