October 1, 2001

A Guide to Understanding A Franchise Disclosure Document

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.