A Guide to Understanding A Franchise Disclosure Document

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.