A Guide to Understanding A Franchise Disclosure Document

This article originally appeared in Canadian Food and Beverage Magazine

Under Ontario law, all franchisors are now required to provide a disclosure statement to prospective franchisees at least 14 days before any contract relating to the franchise is signed or any moneys relating to the franchise are paid.  The purpose of the disclosure statement is to provide a prospective franchisee with sufficient information to determine whether an investment in a particular franchise opportunity is suitable for him or her.  It should not, however, be assumed that the disclosure statement will disclose all information that might be pertinent in making such an investment decision.  To the extent that any potential investor in a franchise opportunity feels that more information is required, a careful review of the disclosure statement will usually suggest possible additional sources for such information.

The beginning of the disclosure statement must contain four generic, but important, statements indicated in italics below:

• The prospective franchisee may obtain additional information concerning the franchisor from private credit reporting companies. This statement refers to the fact that the prospective franchisee can order a credit report on the franchisor from a private credit reporting company, such as Dun & Bradstreet. If the results of such a report were to indicate that the franchisor has a poor credit rating (as determined by its dealings with banks and other creditors) that should be a clear "warning signal" to a prospective franchisee about the risks of investing in a franchise with that franchisor. A prudent investor should be loathe to entrust his or her financial future to a franchisor that, according to a poor credit report, is probably already experiencing financial difficulties and may eventually go out of business.

• Independent legal and financial advice in relation to the franchise agreement should be sought by the investor prior to entering into the franchise agreement. The reason for this statement should be self-evident. If the disclosure statement is to serve its intended purpose of assisting prospective franchisees to make informed investment decisions, a prospective franchisee who is lacking in business and/or legal sophistication should review the disclosure statement and the franchise agreement with a professional financial and/or legal advisor before proceeding with the investment in the franchise. Ideally, the financial advisor should have extensive experience in the industry or market sector of the target franchise (such as the hospitality industry, or the retail grocery food industry etc.). That sort of experience will allow the financial advisor to provide a prospective franchisee with advice concerning general trends in the industry in question and, possibly, specific advice about how the franchisor is positioned within that industry. Similarly, the advice of a lawyer with extensive experience in franchising is preferable to the advice of a lawyer with a more general practice. A lawyer with extensive franchising experience can not only provide a more valuable critique of the franchisor's legal documents, but he or she may also be in a position to provide a prospective franchisee with advice concerning the general commercial reputation of the target franchisor and what changes to the legal documents the franchisor will likely be willing to entertain.

• The prospective franchisee is encouraged to contact any past or present franchisee prior to entering into the franchise agreement. This statement points to the obvious truism that no one can give a prospective franchisee more practical advice on what it would be like to part of a particular franchise system than other franchisees who have been, or still are, in that very position. A prospective investor in a franchise opportunity should always make an effort to contact both past and present franchisees of a particular franchise system to obtain the benefit of their experiences as franchisees.

• Under the terms of the franchise agreement, the cost of goods and/or services provided to the franchisee by the franchisor or its approved suppliers may not be the lowest cost for such goods and/or services available in the marketplace. Many prospective franchisees assume that, by virtue of being part of a large franchise buying network, the cost of their goods and/or services will be lower than the costs of their independent competitors. It follows that (according to this assumption) being a franchisee would, of necessity, give them a "edge" over their competitors in relation to costs. This is a very common assumption, but one that is extremely dangerous and at odds with the realities experienced by franchisees in countless franchise systems. The reality is that, in many franchise systems, much (if not most) of the franchisor's revenue is derived, directly or indirectly, from sales of the franchise-related goods or services to its franchisees. When one considers that, under the terms of most franchise agreements, the franchisee must pay the franchisor a royalty on all sales, the right to buy from "outside" suppliers is highly restricted or prohibited outright, and there are (usually) minimum requirements for spending on regional and local advertising, it is not hard to see that franchisors tend to be in a position to control most of their franchisees' major costs of doing business. Given that reality, it is extremely important that a prospective franchisee make every effort to "link" his or her financial future only to a franchisor with a general reputation for profitable operations and equitable and fair business dealings with its franchisees.

An investor's overall attitude should be that it is far better to engage in the sorts of extensive investigations described above (no matter how daunting they may initially appear) before committing to any investment in a franchise opportunity.  The ability to correct a poor investment in a franchise after the fact will invariably be limited by the extreme one-sidedness of most franchise agreements in favour of the franchisor's interests.  Since an ownership interest in a franchise business is not a highly liquid investment (by comparison to an investment in a publicly-traded security, for example), engaging in the sort of "due diligence" described above can save a prospective franchisee a great deal of future psychological, not to mention financial, pain.

Other Disclosure Requirements

The disclosure statement must contain information concerning the business background of the franchisor, including its head office, a general description of its business activities, the business names and trademarks under which it operates its franchise business, the identity of any corporations with which the franchisor is related, and how long the franchisor has been engaged in its franchise business.  The disclosure statement must also disclose the business backgrounds of the directors, general partners and officers of the franchisor, and any past history of "legal troubles" (such as civil lawsuits, criminal convictions, bankruptcy etc.) that the franchisor and/or its executives may have been involved in.  This area of the disclosure statement indicates, among other things, the identities and business backgrounds of those persons who are primarily responsible for the day-to-day management of the franchisor.  If this area of the disclosure statement indicates that such individuals are extremely experienced business people with "unblemished" business reputations and an established track record of success in the franchise business or in related businesses, common sense would suggest that there are greater prospects for the success of the franchise system.  Conversely, if this area of the disclosure statement indicates that the franchisor or some of its executives are no strangers to "legal troubles" of the kind described above, once again, a prospective franchisee would do well to seriously reconsider investing in that franchise system.  It should be obvious that it would be decidedly unwise to invest in a franchise opportunity where the individuals who may have a profound influence on the prospective franchisee's financial future have a past history of at least unethical and, at worst, outright criminal behaviour.

The disclosure statement is generally required to contain a copy of the financial statement for the most recently completed fiscal year of the franchisor's operations.  Once again, the financial statement can be an extremely important source of information for a potential investor in a franchise opportunity.  When reviewed with an experienced professional advisor, the financial statement can provide vital information concerning the franchisor's financial health and future viability.  For example, the statement may disclose such things as whether or not the franchisor has sufficient cash flow to finance its operations, its main sources of revenue, and whether it has significant aged receivables or bad debts (often signifying that it is having difficulty collecting its royalties from its franchisees).  In our information age, the disclosure statement may not be the only source of valuable financial information regarding the franchisor.  For example, franchisors that are public companies (such as McDonalds or Starbucks), are generally required to file all sorts of financial and disclosure statements under the securities law of most jurisdictions in Canada, including Ontario.  In addition, during the last two decades there has been a significant increase in the coverage of business-related issues in the press.  For comparatively modest fees, searches of the databases of many of our largest newspapers will often turn up useful articles on a target franchisor, ranging from its "success" stories, to coverage of lawsuits involving the franchisor.  Free searches conducted against a target franchsior on the Internet can also yield some useful information about the franchisor and its business reputation, although the reliability of any material that appears on the Internet remains the subject of debate and will tend to vary depending on the reputation of its source.

The disclosure statement must also contain a copy of all relevant legal agreements that a prospective franchisee will be required to enter into as part of its purchase of the franchise.  These agreements will virtually always include a franchise agreement, and, depending upon the particular franchise system, often a trademark license agreement, a sublease agreement, a personal guarantee, and a general security agreement.  As noted above, professional advice concerning all franchise-related legal agreements is an absolute must for most prospective franchisees since, in the main, it is those written agreements (and not oral representations that may have been made to a prospective investor by promoters of the franchise) that document the legal basis of the franchisor/franchisee relationship.

The disclosure statement must indicate any method that will used to resolve any future disputes between the franchisor and the franchisee.  For example, the disclosure statement may indicate that any such disputes must be resolved by arbitration that is binding on both sides.  As a method of dispute resolution, arbitration tends to be more expeditious, inexpensive, informal and "franchisee-friendly" than litigation.If no pre-agreed-upon dispute resolution mechanism is mentioned in franchise agreement, that generally means that disputes that cannot be resolved by the parties will have to be resolved, if need be, in the courts.

One of the most important parts of any disclosure statement is that part of the statement which discloses the franchisor's estimate of fees and costs that will be involved to purchase the franchise rights and to establish the franchise's place of business.  Typically, these costs will include at least some of the following: an initial deposit payment (which may or may not be refundable); an initial franchise fee (which may or may not be refundable); an estimate of costs for opening inventory, supplies and uniforms; training expenses; travel and living expenses while the franchisee is undergoing training; the cost of leasehold improvements and fixtures; the cost of equipment and small wares (for example, in a food-related franchise); the cost for store designs and building permits; the cost for interior and exterior signage; grand opening and regular advertising costs; the cost of furniture; an estimate of rent for the franchise location; and any miscellaneous costs that may be involved (such as utilities, licenses, professional fees and other prepaid expenses).  Since the franchisor must be wary of any possible misrepresentations that may be contained in the above sorts of financial projections, it is common for disclosure statements to qualify some or all of the above projected fees and costs by indicating that they are intended to be "estimates" only which may vary depending upon various factors that are specific to a particular franchise opportunity.  Such qualifications are ostensibly legitimate.  After all, everything from the cost of goods, to rent, to labour costs, to the cost of utilities etc. will be affected by the relevant market in which the franchise would be located.  Prospective franchisees should be aware, however, that such qualifications also provide the franchisor with significant "wiggle room" if the actual costs of establishing the franchise business turn out to be higher than the franchisor's projections.

The disclosure statement must indicate whether the franchisor will be charging any fee for services rendered in the construction and development of the franchise premises, as well as any rights which are reserved to the franchisor to terminate the franchise agreement if there are "unforeseen" costs involved in developing the franchise. If a permit, a license, or re-zoning were required, for example, which would involve incurring extraordinary expenses, the franchisor may have included a right for it to "back out" of the franchise agreement.

The disclosure statement must also disclose whether there are other "incidental" costs associated with the franchise opportunity.  Under this "heading", the disclosure statement will usually indicate the amount of the franchisor's continuing royalty fee, fees related to general advertising, and the minimum amounts that the franchisee will be required to pay for local advertising and promotion.  Other "incidental" costs might (and routinely do) include the costs of the franchisee's liability insurance, the cost of acquiring the computer and accounting system required by the franchisor, and regular accounting costs that would be incurred by the franchisee to prepare regular profit-and-loss and other financial statements.

Since the franchise agreement provides the franchisee with certain franchise rights that are personal to that franchisee and that expire after a specified term, it is not uncommon for an additional fee to be involved if the franchise agreement is renewed, or if the franchisee decides that it wishes to sell its franchise business to a third party.  The disclosure statement must disclose whether, and, if so, the amount of any renewal or transfer fees and how and when such fees must be paid.

The disclosure statements of many franchisors include "earnings claims" information in the form of a pro forma operating statement.  A "pro forma" is intended to be a "realistic" projection of the sort of financial performance that a prospective franchisee can expect from his or her franchise business should it achieve various sales levels; more often than not, such pro formas exclude the impact of such important factors as the owner's compensation, the costs of servicing any business loans associated with the franchise, and depreciation costs. In order to reduce the risk of franchisors providing "overly-optimistic" pro formas, the law requires that the disclosure statement must specify the underlying assumptions that a franchisor's pro forma is based on.  Such assumptions would typically include the assumed cost of goods sold, the contribution made to the financial performance of any franchise location by the business ability of the franchisee's management personnel and staff, wage costs, lease costs, and the typical costs for such items as insurance, repairs and maintenance, telephone, store supplies, local marketing and miscellaneous expenses.  The royalty rate and advertising costs assumed by the pro forma must also be disclosed, as must the cost of financing (if any) provided by the franchisor, training costs, and the costs of national and local advertising.

One of the areas of the disclosure statement that should be reviewed with particular care by prospective franchisees is that area which discloses the nature of the franchisee's rights and obligations in relation to the purchasing or leasing of goods and services.  As noted above, typically in a franchise system, franchisees will be required to purchase or lease virtually all of their goods, services, fixtures, equipment and inventory etc. from either the franchisor (or a related company) or from sources approved by the franchisor.  The franchisor's usual rationale for this requirement is that it gives the franchisor the necessary rights to ensure that all standards and quality-control requirements of its franchise system will be adhered to by all of its franchisees.  While that rationale may be logically credible, from the franchisee's perspective, such requirements can make it difficult, if not impossible, for the franchisee to operate his or her business profitably particularly if, as noted above, it turns out that the cost of goods and services from the franchisor or its improved suppliers is greater than the cost of comparable goods and services available in the marketplace.  Because the typical franchise agreement will make the franchisee a "captive" purchaser from the franchisor or its improved suppliers, any attempt by the franchisee to purchase or lease goods or services outside of the above "closed circle" (usually as part of a "last ditch" effort to survive economically) can, and usually does, give rise to serious (and often prohibitively expensive) legal disputes with the franchisor.

The disclosure statement must also indicate whether the franchisor may, or does, receive rebates, bonuses, discounts or other fees or allowances from some or all of the suppliers to the franchise system.  Prospective franchisees should be aware that the retention by the franchisor of most, if not all, of these usually very substantial financial benefits is currently the norm in the franchise industry and, if anything, that tendency is increasing.  Most disclosure statements will indicate that franchisees are required, under the terms of the franchise agreement, to acknowledge that the franchisor will be entitled to retain such financial benefits without accounting for, or passing on any portion of them down to, the franchisees.

One of the vital elements of any successful franchise system is its trademarks; that is, the widely-known brand names under which the goods and/or services associated with franchise system are recognized by the buying public.  The disclosure statement must indicate the trademarks, logos, emblems or other commercial symbols associated with franchise system.

Since franchisees are, as a matter of law, independent business operators, they must usually obtain various licenses, registrations and other governmental forms of authorization to operate their franchise businesses.  The disclosure statement must set out the nature of any such licenses, registrations, and authorizations. Typically, they will include obtaining a vendor's permit, a GST and PST registration number, municipal business licenses, registration under workers compensation legislation etc.

The disclosure statement must also indicate the degree of time, attention and effort that the franchisee, or, where the franchisee is a corporation, the principal shareholders of the franchisee, will be required to devote to the franchise business.  This will obviously be important if the potential investor in a franchise opportunity has, or wishes to have, additional business interests.  Typically, the franchise agreement will require that a franchisee must devote his, her or its full-time, attention and effort to the franchise business, that the franchise business must remain open continuously for the hours of business prescribed by the franchisor, and that a franchisee cannot be engaged in any other business venture without the prior written consent of the franchisor.

A prospective franchisee will obviously be concerned about any competition that his or her franchise business may face not only from other providers of similar goods and services in the marketplace, but from other franchisees who are part of the same franchise system.  The disclosure statement must indicate whether their prospective franchise will be granted what is usually characterized as an "exclusive territory" by the franchisor, and, if so, the nature and extent of the exclusive territory.  The exclusive territory, if any, usually indicates a geographic territory within which the franchisor will not grant additional franchises that would compete with the franchise of the prospective franchisee.  It is not unusual for the franchise agreements of the more "established" franchisors not to grant an exclusive territory to franchisees at all.  The franchisor's typical response to a prospective franchisee's concern about competition from other franchisees is that, since the franchisor's own main sources of revenue derive from the royalties and purchases of goods and services that are part of its franchise system, it would not be in the franchisor's best interests to grant more franchises then can operate profitably within a given market.  In reality, franchisors may have many incentives that may lead them to "over -franchise" a particular market without regard to their impact of franchisees.  Such, incentives may include generating the payment of more initial franchise fees, generating more royalties in the aggregate for themselves (even if the profitability of individual franchise stores suffers in the process), and, perhaps even more significantly, generating more financial benefits for themselves in the form of rebates, bonuses, discounts or allowances etc. that may be paid to them by some or all of the suppliers to the franchise system.  These last-mentioned financial benefits -- that are increasingly being retained by franchisors in their entirety - usually depend on the total volume of purchases made by the franchise system as a whole from its suppliers, without regard to the profitability (or lack of profitability) of individual franchisees.

In order to enable a prospective franchisee to contact both past and present franchisees of the franchisor, as noted above, the disclosure statement must indicate contact information for past franchisees whose franchises have either been terminated, cancelled, not renewed, reacquired or who otherwise left the franchise system within the most recently completed fiscal year of the franchisor immediately preceding the date of the disclosure statement.  A prospective investor in a franchise opportunity should always make an effort to contact such past franchisees to obtain their perspective on what it was like to be a franchisee in the target franchise system.  The number of franchise closures occurring during the three years immediately preceding the date of the disclosure statement, and the reasons for such closures, must also be disclosed in the disclosure statement.  The above information regarding recent franchise terminations, cancellations, non-renewals and closures etc. can be extremely useful to a prospective franchisee since a relatively high percentage of such incidents usually indicates that the former franchisees were either unwilling or unable to make payments due to the franchisor or others under their franchise-related agreements.  If that was the experience for a disproportionately high percentage of former franchisees, a prudent investor should ask him- or herself why he or she would want to risk being in that very same situation.

Another valuable source of useful information to a potential investor in a franchise opportunity is contained in that part of the disclosure statement that must indicate contact information for all of the present franchisees operating in the franchise system in the Province of Ontario.  Once again, such a list can prove invaluable by providing a prospective investor in a franchise opportunity with the means to speak to a representative sample of the existing franchisees to canvas their views on the " pros and cons" of being a franchisee in that system.

Most franchise agreements are extremely lengthy legal documents.  Their main purpose is to make explicit the extensive rights that a franchisor has to control various of the costs and the business activities of its franchisees. One of the most important sections of any franchise agreement is that part of the agreement that describes the franchisor's rights to terminate (or end) the franchise agreement.  The rights or restrictions relating to termination of a franchise agreement, and the sorts of conduct or events which may give rise to termination, must be disclosed in the franchisor's disclosure statement.  This section of the disclosure statement should be scrutinized with particular care since either a high number of individual events of default or a high degree of subjectivity in the exercise of rights of termination granted to the franchisor can make the franchisee's investment in his or her business extremely vulnerable to the whims of the franchisor.  It should also be borne in mind that even if the franchisor with whom a franchisee entered into a franchise agreement had a reputation for equitable and fair business dealings with its franchisees, in today's global economy, where consolidation through mergers is extremely common, a one-sided contract that may not be a cause of concern today -- because of the franchisor's "sterling" reputation -- may be a cause for concern tomorrow, when that franchisor is acquired as part of a corporate merger and the new "powers that be" decide that the franchisor's corporate culture requires a drastic "overhaul".     Typically, the disclosure statement will indicate that, upon termination, the franchisee must cease holding itself out as a franchisee of the franchise system and must return all materials bearing the franchisor's trademarks to the franchisor.  The disclosure statement will often go on to disclose that, under the terms of the franchise agreement, the franchisor will have an option to purchase the terminated franchise business on terms and conditions that are usually extremely favorable to the franchisor.

The disclosure statement must also indicate any restrictions or conditions in the franchise agreement that relate to the renewal of the franchise.  Such restrictions or conditions may, and usually do, include the requirement that the franchisee must have complied with all agreements with the franchisor, must enter into the franchisor's then current form of franchise agreement and sublease, and must pay any prescribed renewal fee, any renovations required by the franchisor, any costs related to obtaining or extending the lease for the store premises, and all the franchisor's costs for renewing the franchise agreement, the lease and/or any sublease.

As noted above, most franchise agreements will impose restrictions or conditions on the franchisee's ability to sell or "transfer" the franchise business to a third party.  The disclosure statement must indicate the nature of those restrictions or conditions.  Some common transfer-related restrictions or conditions would include the following: the payment of a transfer-related security deposit; the franchisee must have complied with all agreements with the franchisor; the franchisee must repair any operational deficiencies prior to the transfer (such as upgrading signage, completing renovations, or purchasing new equipment); the franchisee must pay the franchisor's prescribed transfer fee; and the transferee must also satisfy any additional conditions of the franchisor (such as signing the franchisor's the current form of franchise agreement, providing personal guarantees, and successfully completing the franchisor's training program).  It is very common for the disclosure statement to indicate that, where a franchisee has obtained an offer to purchase its franchise from a third party, the franchisor has the right of first refusal to purchase the franchise business on the same terms and conditions.

Ideally, a prospective franchisee should try to negotiate changes to the franchisor's rights to impose restrictions or conditions relating to either the renewal or transfer of his or her franchise agreement.  In particular, it would be prudent for a prospective franchisee to try to "cut back" on any broadly-worded conditions that, if interpreted literally, will almost always provide the franchisor with a basis for refusing to grant a renewal or a consent to a transfer of the franchise agreement.  Whether such changes to the franchise agreement can be negotiated by a prospective franchisee will tend to depend not only on the parties' relative bargaining strength but also (initially at least) on the competence of the prospective franchisee's legal advisor in recognizing the importance of the issue and in formulating effective responses that will protect the franchisee's interests.

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This article is intended solely as a general guide concerning some of the more important areas of a franchise disclosure statement that a prospective franchisee should pay special attention to.  It is not intended as a substitute for professional advice.  The reader is strongly encouraged to contact his or her professional financial and/or legal advisor for specific advice on whether an investment in a particular franchise opportunity might be a suitable investment for him or her.