October 1, 2001

A Guide to Understanding A Franchise Disclosure Document

This article originally appeared in Canadian Food and Beverage Magazine

Under Ontario law, all franchisors are now required to provide a disclosure statement to prospective franchisees at least 14 days before any contract relating to the franchise is signed or any moneys relating to the franchise are paid.  The purpose of the disclosure statement is to provide a prospective franchisee with sufficient information to determine whether an investment in a particular franchise opportunity is suitable for him or her.  It should not, however, be assumed that the disclosure statement will disclose all information that might be pertinent in making such an investment decision.  To the extent that any potential investor in a franchise opportunity feels that more information is required, a careful review of the disclosure statement will usually suggest possible additional sources for such information.

The beginning of the disclosure statement must contain four generic, but important, statements indicated in italics below:

  • The prospective franchisee may obtain additional information concerning the franchisor from private credit reporting companies. This statement refers to the fact that the prospective franchisee can order a credit report on the franchisor from a private credit reporting company, such as Dun & Bradstreet. If the results of such a report were to indicate that the franchisor has a poor credit rating (as determined by its dealings with banks and other creditors) that should be a clear “warning signal” to a prospective franchisee about the risks of investing in a franchise with that franchisor. A prudent investor should be loathe to entrust his or her financial future to a franchisor that, according to a poor credit report, is probably already experiencing financial difficulties and may eventually go out of business.
  • Independent legal and financial advice in relation to the franchise agreement should be sought by the investor prior to entering into the franchise agreement. The reason for this statement should be self-evident. If the disclosure statement is to serve its intended purpose of assisting prospective franchisees to make informed investment decisions, a prospective franchisee who is lacking in business and/or legal sophistication should review the disclosure statement and the franchise agreement with a professional financial and/or legal advisor before proceeding with the investment in the franchise. Ideally, the financial advisor should have extensive experience in the industry or market sector of the target franchise (such as the hospitality industry, or the retail grocery food industry etc.). That sort of experience will allow the financial advisor to provide a prospective franchisee with advice concerning general trends in the industry in question and, possibly, specific advice about how the franchisor is positioned within that industry. Similarly, the advice of a lawyer with extensive experience in franchising is preferable to the advice of a lawyer with a more general practice. A lawyer with extensive franchising experience can not only provide a more valuable critique of the franchisor’s legal documents, but he or she may also be in a position to provide a prospective franchisee with advice concerning the general commercial reputation of the target franchisor and what changes to the legal documents the franchisor will likely be willing to entertain.
  • The prospective franchisee is encouraged to contact any past or present franchisee prior to entering into the franchise agreement. This statement points to the obvious truism that no one can give a prospective franchisee more practical advice on what it would be like to part of a particular franchise system than other franchisees who have been, or still are, in that very position. A prospective investor in a franchise opportunity should always make an effort to contact both past and present franchisees of a particular franchise system to obtain the benefit of their experiences as franchisees.
  • Under the terms of the franchise agreement, the cost of goods and/or services provided to the franchisee by the franchisor or its approved suppliers may not be the lowest cost for such goods and/or services available in the marketplace. Many prospective franchisees assume that, by virtue of being part of a large franchise buying network, the cost of their goods and/or services will be lower than the costs of their independent competitors. It follows that (according to this assumption) being a franchisee would, of necessity, give them a “edge” over their competitors in relation to costs. This is a very common assumption, but one that is extremely dangerous and at odds with the realities experienced by franchisees in countless franchise systems. The reality is that, in many franchise systems, much (if not most) of the franchisor’s revenue is derived, directly or indirectly, from sales of the franchise-related goods or services to its franchisees. When one considers that, under the terms of most franchise agreements, the franchisee must pay the franchisor a royalty on all sales, the right to buy from “outside” suppliers is highly restricted or prohibited outright, and there are (usually) minimum requirements for spending on regional and local advertising, it is not hard to see that franchisors tend to be in a position to control most of their franchisees’ major costs of doing business. Given that reality, it is extremely important that a prospective franchisee make every effort to “link” his or her financial future only to a franchisor with a general reputation for profitable operations and equitable and fair business dealings with its franchisees.

An investor’s overall attitude should be that it is far better to engage in the sorts of extensive investigations described above (no matter how daunting they may initially appear) before committing to any investment in a franchise opportunity.  The ability to correct a poor investment in a franchise after the fact will invariably be limited by the extreme one-sidedness of most franchise agreements in favour of the franchisor’s interests.  Since an ownership interest in a franchise business is not a highly liquid investment (by comparison to an investment in a publicly-traded security, for example), engaging in the sort of “due diligence” described above can save a prospective franchisee a great deal of future psychological, not to mention financial, pain.