Item 7 of the Franchise Disclosure Document (FDD) requires franchisors to set out in a prescribed tabular format a franchisee’s estimated initial investment – i.e., all the expenses required by the franchise agreement and all other costs necessary for a franchisee to commence business. These costs go beyond the fees in Item 5-Initial Franchise Fees and Item 6-Recurring/Occasional Fees discussed previously.
The expenses included in Item 7 reflect amounts franchisees will likely have to pay to third parties for a reasonable initial period, encompassing the time between signing the agreement through the beginning stages of operations. The purpose of Item 7 is to give prospective franchisees a detailed picture of their likely investment so they can make an informed decision about buying the franchise. For the franchisor, Item 7 represents a possible danger area because making mistakes in these numbers can make it harder to sell the franchise as well as result in legal liability. Important issues franchisors need to know include the following:
Types of expenses. Item 7 is not intended to be an exhaustive list of all of the fees or expenses that franchisees will incur. The categories of expenses to be included will necessarily vary depending upon the nature of the franchised business. However, some of the typical expenses are training expenses, rent, inventory, equipment, supplies, furnishings, advertising, software, permits, insurance, professional fees, utility costs and other payments. There is also another category called “Additional funds – [initial period]” where franchisors must include a dollar range that will cover the other expenses that franchisees will pay both before operations begin and during “the initial period” of operations. In the footnotes to Item 7, franchisors will typically list a few categories of the expenses that are included and specifically state that there may be additional ongoing expenses as well as whether the payments are refundable.
Time frame. For purposes of disclosure, most expenses generally cover the period prior to the date the franchise opens with some exceptions. With respect to “Additional funds,” the costs must encompass the period both before operations begin and during “the initial period” of operations. In general, a reasonable period is at least three months. Franchisors may use a longer period that is reasonable for the specific industry. In either event, they must disclose the initial period used to calculate the costs.
Reasonable basis for estimates. Franchisors must take care that they conduct due diligence in determining the relevant costs. Item 7 requires that they have a reasonable basis for each amount identified. They must also state, in general terms, the factors, basis and experience they considered or relied upon to calculate the amount of estimated additional funds. They should consider local market variations in price and update figures annually to ensure they are providing accurate numbers. If the exact amount of a payment is unknown, then franchisors may use a low-high range, but must explain the basis for their estimates. For example, in the case of real estate-related expenses, franchisors may describe the approximate size of the property and building that they used to determine the cost.
It is important to note that if franchisors provide estimates that are too low, they may be subject to liability. A franchisee may sue for misrepresentation or fraud. Although franchisors may consider listing their costs on the high end to avoid potential lawsuits, the higher the expenses, the more difficult it may be to sell the franchise.
If you are considering franchising your business, consult an experienced franchise attorney to help ensure you comply with all relevant laws and good business practices. Contact Lusthaus Law for a consultation.