The Franchise Disclosure Document’s Most Critic Item

A franchise disclosure document (FDD) is designed to provide a prospective franchisee with all the information she or he needs to make an informed purchase decision. Item 20, which details outlets and franchise information, is where a franchisee will find information about how many franchises have opened in the last three years, the turnover rate, the projected openings and other critical facts. Item 20 also provides contact information for other franchisees, including ones who have left the franchise and can provide even more insight into the strengths and weaknesses of the business. For more on this continue reading the following article from Blue MauMau.

This is the second 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 refine and expand your due diligence efforts.

ITEM 20 – OUTLETS AND FRANCHISE INFORMATION

In the first article in this series, I wrote that Item 19 (Financial Performance Representations) might be one of the most important disclosure items in a franchise disclosure document (FDD). Item 20 may be the most important item. There are at least a couple of reasons to make this claim. First, Item 20 provides one of the best snapshots of a franchise system’s overall vitality. Second, Item 20 is the most significant gateway to critical information that lies outside of the FDD.

What you will learn

Information about Franchise Outlets. Through five mandated tables Item 20 provides a wealth of information about trends in a franchise system’s outlet growth and health. Specifically, these tables provide a description of:

• The number of franchised and company-owned outlets at the beginning and at the end of each of the last three fiscal years (Table 1 – Systemwide Outlet Summary)
• State-by-state outlet transfers (not including terminations and non-renewals) for each of the last three fiscal years (Table 2 – Transfers of Outlets from Franchisees to New Owners) (Other than the Franchisor))
• State-by-state turnover rates for franchised outlets for each of the last three fiscal years (Table 3 – Status of Franchised Outlets)
• State-by-state turnover rates for company-owned outlets for each of the last three fiscal years (Table 4 – Status of Company-Owned Outlets)
• Projected outlet openings in the next fiscal year and the number of franchise agreements signed in the previous year where a store has not yet been opened (Table 5 – Projected Openings)

The statistics these tables present can be more informative in some respects than the franchisor’s financial statements, which, for example, may show impressive year-to-year earnings growth but may not reveal a diminished or churned base of outlets.

Contact Lists. Item 20 requires disclosure of contact Information for current franchisees, franchisees who left the system within the last year, franchisees who have not communicated with the franchisor within 10 weeks of the FDD issuance date and certain “trademark-specific” (i.e., same franchise system and same brand) franchisee associations.

This contact information provides invaluable access to information outside the four corners of the FDD. For example, a prospective franchisee can only obtain limited financial performance data from franchisors and, even then, only under the narrow disclosure restrictions of Item 19. Franchisees, former franchisees, and trademark-specific franchise associations, however, generally are subject to no such restrictions and, as a result, can provide what may prove to be the most important information uncovered in any prospective franchisee’s due diligence process.

This part of your diligence should include, at a minimum, the following questions:

• If you could go back in time, would you invest in the franchise?
• How much money are you making? What were your revenues and net income last year and are they trending up or down?
• At what point was your outlet cash flow positive?
• How much of the business did you finance (to ensure that you’re comparing apple-to-apples on revenues, net income and cash flow)?
• Were you satisfied with the franchisor’s training and support?
• What’s a typical day as a franchisee like?
• What questions should you be asking the franchisor?

What you will not learn

In certain limited circumstances, a franchisor may provide a cherry-picked selection of current franchisees and, accordingly, you may not get a truly representative sample of the success, failure or general satisfaction of current franchisees.

In addition, because of unspecified “privacy concerns,” franchisors are required to provide only limited contact information for both current and former franchisees. For current franchisees, franchisors need only disclose the name of the franchisee and the address and telephone number for the franchise outlet. For franchisees who:

• had an outlet terminated, canceled or not renewed or otherwise ceased to do business under the franchise agreement during the most recently completed fiscal year or
• has not communicated with the franchisor within 10 weeks of the FDD issuance date

the franchisor is only obligated to disclose the name, city, state and current business telephone number, even if that business number connects to an unrelated business. If the current business telephone number is unknown, the franchisor is required to disclose the last known home telephone number. The upshot of this is that your franchisee contact information may be dated, incomplete or incorrect.

For trademark-specific franchisee associations, there are a number of disclosure limitations:

• the disclosure pertains only to associations of franchisees of the franchise brand being offered (Joe’s Smoothies but not Joe’s Burgers or the “Smoothies and Hamburger Restaurant Franchisee Association”)
• the association must be organized under State law
• the association must expressly request permission to be included in the FDD and
• the association must timely renew its request for inclusion on an annual basis.

There are also limits to what a current or former franchisee may be willing or legally permitted to say. For any number of reasons, a franchise may be less than forthcoming about his or her success or failure.

More importantly, franchisees may be restricted in what they can tell you because they are bound by the terms of a confidentiality agreement. Item 20 requires franchisors to disclose whether franchisees have signed a confidentiality agreement with the franchisor during the last three fiscal years. This requirement is too limited to provide any truly meaningful information, however.

First, the required disclosure only reveals whether at least one franchisee has signed a confidentiality agreement. The number and percent of franchisees who have signed confidentiality agreements and the circumstances under which they signed confidentiality agreements are only optional disclosures. These disclosures, of course, would be the most helpful. Imagine, for example, how differently you would view a franchise where one of 100 franchisees entered into a confidentiality agreement versus a franchise where, say, more than 50 percent of franchisees did so. Second, because you won’t know who on the contact lists signed a confidentiality agreement, you may waste a lot of time calling franchisees who are prohibited from discussing their personal experience with the franchise system. During the rulemaking process for the then new FTC franchise rule in 2007, one commentator noted that “in a perfect world” he would have a list of those franchisees who signed confidentiality agreements so he “didn’t have to make those extra 75 calls.” He said, though, that he could live without the list because it’s more important to disclose the fact that confidentiality agreements exist. I disagree completely. The fact that one or more confidentiality agreements exist, without more, is not especially helpful information. Because of the way “confidentiality agreement” is defined under the FTC franchise rule you only will learn whether at least one franchisee may have had a negative personal experience as a franchisee within the franchise system. This is hardly instructive.

Despite these limitations, Item 20 should be a primary focus of your FDD review. Reading and fully comprehending the massive amount of information contained in an FDD is challenging for even the most patient and savvy business people. But, if there’s a single item in the FDD that should command your utmost focus, it ought to be Item 20.

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.