A Guide to Understanding A Franchise Disclosure Document

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.