Franchise disclosure documents (FDDs) are very important elements of a franchise transaction, and should be used by the prospective buyer to fully understand the parameters of the investment. Items 1 and 2, which relate to the Franchisor and Business Experience, respectively, serve as a review of the organization and people the buyer will be working with for the duration of the partnership. Item 1 discusses the owner and any parent or affiliate relationships and Item 2 discusses the business’s organization in terms of directors, trustees, principle officers and so forth. This part of the FDD should not be taken as the whole story, though, and should be augmented with personal investigation. For more on this continue reading the following article from Blue MauMau.
This is the ninth in a series of articles for prospective franchisees that discuss the components of a franchise disclosure document. Unlike almost all other articles about what you will learn in a franchise disclosure document, however, this series will focus on what you may not learn. This focus is intended to help you both refine and expand your due diligence efforts.
Items 1 (The Franchisor, and any Parents, Predecessors, and Affiliates) and 2 (Business Experience) of the franchise disclosure document (FDD) tell you a little bit about the people with whom you are about to start a long-term relationship. You will learn some pretty helpful things through these items, like who your future partner was involved with and the extent of that involvement, and you will get a very basic set of management resumes. But Items 1 and 2 can sometimes disclose little more than a well constructed Google search would reveal. In fact, you really owe it to yourself to supplement the disclosures in Item 1 and 2 with a focused set of Internet searches that reach beyond the time parameters that limit these disclosures.
What you will learn.
Item 1 requires the franchisor to disclose the name and principal business address of:
- The franchisor
- Any parent entity
- Any affiliate that offers
- Franchises in any line of business or
- Provides products or services to the franchisor’s franchisees
- Any predecessor during the 10-year period before the close of the franchisor’s most recent fiscal year
The franchisor also must disclose certain information about its business and the franchises being offered, including
- Whether the franchisor operates any businesses of the types being franchised
- The franchisor’s other business activities and
- The business that you as the franchisee will conduct
In my view, the most important Item 1 disclosures may be about the "general market for the product or service the franchisee will offer" and a "general description of the competition." Together, these disclosures might give you some non-quantitative sense about how well your franchise may fare. But note that the descriptions are qualified by the word "general" and in many – and maybe most – cases that’s all you will get: a very unspecific and generally unhelpful description.
The franchisor is also required to disclose the prior business experience of the franchisor and any of the affiliates or predecessors that are within the scope of Item 1.
Other mandated Item 1 disclosures include the name that the franchisor uses and any names it intends to use to conduct business; the name and address of the franchisor’s agent for service of process (really only useful if you want to sue the franchisor); the franchisor’s form of business organization (corporation, partnership, limited liability company, etc.) and the state in which it was organized; and any laws or regulations that are specific to the industry in which the franchise operates.
Item 2 essentially requires a franchisor to disclose a 5-year employment history for each of the franchisor’s
- General partners
- Principal officers, and
- Any other people who will have management responsibility relating to the sale or operation of franchises offered by your FDD – even if they do not have a formal title.
These individuals must also disclose their litigation (Item 3) and bankruptcy (Item 4) histories, the scope of which I will describe in my next article in this series.
What you will not learn.
First, you will not learn anything beyond the temporal scope of Items 1 and 2. Specifically, you will not learn about (1) any person (individual or entity) from whom a franchisor acquired the major portion of its assets more than 10 years before the close of the franchisor’s last fiscal year or (2) more than 5 years of work history for any of the people who manage and control the franchise.
Second, you will not learn much if anything about owners who have a controlling interest in the franchise. This may seem to contradict the scope of the disclosures described above but the focus of the disclosure is on control over franchise operations and not control over ownership. This may be, of course, an illusory distinction. It’s hard to imagine an owner ceding complete control to its management. And even though "indirect" responsibility for the sale or operation of the franchise might arguably bring an owner within the ambit of Item 2, don’t bank on any disclosures. So, while the Federal Trade Commission recognizes that the background of individuals who "control" the franchisor is material "because prospective franchisees need to know the identity and business experience of the individuals in command of the franchisor," franchisors generally do not provide any information about controlling owners.
Finally, you will only get a general description of the market for the products and services that you will offer as a franchisee. Item 1 instructs the franchisor to "consider" putting at least some meat on the "general market" bones, including
- Whether the market is developed or developing
- Whether the goods will be sold primarily to a certain group, and
- Whether sales are seasonal.
Accordingly, any substance to the general market description is only permissive disclosure and, even then, it is not very helpful. You don’t need to stay at a Holiday Inn Express to figure out that a frozen yogurt business in North Dakota is seasonal. But you do need a good night’s sleep and a strong cup of coffee to draw any useful conclusions from a statement, without more, that "the market is [developed][developing]."
Mike Sheehan is a franchise consultant and attorney. He is the president of Focus Ventures (www.focusonfranchise.com) and formerly served as a securities attorney and as general counsel for a Fortune 100 financial services company. His Franchise Focus Blog (www.franchisefocus.blogspot.com) focuses on helpful information, tips and current news for prospective franchisees.
This article should not be construed as legal advice or a legal opinion on any specific facts or circumstances. The contents are intended for general information purposes only and you are urged to consult your own franchise attorney concerning your own situation and any specific legal questions you may have.