Items 5, 6, and 7 of a Franchise Disclosure Document (“FDD”) are all about money – how much the franchisor charges for the goods and services it provides franchisees before the franchised business opens, how much the franchisee will pay to the franchisor throughout the business relationship, and how much the franchisee will need to invest to open the business. After reading Items 5, 6, 7, the franchisee must understand how much things cost, how much they’ll be paying you, and when they will be making payments.
It is important for you to give accurate estimates to avoid litigation risks and help prospective franchisees evaluate their ability to successfully finance and open the business.
The three required disclosures of Item 5 are initial fees, refundability, and uniformity. An “initial fee” is payment that a franchisee makes for goods and services received from the franchisor or the franchisor’s affiliates from the time of signing the franchise agreement to the opening of the business. While the initial franchise fee is the most common example of an Item 5 fee, franchisors may offer services for additional fees like selecting a site, providing architecture plans, or providing opening inventory and those would need to be disclosed as well.
If you determine that any of the above fees are refundable, you will need to describe the conditions that make it so. Some of these conditions might be failure to find a location for the business or failure to receive required licenses.
Franchisors may negotiate different initial franchise fees among prospective franchisees, especially if the franchise system is emerging. Any variation from the initial fee disclosed (discounts, payment plans, etc.) in the previous fiscal year needs to be described in Item 5. This disclosure does not obligate the you to offer the same discount to future franchisees, but it puts prospective franchisees on notice that you have been willing in the past.
While Item 5 focuses on the fees a franchisee pays to the franchisor before it opens the business, Item 6 describes the fees that may be paid to the franchisor or its affiliates throughout the business relationship. If the franchisor collects a fee on behalf of another party, that will also be included in Item 6. Item 6 requires these fees to be in a specific table, a model of which is found below.
|Name of Fee||Amount||Due Date||Remarks|
|Royalty||5% of monthly Gross Sales||You must submit your sales reports to us by the 5th of each month. The royalties will be electronically drafted from your bank account in one installment each month on the 7th.||Monthly Gross Sales is defined in Note 1.|
|Brand Fund Fee||2% of monthly Gross Sales||Payment made by debit or check to us or by electronic funds transfer (“EFT”) on the 7th of each month, as we designate.||Can be raised up to 3% of monthly Gross Sales|
|Minimum Local Advertising Spend||$500/month||As incurred/monthly||You are required to spend at least $500 per month on local advertising, in the form and manner we require, and to the vendors we approve.|
|Renewal Fee||$10,000||Upon signing of new franchise agreement.||Payable in immediately available funds. Renewal is for a single 10-year term.|
|When we approve franchise transfer.||Fee must be deposited with us prior to our undertaking any review, drafting of documents|
Most franchise systems require franchisees to pay a royalty. This fee is typically a percentage of gross sales and may be subject to a weekly or monthly minimum payment. Another very common fee is a brand advertising or marketing fund used for marketing services and tools that benefit the entire franchise system. Item 6 also lists fees that must be paid to the franchisor upon the occurrence of certain events like renewal of the franchise agreement, transfer of the franchise agreement, or additional training. Finally, some fees function as penalties for breaches of the franchise agreement, such as using unapproved advertising, failing to obtain insurance, or failing to attend required trainings.
The menu of fees that you select will be driven by the needs of your franchise system and the support that you offer franchisees.
Item 7 is designed to help franchisees understand how much money they will need to spend to get the business open and operating. Item 7 includes payments franchisees will make to third parties.
In a table titled “Your Initial Investment”, the franchisor describes the types of expenditures a franchisee will make. The types of pre-opening expenses include the initial fees from Item 5, training, cost of leasing or purchasing real property, equipment and fixtures, construction and improvements, signage, computer equipment, and opening inventory. You can add other categories based upon the unique elements of your system. The final category represents the amount of funds necessary to operate the business for three months.
For each category of initial investment, you will identify the high and low estimates, method of payment, payment due date, and to whom the payment will be made.
The footnotes to the table are just as important as the estimates. These notes give the rationale for the estimates. These are a practical guide to the requirements and best practices of opening and operating a new franchised business. For example, the franchisor will explain that its estimate assumes a certain type of leased space and square footage, that certain equipment will be leased rather than purchased, and the cost of required licenses.
An example of Item 7 is below.
YOUR ESTIMATED INITIAL INVESTMENT1
|TYPE OF EXPENDITURE||AMOUNT LOW||AMOUNT HIGH||METHOD OF PAYMENT||WHEN DUE||TO WHOM PAYMENT IS MADE|
|Initial Franchise Fee||$50,000||$50,000||One lump sum payable upon signing of the Franchise Agreement.||Franchise fee is due on signing Franchise Agreement.||Franchisor|
|Leasehold – first 3 months||$10,000||$30,000||Monthly Rent or landlord terms.||Typically at the first of each month. May vary depending on landlord.||Landlord|
|Leasehold Improvements||$50,000||$100,000||Lump sum or (possibly) amortized by landlord.||Varies depending on your contract with supplier.||Supplier or Landlord|
|Signage||$1,000||$5,000||Lump sum.||Varies depending on contract with vendor.||Approved Vendor|
|Furniture, fixtures, and equipment||$10,000||$15,000||Progressive payments or lump sum incurred||Varies depending on contract with vendor.||Approved Vendor|
|Initial Inventory||$10,000||$15,000||Progressive payments or lump sums incurred||At time of purchase or varies depending on contract with vendor or supplier.||Various Vendors and Suppliers|
|Computer Systems and Equipment||$5,000||$7,000||Lump sum.||At time of purchase or varies depending on contract with vendor or supplier.||Various Vendors and Suppliers|
|Training living expenses||$500||$1,500||As incurred.||Before opening.||Air travel, hotels, meals, incidentals|
|Insurance||$500||$1,000||Lump sum or terms of provider.||Varies depending on contract with provider.||Approved Provider|
|Accounting and Legal Services||$1,000||$1,500||Paid monthly or as invoiced by vendor in lump sum.||Varies depending on vendor.||Various Suppliers|
|Grand Opening Marketing and Events||$10,000||$10,000||Lump sum or as incurred.||As incurred.||Various suppliers, our approved grand opening marketing provider|
|Minimum Local Advertising Spend||$500||$500||Lump sum or as incurred.||As incurred.||Various suppliers or us or our affiliate|
|Additional Funds—3 Months||$7,500||$10,000||As incurred.||(Money to work with still after 90 days – as incurred.)||Vendors, employees, utilities, landlord, suppliers, insurers, tradesmen, city, county|
Note 1: The estimates are based on an initial period consisting of pre-opening and the first 3 months of operation. All fees and payments are non-refundable unless otherwise noted or allowed by third-party vendor. During our last fiscal year all fees in this Item that were paid to us were applied uniformly. Preparing compliant and accurate Items 5, 6, and 7 takes a combination of your business experience and a lawyer’s understanding of what fees need to be disclosed in each Item. The process of developing Items 5, 6, and 7 will help you to make decisions about how the franchise system will operate and help you to articulate that clearly to franchisees. Items 5, 6, and 7 are highly scrutinized by franchisees, both before and after they sign the franchise agreement, because they describe the critical economic components of the franchisor/franchisee relationship. Failure to disclose these Items fully or accurately is a significant, but avoidable, litigation risk.
The attorneys at Manning, Fulton & Skinner have extensive experience drafting Items 5, 6, and 7. Reach out if you have questions about what disclosures you need to make and how you need to make them.