Item 1 of the Franchise Disclosure Document (FDD) provides prospective franchisees an overview of the franchise opportunity by requiring franchisors to disclose background information about the type of business the franchisee will operate, the franchisor’s business background, and the business backgrounds of parents, predecessors, and affiliates. Our knowledgeable attorneys know what information a franchisor must disclose under Item 1 for each of these categories, as well as the best practices for disclosing such information and determining what information needs to be disclosed.
Under Item 1, “franchisor” means any person or entity who both grants a franchise and takes part in the franchise relationship thereafter. It is important to note that a sub-franchisor that engages in pre-sale activities and has post-sale performance obligations also falls within this definition. Information that must be included in Item 1 for any persons or entities falling within the definition of a “franchisor” include:
Additionally, Item 1 of the FDD should describe the franchisor’s prior business experience in the industry, including the length of time the franchisor has operated and offered franchises in these areas of business, as well as any prior business experience that they have offered franchises in but have not operated in themselves. In these situations, Item 1 should provide a description of each other line of business, the number of franchises sold under that line of business, and the length of time the franchisor has offered franchises in that line of business.
Item 1 also requires disclosure of certain background information concerning the franchise itself. This includes an overview of the franchise opportunity and explanation of the type of business the franchisee will run. This section of the FDD also describes in general terms, without citation to specific provisions, any laws or regulations that specifically apply to the franchised business, not including those that pertain to all businesses generally, such as child labor laws or tax regulations. Other pieces of information in this item may include:
A “parent” is a person or entity that directly or indirectly controls the franchisor through one or more subsidiaries. A franchisor must disclose all parents of the franchisor under Item 1; not just the parent that the franchisor reports to or the highest parent in the chain of ownership. Unlike predecessors and affiliates, a franchisor need only disclose minimal information regarding each parent; namely, each parent’s name and principal business addresses.
A “predecessor” is a person or entity from whom the franchisor directly or indirectly acquired the major portion of the franchisor’s assets. A predecessor must be reported only if that acquisition occurred within the ten years immediately preceding the close of the franchisor’s most recent fiscal year. The key to determining whether a person or entity who the franchisor acquired assets from is a “predecessor” is figuring out whether the acquisition amounted to more than 50% of the franchisor’s assets on the date of acquisition. It is for this reason that a mere change in ownership of a franchisor, or the franchisor’s purchase of another entity’s assets, does not necessarily qualify those persons or entities as predecessors.
While implicit in the term, another consideration is often overlooked: the “predecessor” must have operated or offered franchises in the same or similar business as the franchisor. Simply put, if within the 10 years prior to the franchisor’s most recent fiscal year, the franchisor acquired assets from a person or entity in the same or similar business; and at the time of that acquisition, the assets acquired constituted more than 50% of the total assets, the person or entity from which they were acquired is likely a predecessor required to be included under Item 1.
In addition to the predecessor’s name and principal address, Item 1 must also disclose the predecessor’s prior business experience in the same or similar line of business as the franchisor, including the length of time the predecessor operated and offered those franchises. If a predecessor offered franchise opportunities but did not operate within that business itself, Item 1 must still provide prior business experience in other lines of business. This information should include, a description of each other line of business, the number of franchises sold under that line of business, and the length of time the predecessor has offered franchises in that line of business.
An “affiliate” is the catchall term for Item 1 disclosures. It is a person or entity that is controlled by, controlling, or under common control with, another entity. Parents are a type of affiliate because they exert direct or indirect control over the franchisor. For purposes of Item 1, however, the franchisor need not re-disclose the same parent information. Rather, this term is meant to refer to those persons or entities controlled by the franchisor or controlled by the same parent as the franchisor. However, Item 1 requires disclosure of the franchisor’s affiliates only if the affiliate either offers franchises in any line of business or provides products or services to franchisees. Therefore, the following information must be provided:
The disclosures required under Item 1 of the franchise disclosure document are intended to provide a prospective franchisee with enough background information on the franchise opportunity, the franchisor, and its affiliates, predecessors, and parents, as to make an informed decision before entering into a franchise agreement. Some franchisors view this as an invitation to disclose as much information as possible, to appear genuine and fair to a prospective franchisee.
While it is true that most prospective franchisees direct a substantial amount of their focus to the information disclosed in Item 1, it is best practice to disclose only the information required. Disclosing extraneous information, such as sales materials, is unnecessary. Moreover, it may tend to paint the franchisor in a less favorable light and state franchise examiners are likely to request that such information be removed from the FDD.
If a franchisor is uncertain whether there relationship with a person or entity is such that they may be considered a predecessor, parent, or affiliate, consulting with the franchisor’s CPA is an efficient way to identify the corporate structure, and ensure that the necessary persons and entities are disclosed.
Another relevant point concerning the language used in the FDD: there is no express requirement as to how the franchisor should refer to him- or herself under the Franchise Rule. The Rule does require, however, that the disclosures be made in plain English. Therefore, self-reference to the franchisor as “we” or “you,” or by use of initials, a one or two-word shorthand form, or other abbreviated reference, is consistent with the “plain English” requirement and highly recommended.
Overall, the disclosures required under Item 1 of the FDD allow a prospective franchisee to gauge whether it is in his or her best interest to enter into a franchise agreement with the franchisor. While it is important for the franchisor to disclose the information required to affect that purpose, it is also in the franchisor’s best interest to disclose no more than is required.