The Franchise Disclosure Document (FDD) provides a significant amount of information about the franchisor and franchise system as noted previously. Among the most important items in the FDD are the business terms between the franchisor and franchisee. These are encompassed in Items 5, 6, and 12 of the FDD, which set forth the fees and territory rules that will apply to the franchisees. The key issues you must decide as a franchisor include the following:
- Item 5. This section describes the initial fees that the franchisee must pay to the franchisor prior to opening the franchise for business. At a minimum, Item 5 of the FDD will identify the Initial Franchise Fee. In determining the amount of the Initial Franchise Fee, you must consider the expense of onboarding including your costs to provide franchisees with initial training.
You may charge a different Initial Franchise Fee for different types of franchises and may offer a discount to certain franchisees, such as veterans or existing franchisees. However, if a different Initial Franchise Fee will be charged to different franchisees, the FDD must indicate the basis by which the fees will be differentiated.
If the franchisee will be required to purchase certain items such as inventory, equipment, software technology or branded materials from the franchisor or its affiliates, the costs of these purchases should also be listed in Item 5. It should be noted that the fees listed in Item 5 do not represent all of the costs of opening the franchise. Other upfront expenses are listed in Item 7-Estimated Initial Investment.
The FDD must also state whether payment is made in a lump sum or installments and whether it can be refunded.
- Item 6. In addition to the initial fees, the FDD must disclose in Item 6, the recurring and other occasional fees the franchisee may be required to pay to the franchisor or its affiliates or that the franchisor imposes or collects on behalf of third parties, while the franchisee is operating the franchise. These amounts may include marketing fees, royalties, ongoing software fees, late fees, renewal fees, transfer fees, etc.
Franchise marketing fees generally cover the franchisee’s share of the franchisor’s advertising of its “brand.” Royalties are compensation for the franchisee licensing the rights to use the franchisor’s trademarks, logos, services marks and systems of operation. The amount may be based on a percentage of the franchisee’s revenue, a minimum amount, or the greater of the two.
An important note about setting the amount of any of the Item 5 or Item 6 fees is for franchisors to be competitive. You must determine what makes sense for your business but also remember that the franchisee has to make money from the operation of the franchise. Fees that are too high may discourage franchisees.
- Item 12. In the FDD, you must define the geographical areas within which your franchises will/may operate. That means describing the size of a typical franchisee’s territory and how it is determined (e.g. population, radius, square blocks or miles). In addition, you must specify whether the franchisee will receive exclusive territorial rights and how those rights will be defined. If the rights can be lost or modified, that information should also be included in the FDD. If you do not provide any territorial protection to your franchisees, you must include a “special warning” in the FDD.
An important issue to consider is whether you want to reserve any rights for the franchisor or its affiliates. For instance, do you want the ability to sell products and/or services within a franchisee’s territory through Internet activities, catalogue sales, telemarketing, supermarkets, direct sales, co-branding, “non-traditional locations” (e.g. universities, stadiums, trucks, etc.) or other alternative channels within the franchisee’s territory?
- Area development fees. Some franchisors choose to offer area development franchises in addition to franchises for single locations. Area development franchises typically grant the area developer an exclusive area in which to develop a specified number of franchised businesses. The Area Development Fee is the fee paid in connection with the signing of an Area Development Agreement. Whether the fee must be paid as a lump sum or installments and whether it can be refunded also must be determined.
Deciding your business terms is a difficult but necessary part of building a successful franchise. An experienced franchise attorney can help walk you through the issues you must consider before attempting to launch a franchise.
If you are thinking of franchising your business, Lusthaus Law can help. Contact us for a consultation.
