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Item 13: Trademarks

This section is straightforward but important to your franchisees as it is arguably the most important component of what they are purchasing. It identifies all of the franchisor’s registered trademarks and the information regarding such registration.

The one incredibly obvious red flag that can come up here with regard to a registered trademark is if there is anyone contesting the rights in that trademark. Additionally, if the trademark has been filed but the registration is pending, you will likely face some questions from your potential franchisee regarding the USPTO’s approval.

As a franchisor, you will have to disclose whether or not you are obligated to pursue legal action against those that infringe your trademark. I advise clients to accept this obligation as not only does it benefit them to vigorously protect their mark, but the franchisee may consider it a positive in evaluating the opportunity.

In addition to questions regarding the registration, you may face some questions about the value of the trademark itself, including:

• How well known the brand is in the region in which the franchisee is seeking to open his or her business
• How well known the brand is in the United States at large
• If the franchisor has full use of the trademark

Item 14: Patents, Copyrights, and Proprietary Information

Item 14 is another straightforward, but less often important, section of the franchise disclosure document that lays out other intellectual property rights the franchisor holds. Depending on your franchise model, holding a wide assortment of intellectual property rights (especially relative to competitors) could be very valuable.

Again, franchisees will be concerned with any limitation on these rights, especially if a third party contests them.

Item 15: Obligation to Participate in the Franchise Business

This section discloses whether or not the franchisee will be required to personally participate in the day-to-day operations. If not, you must state whether you recommend such participation. Additionally, this is where you must disclose any restrictions on whom the franchisee can hire as a supervisor.

I strongly recommend that the franchisee be required to participate in the day-to-day operations as there is a strong correlation between such participation and success of the franchise. After all, one of the biggest advantages of franchising is that you have franchisees that have an interest in the success of the business beyond a weekly paycheck. Ideally, you want your franchisees to think of themselves as “lifetime managers,” not passive owners.

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Item 9: Franchisee’s Obligations

Item 9 is essentially a table listing a number of obligations that the franchisee will have in the operation of the franchise, along with its location within both the franchise agreement and the disclosure document. It will reference and make clear the duties that you are imposing on your franchisee both pre- and post- opening. Very straightforward.

Item 10: Financing

If you offer financing to your franchisees, then you will detail that financing here in tabular form – the interest rate, the amount of financing, etc. – for each item financed. Because few small franchisors offer such financing, this section is typically little more than a footnote.

Item 11: Franchisor’s Assistance, Advertising, Computer Systems, and Training

The former name of this section was “Franchisor’s Obligations,” which is descriptive of what this section encompasses. Item 11 is of particular importance from a franchisee’s perspective, because the paragraphs within this section detail the franchisor’s operating system that they will be paying for.

A well-informed franchisee will have an idea coming into the business of what he or she will need to succeed in the business. This section had better cover all those things. Furthermore, you should know the difference between something that you offer as the franchisor and something you are obligated to do as a franchisor. You may go above and beyond your obligations, but performing less than that which you obliged yourself is inviting failure, litigation, and just a bunch of headaches in your day-to-day.

Item 12: Territory

This section will detail the territory in which the franchisee may operate its franchise and whether or not the territory is exclusive. In this case, exclusivity means an absence of competition from other businesses operating under your trademark, whether franchised or company-owned.

Exclusivity is one of the areas typically of utmost importance to franchisees. If you will not grant an exclusive territory, you must include a conspicuous warning to the franchisee within this section, stating: “You will not receive an exclusive territory. You may face competition from other franchisees, from outlets that we own, or from other channels of distribution or competitive brands that we control.”

Part 5 of our series of post seeking to answer the question, “what is a franchise disclosure document?” can be found here.

Because of this, the field operations manager is one of the most important players on the franchisor’s team. He or she will be the liaison between the franchisor and franchisee, conducting quality control, streamlining the implementation of new programs across franchises, and aiding the franchisee with any issues. Think of your field ops person as a franchisor-franchisee ambassador.

For this reason, I advise clients that whomever they hire for their field ops personnel will ideally have had significant experience on the franchisee side of a business. This experience will give them a unique perspective, having been on both sides of the fence, and enable them to relate well to the franchisees within their territory. Someone that has been in the franchisee’s shoes before can be invaluable to you in maintaining a good relationship with your franchisees.

Unfortunately, many franchisors do not see this point intuitively. Rather, they hire recent college graduates as field operations managers – people that, while they could very well be educated and intelligent, lack the proper experience to enable them to effectively relate to franchisees. This is a real problem for franchisors when the field ops team is the main point of contact between them and their franchisees.

The bottom line is that franchisors need to see their franchisees as something more than a task, something to be dealt with. They need to give the relationship that they have with their franchisees, its appropriate level of importance and devote time, energy, and resources to fostering that relationship. Otherwise, neither the franchisor nor the franchisee can reach the optimum level of success within the franchise system.

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Item 7: Estimated Initial Investment

Here, the franchisor is to disclose, in chart form, a comprehensive listing of all the costs that the franchisee can expect to incur in at least the first three months following the opening of the franchise. In addition, the franchisor must disclose to whom the payment is made, when the payment is due, under which circumstances (if any) that the payments are refundable, and whether financing is available. Additionally, the franchisor must disclose within the footnotes the basis by which the franchisor estimated the amounts indicated.

The categories of expenses to be listed here include:

• The initial franchise fee
• Any initial or ongoing training expenses
• Purchase or lease of any real property (i.e., your location)
• Inventory costs over that time
• Purchases of equipment, fixtures, or decorations
• Security deposits, business licenses, and other prepaid expenses
• Additional funds required by the franchisee before operations begin and during the initial phase of the franchise business

This detailed breakdown is (yet again) an attempt by the Federal Trade Commission to eliminate any “surprise” costs to the franchisee. You should expect that your franchisee will be asking your existing franchisees about the accuracy of these estimated costs. It is better to overestimate here than to underestimate, otherwise you give a failed franchisee ammo with which to blame you for his or her failure.

Item 8: Restrictions on Sources of Products and Services

This section is all about from whom the franchisee must purchase products or services relating to the operation of the franchise. The franchisor must disclose (1) which products or services the franchisee must purchase from the franchisor; (2) which products or services the franchisee must purchase from approved third party suppliers; and (3) which products and services the franchisee may purchase from a vendor of his or her choice.

Potential franchisees are going to be wary of any arrangement that is too restrictive as to the source of any such product or service as any restriction limits his or her bargaining power. Even if your initial franchise fee and/or royalty fees are relatively low, heavy restrictions here can be particularly unattractive to the franchisee as these costs may be completely out of the franchisee’s hands, and thus more likely to be subject to change.

Additionally, as a franchisor, you must be mindful of anti-trust issues related to tying arrangements and vertical price restraints when developing your franchise model.

Part 4 of this series where we continue to ask the question, “what is a franchise disclosure document?” can be found here.

Item 4: Bankruptcy

In this section, you must disclose any bankruptcy occurring in the last 10 years that involved “the franchisor, its affiliate, its predecessor, officers, or general partner.” This means that, in addition to the entity itself, any individual that is a key player in the operation of the franchisor’s business must disclose any such bankruptcy.

Bankruptcy does not carry the same stigma it did even 10 years ago, and having a bankruptcy on your FDD shouldn’t disqualify your offering in the mind of a franchisee. That being said, you should expect inquiries regarding the circumstances of any bankruptcy named in your FDD.

Item 5: Initial Franchise Fee

This will be one of the items of greatest interest to your franchisees as it lays out the range of fees that the franchisee will have to pay up front and the conditions under which (if any) that the fees are refundable. If your initial franchise fee is not uniform, then you will have to disclose the range franchisees have paid in the previous fiscal year and the factors by which you determine the fee.

Your franchisees will want to know the exact basis by which you came to these figures, and you may have to ask direct questions regarding its calculation. Higher fees are not necessarily better. A franchise that offers its franchises on a modest initial fee (so long as it covers the franchisor’s initial costs, at least) can be very successful long term through the collection of royalties. It will depend entirely on your business model.

Item 6: Other Fees

Here, you will disclose in chart form any other “isolated or recurring payments” to be made to the franchisor or its affiliates. This is the section in which one would find things like royalty and advertising payments. Along with each enumerated payment, the franchisor must disclose the amount paid, the due date, and any explanatory notes.

An educated (or well advised) franchisee will look over this section with particular scrutiny so as to avoid any unexpected costs after locking into the franchise. He or she will also pay particular attention to the calculation of the royalty payments – namely whether it is calculated by “gross” or “net” receipts, and furthermore, how “net” is calculated.

Part 3 of this series can be found here.

What Is A Franchise Disclosure Document?

Your FDD is a very robust disclosure document that is designed to give your potential franchisees the “who,” “what,” “when,” “where,” and “how” of your future relationship. The Federal Trade Commission’s (FTC) regulations dictate that it should be comprised of 23 parts. The purpose of the following series of posts is to introduce and acclimate you, the potential franchisor with the anatomy of an FDD. Additionally, I will be highlighting some pitfalls from which a franchise attorney like myself will frown upon, along with some tips.

Item 1: The Franchisor, Its Parents, Predecessors, and Affiliates

Here, your FDD is telling the franchisee from whom they are purchasing their franchise and from where the franchisor came – i.e., history and parent organizations, if any.

Information about the franchisor this section may include:

• Name
• Business address
• Type of business
• Years in business (and years it has been franchising outlets)
• Other businesses the franchisor, its parent, or affiliates operate

Item 1 is pretty straightforward. The potential franchisee should have a good idea of who you are and what you do after reading this section.

Item 2: Business Experience

Any of the franchisor’s directors, trustees, general partners, principal officers, and any other individuals who will have management responsibility relating to the sale or operation of franchises must disclose every position they have held in the previous five years. Think of it as a resume.

Your potential franchisee will be looking in the FDD for reasons that they can lean on your expertise to lead them to a successful business. From your franchisee’s perspective, your role is all about guidance. They are going to be looking for your business experience to reflect that and if you don’t have such experience, you may want to consider partnering with someone who does to legitimize yourself.

Item 3: Litigation

Item 3 is a list and description of all litigation in which the company is currently involved and any criminal actions of which the company or its management have been convicted in the previous ten years. If the company or members of its management have been held liable in certain civil actions, that must also be disclosed here:

• Violations of franchise, antitrust, or securities law
• Allegations of fraud
• Unfair/deceptive business practices
• Any comparable allegations to the above

Obviously, the big red flag to any potential franchisee is going to be any crime that indicts the character and trustworthiness of the franchisor. Furthermore, while the existence of litigation is not bad in itself, the amount of litigation relative to the size of the operation is very important.

Part 2 of our attempt to answer the question, “what is a franchise disclosure document?” can be found here.