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Posted on Feb 25, 2011

Franchise Disclosure Document for Dummies – Part 3

In part three of this series on understanding the Franchise Disclosure Document, we continue with Items 8 and 11 (Items 9 and 10, while important, do not lend themselves particularly well to discussion). Item 8 covers suppliers, mandatory purchases and franchisor rebates, while Item 11 covers the franchisor’s pre- and post-opening obligations to its franchisees.  Click here to read Part 1 or Part 2.

Item 8 – Restrictions on Sources of Products and Services

In Item 8 of the FDD, franchisors are required to disclose designated and approved suppliers, franchisees’ mandatory purchases, and any rebates they receive from vendors as a result of franchisee purchases.

When a franchisor mandates purchases—whether from itself or a related or independent third-party—prospective franchisees need to perform the appropriate due diligence to ensure that the designated vendor’s prices are in line with industry standards. This is particularly important where the vendor is the franchisor itself, the franchisor’s affiliate, or a vendor who pays rebates to the franchisor as a result of franchisee purchases. Generally, the prospective franchisee will be looking to see that their required purchases are not a significant revenue source for the franchisor.

Important Item 8 disclosures include:

  • Franchisees’ mandatory purchases
  • Identification of designated suppliers
  • Provisions for obtaining approval of alternate suppliers
  • Franchisor ownership of, or affiliation with, designated suppliers
  • Terms of rebates, commissions and other benefits paid to the franchisor by franchisee suppliers
  • Financial disclosures regarding rebates and commissions
  • Whether the franchisor negotiates purchase arrangements for the benefit of franchisees

Each of these disclosures, even if omitted (or, more accurately, made “negatively” [i.e. the franchisor does not negotiate purchase arrangements]), can provide important insight for prospective franchisees when evaluating proposed franchise opportunities.

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

Item 11 covers the franchisor’s pre-opening and ongoing support obligations to its franchisees. Item 11 disclosure obligations can be separated into 7 main categories.

Item 11 disclosures include:

  • Pre-Opening Obligations
  • Timeline for Opening for Business
  • Ongoing Support Obligations
  • System-wide and Local Advertising
  • Computer Systems
  • Initial and Ongoing Training
  • Operations Manual

Pre-opening Obligations

The scope of a franchisor’s pre-opening obligations can vary widely depending on the nature of the franchise system. In addition, franchisors required by state regulators to defer or escrow initial franchise fees will often try to limit their pre-opening obligations in order to accelerate their ability to collect. Post-opening and ongoing support obligations will also vary widely from franchisor to franchisor.

System-wide Advertising

With regard to advertising programs, in performing their due diligence, prospective franchisees will want to investigate the efficacy and geographic scope of the franchisor’s advertising efforts. Prospective franchisees will also want to make sure that ad fund contributions are predominantly used for direct ad placement, as opposed to in-house R&D or “administrative” expenses.

The Initial Training Program and Operations Manual

Training and Operations Manual disclosures are similarly critical to the due diligence process. Prospective franchisees should seek to make sure that the initial training program is conducted by qualified individuals, and is sufficiently comprehensive to prepare them to get their franchised businesses off of the ground and running smoothly during the initial phase.

Likewise, whether the franchisor discloses its Operations Manual’s table of contents in the FDD or permits franchisees to review the Operations Manual at its headquarters, prospective franchisees will want to ensure that the Manual is sufficiently comprehensive to meaningfully assist them in successfully operating their business in accordance with the franchisor’s system standards.

Next week, Franchise Disclosure Document for Dummies - Part 4 will discuss Item 12 of the FDD, which covers territory rights of franchisees.

Jeff Fabian is the owner of Fabian, LLC, a boutique intellectual property and business law firm serving new and established franchisors and prospective franchisees. Visit www.fabianlegal.com or www.thefranchisecafe.com for more information, or contact the firm directly at 410.908.0883 or jeff@fabianlegal.com. You can also follow Jeff on Twitter @jsfabian.

This article is provided for informational purposes only, and does not constitute legal advice. Always consult an attorney before taking any action that may affect your legal rights or liabilities.

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