As a prospective franchisee, it is critical to thoroughly review the Franchise Disclosure Document (FDD) for all of the franchise opportunities on your short list. The FDD contains a wealth of information—including information that franchisors are required (but may not necessarily want) to disclose. Once you decide on the franchise opportunity you want to pursue, you should have the FDD reviewed by an experienced franchise lawyer as well.
You should also review the franchise agreement for each opportunity you are seriously considering when doing your due diligence. This is true even though Item 17 of the FDD provides a summary of the key terms of the agreement.
Why It’s Important to Review the Franchise Agreement During Your Due Diligence
Why do you need to review the franchise agreement when Item 17 of the FDD summarizes the key terms? There are three main reasons:
1. The Item 17 Summaries May Not Be 100 Percent Accurate
The first reason why you should read the franchise agreement itself is that the Item 17 summaries may not be 100 percent accurate. While franchisors are supposed to ensure that their Item 17 summaries are accurate, in their efforts to summarize, they may mischaracterize or misrepresent certain information. Even if these errors are entirely inadvertent, if you rely on inaccurate information, you could end up making a buying decision that you will regret down the line.
In a well-written franchise agreement, every single word (or nearly every single word) will be there for a reason. As a result, summarizing key franchise agreement terms accurately can be difficult. While this isn’t an excuse for including inaccurate summaries in Item 17, the reality is that it leads to inaccurate (or incomplete) summaries in many cases.
2. The Item 17 Summaries Don’t Cover Everything You Need to Know
Even if all of the summaries in a franchisor’s Item 17 disclosures are accurate and complete, they still won’t tell you everything you need to know. This is the second reason why you should read the franchise agreement itself.
When preparing their Item 17 disclosures, franchisors are required to use a table format that the U.S. Federal Trade Commission (FTC) created in 2008. The FTC’s table specifies the provisions that franchisors need to summarize. While the FTC’s table covers most of the key provisions in a typical franchise agreement, every franchisor’s agreement is unique—and this means that there will almost always be important terms that aren’t covered in Item 17.
3. The Franchise Agreement Will Govern Your Relationship with the Franchisor
While the FDD is a federally mandated disclosure document, it is the franchise agreement that will ultimately govern your relationship with the franchisor. As a result, it is critical that you have a clear and comprehensive understanding of the terms of the franchise agreement itself. If you have questions about the terms of the franchise agreement (which you almost certainly will), you should ask them—and you should make sure you get the answers you need before moving forward.
With this in mind, rather than relying on the summaries in Item 17, it can be helpful to use Item 17 as a sort of checklist to make sure you have reviewed the key terms in the franchise agreement itself. Again, the terms summarized in Item 17 are not the only terms you need to review. But, when comparing franchise opportunities during your due diligence, these terms are likely to be among the easiest to compare, and they are likely to be among the most important for your decision-making as well.
What to Look for When Reviewing the Franchise Agreement
With all of this in mind, what should you look for when reviewing the franchise agreement for a potential franchise opportunity? Some key considerations include:
- Initial Term and Renewal Rights – How long is the initial term? How much control will you have over whether you are able to renew? It often takes multiple years for franchises to become profitable, so you need to ensure that you will have sufficient time to recoup your investment.
- Operating Requirements and Restrictions – How much control will the franchisor have over your day-to-day operations? Will you be subject to purchasing restrictions or requirements? Can the franchisor impose new restrictions or requirements in the future? These are all critical questions.
- Grounds for Termination – What defaults will constitute grounds for the franchisor to terminate your franchise? If you default under your franchise agreement, you might not get a second chance—and this could also leave you unable to recoup your investment.
- Remedies Upon Termination – What are the franchisor’s rights in the event of termination? Beyond being unable to recoup your investment, facing early termination of your franchise agreement can present other financial risks as well. For example, many franchise agreements entitle franchisors to “lost future royalties” for the remainder of the franchise term.
- Dispute Resolution – If you need to take legal action against your franchisor, will you be able to seek appropriate remedies in court? Or, will you have to travel to the franchisor’s headquarters for arbitration? Will you be liable for the franchisor’s legal fees if your efforts to enforce your rights are unsuccessful? These are all critical questions as well.
This is just a small sampling. Franchise agreements are long, complex contracts that put the franchisor’s interests first. This fact is critical to keep in mind. When reviewing the franchise agreement for a potential franchise opportunity, it is imperative to ensure that you have a clear and comprehensive understanding of the risks it presents—and you need to decide whether you are willing to take on these risks in light of the potential benefits the franchise opportunity offers.
Schedule a Call with National Franchise Lawyer Jeffrey M. Goldstein
If you are considering a franchise opportunity and would like to know more about what you can (and should) do to ensure that you make an informed buying decision, we invite you to get in touch. To schedule a call with national franchise lawyer Jeffrey M. Goldstein, please call 202-293-3947 or request a free consultation online today.
