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Item 5 is the first of several Items in the Franchise Disclosure Document (FDD) that requires a franchisor to disclose the various types of fees that a franchisee will pay in opening and operating the franchise. In particular, Item 5 requires a franchisor to disclose the type and amount of initial fees that a franchisee will pay, or make a commitment to pay, before opening the business. Our knowledgeable franchise attorneys could discuss what types of fees a franchisor must disclose, as well as the best practices for drafting such disclosures, under Item 5.
The required disclosures under Item 5 of the FDD are codified at 16 C.F.R. § 436.5(e). Under Item 5, a franchisor is required to disclose any initial fee to be paid by a prospective franchisee. “Initial fees” means any amounts that the prospective franchisee will pay, or make a commitment to pay, to the franchisor or its affiliates before it is permitted to open its franchise unit. These amounts typically include a flat fee, but often times involve training fees, opening extension fees, construction review fees, and fees for initial product or marketing supplies.
For each type of initial fee, the franchisor must indicate whether it is uniform. An initial fee is “uniform” if the amount of the fee is the same for every prospective franchisee. If the fee is not uniform, the franchisor must still provide an estimation of the typical fee to meet the disclosure requirements under Item 5. A franchise can do so in one of two ways: range or formula.
First, the franchisor can disclose a range of fees paid by prospective franchisees in the prior fiscal year. For example:
During our last fiscal year, new franchisees paid an initial fee that ranged from $10,000 to $50,000. Certain franchisees paid a lower fee because they were opening franchises in markets that we currently do not have franchisees in or because they committed to develop multiple franchised businesses in a short period of time.
Alternatively, the franchisor can disclose the formula and factors used to calculate the initial fee amount in the prior fiscal year. For example:
During our last fiscal year, new franchisees paid us Initial Franchise Fees ranging from $21,444.80 to $48,288.80. This amount varies because it is based upon the number of designated households in the franchisee’s territory. Franchisees pay $1.10 per designated household.
Franchisors typically provide a range of initial fees when such fees have varied over time due to increases in costs. Franchisors utilize the second option when the initial fees are based on a dollar amount per number of potential consumers in the prospective franchisees’ territory.
Lastly, if any of the initial fees are to be paid installments, such as for goods, supplies, or equipment to be used in the operation of the franchise unit, a franchisor must disclose the installment payment terms. However, a franchisor retains the discretion whether to make this disclosure under Item 5 or under Item 10, which relates to financing. For each initial fee to be paid by a prospective franchisee, a franchisor is also required to disclose whether the fee is refundable. If so, a franchisor must also disclose the terms and conditions of the refund, for example:
Franchisor will refund the entire amount to you if Franchisor does not approve your application within 30 days. Franchisor will refund [$00.00] of this fee if you do not satisfactorily complete your two-week training. No refunds are available under any other circumstances.
It is worth noting that a franchisor is not required to refund initial fees paid by prospective franchisees. However, if initial fees are in fact refundable in the franchisor’s business, the franchisor must disclose the terms and conditions to obtain a refund.
The Federal Trade Commission requires that the total amount of initial fees disclosed in Item 5 be provided in a short blurb on the cover page of each FDD, as follows:
The total investment necessary to begin operation of a [franchise system name] franchise is [the total amount of Item 7]. This includes [the total amount in Item 5] that must be paid to the franchisor or affiliate.
The franchisor must use the actual total amounts from Item 5 (and Item 7) without alteration, adjustment, or explanation. The franchisor should not adjust the actual total to reflect the fact that some franchisees may not incur some of the specified fees or expenses disclosed.
In drafting the necessary disclosures under Item 5, a franchisor should ensure that the information provided completely and accurately discloses all amounts that will be received by franchisor or its affiliates from a franchisee prior to the development and opening of the franchised business. For this information in this section to be complete, a franchisor should not forget to include some often-overlooked initial fees, such as those relating to training, product inventory, and marketing materials. Comparing the disclosures in Item 7 with those in Item 5 is a prudent way to make sure an initial fee was not mistakenly omitted.
Accuracy is also important. When disclosing initial fees that are non-uniform, franchisors should not disclose fees collected from occasional sales of company-owned outlets, as such isolated sales may be misleading and inaccurately reflect the typical initial fees paid by franchisees. Additionally, it is worthwhile to have the franchisor’s sales team review the range or formula disclosed, as it will likely provide insight into how prospective franchisees will react to reading about such fee variations.
Finally, as with all Items in the FDD, it is best practice for a franchisor to disclose the initial fees under Item 5 in a simplistic manner. This can be accomplished by using subheadings for different types of initial fees and setting them out in the chronological order in which the franchisee must pay them. If a franchisor utilizes such subheadings, it is also prudent to indicate under each whether that type of fee is refundable and whether any fee is credited against other fees. However, remember that the key is simplicity: a franchisor should limit the disclosures to only what is required, and should sustain from providing additional information relating to the fees, such as the training or opening support the franchisee receives in consideration for the fees paid. Any doubt a franchisor has in making the necessary disclosures under Item 5 of the FDD can be resolved by consulting a franchise attorney.
