If you are considering buying a franchise, think about how you purchase a new car. You don’t just watch the TV ads, consider how great the car looks, or take the dealer’s word about how fantastic the car is. You do your research; you evaluate its dependability, safety, features, and whether it suits your budget and your needs.
Given that purchasing a franchise represents a significantly greater investment of money, time, and resources, and that it will impact the trajectory of your finances and life for years or decades to come, the due diligence required to make the right call should be equally extensive.
The cornerstone of that due diligence – but not the entirety of it – is the Franchise Disclosure Document (FDD) required by the Federal Trade Commission’s (FTC) Franchise Rule. Prospective franchisees must receive the FDD at least 14 days before they are asked to sign any contract or pay any money to the franchisor or one of its affiliates. In fact, they have the right to the FDD once the franchisor has received their application and agrees to consider it.
The FDD contains 23 required sections designed to provide the information a potential franchisee needs to make an informed decision about whether and how to proceed. These 23 section categories are the same whether you are buying a McDonald’s franchise or a Camp BowWow Pet franchise. In this first in a series of deep dives into the FDD, we look at the initial sections of the document that discuss the franchisor’s experience, background, key players, and history of disputes with franchisees or others.
Section 1: Franchisor’s Background
Section 1, titled “The Franchisor and Any Parents, Predecessors, and Affiliates,” is all about the who, what, and how of the company offering the franchise. It explains the franchisor’s business history, describes the franchise system, and outlines the general nature of the products or services the franchise offers. It may also identify related companies that play a role in the franchise system, such as parent companies or affiliates.
One of the most important aspects of Section 1 is its discussion of the experience required to operate the franchise. Some franchise systems are designed for first-time business owners, while others expect franchisees to have industry knowledge, management experience, or specialized licenses. This information is critical to understanding whether the business is a good fit for your capabilities and goals.
A franchise can’t be evaluated in a vacuum, which is why Section 1 also discusses the competitive environment in which you would be doing business. It may identify the primary competitors and describe the market in which the franchise operates. While this information is generally broad, it can help you begin researching your local market and assessing whether there is sufficient demand for the franchise concept.
In addition to the market landscape, the legal landscape that will govern your business will play a significant role in its viability. Depending on the industry, franchisees may need to comply with health, labor, environmental, licensing, or other regulatory requirements. These obligations can affect your startup costs, operating procedures, and ongoing compliance responsibilities.
Perhaps most importantly, Section 1 helps you ask and answer thoughtful questions about the franchisor. Though additional inquiries may be needed, the FDD should provide answers to such questions as:
- How long has the franchisor been in business? Is this a ground floor opportunity or will you, in reality, be a test case for the concept?
- Has it changed business models over time?
- Are there sufficient staff who can be available to assist you when needed?
- Are affiliated companies responsible for providing essential products or services?
- Does the franchisor have experience supporting franchisees in markets like yours?
- Does the franchisor have company owned locations where they have tested and honed the business model or are they relying on the experience of their franchisees to understand the good, bad, and ugly?
Section 2: Franchisor’s Leadership and Key Players
FDD Section 2 identifies the franchisor’s directors, principal officers, and other key executives. It summarizes their business experience over the past five years, allowing prospective franchisees to assess whether the leadership team has the expertise necessary to operate and grow a successful franchise system.
Anyone can give themselves a fancy job title, but very little is in a name. Consider whether the leadership has meaningful experience in franchising, the specific industry, operations, marketing, and franchisee support. A management team with a strong background in franchise development and day-to-day operations may be better equipped to provide the guidance and resources franchisees need.
It’s also worth looking for stability. Frequent executive turnover can signal internal challenges or shifting business priorities. Conversely, long-term leaders with relevant experience may indicate a more established and consistent organization.
Section 3: Litigation History
In the United States, the reality of litigation is that anyone can sue anyone for almost anything. That doesn’t mean a case has merit or, conversely, is meritless. But a franchisor’s litigation history, and the substance and outcomes of those lawsuits, can provide valuable insights into the company’s business practices and whether consistent red flags have been raised in past cases.
Section 3 of the FDD discloses certain lawsuits involving the franchisor, its affiliates, and key executives. These disclosures may include claims alleging fraud, violations of franchise laws, unfair business practices, antitrust violations, or other significant legal matters. It also includes certain actions brought by franchisees and, in some cases, litigation initiated by the franchisor against franchisees.
The existence of litigation alone does not necessarily mean you should avoid a franchise opportunity. As noted, just because someone makes a claim doesn’t mean it will ultimately be deemed meritorious. Franchisors, particularly those with large systems, may routinely be involved in legal disputes. The key is understanding the nature, frequency, and outcome of the litigation. For example, a pattern of lawsuits alleging misrepresentations or repeated disputes over franchisee support may warrant closer examination. On the other hand, isolated contract enforcement actions may be less concerning depending on the circumstances.
In my next post, I will discuss sections of the Franchise Disclosure Document involving the dollars-and-cents of purchasing and operating a franchise. In the meantime, if you have questions or would like assistance in evaluating a franchise opportunity, please contact Roy Hibberd at Ansell.Law.