How the New FDD Has Affected the Franchise Sales Process

Prior to the announcement of the revised Franchise Rule in January 2007, there was much speculation among franchisors as to how changes to the Rule would affect the sales process. The phase-in period between July 2007 and July 2008 was hectic for many franchisors as they worked with their legal counsel to transition to the new Franchise Disclosure Document (“FDD”) format and educated their sales teams on how the sales process would need to be adjusted to comply with the new Rule.

Little did franchisors know, of course, that the recession, which began about the same time, would be so devastating to their expansion plans. While the impact of the new Franchise Rule on the sales process has paled in comparison to that of the recession, franchisors have expressed their opinions as to how changes to the Rule have influenced their approach to the sales process. Based on what we have heard since franchisors have updated their FDDs, there are mixed feelings as to whether changes to the Rule have improved or complicated the sales process from the perspective of franchisors.

Perceived Benefits of the New Rule

Several aspects of the new Rule should simplify the franchise sales and disclosure process. Examples of this include:

• The disclosure of the FDD is now required at least 14 calendar days prior to signature or the receipt of monies by the franchisor. This change from the first personal meeting is more appropriate based on the variety of sales and qualification processes that franchisors now employ, given the use of technology. The old requirement that a candidate must receive an execution-ready copy of the franchise agreement at least five business days prior to signing has been eliminated under the new Rule, as franchisors are now only required to provide candidates with an execution copy of the documents (now seven calendar days in advance) if material changes have been made by the franchisor from the franchise agreement contained within the FDD they were disclosed with. This change streamlines the sales process and reduces the administrative work needed to support each sale.
• For those franchisors fielding inquires from candidates outside the United States, the new Rule clarifies that international transactions are not subject to U.S. disclosure requirements. While this was generally understood by most franchisors to be true under the old Rule, ongoing debate and questions about international transactions existed, and some franchisors adopted a conservative approach and disclosed international candidates with their UFOC.
• Under the new Rule, brokers no longer must be disclosed within Item 2. This change has simplified updates to the FDD for systems utilizing multiple broker organizations or making changes to their broker relationships throughout the year.
• Within Item 11, the new Rule lessens the amount of detail that must be provided on the franchisor's computer and point-of-sale systems. This change is more relevant to the current franchise environment, in which franchisors are likely to make updates to their technology on a more frequent basis than in the past.
• The new Rule now permits franchisors to provide expense and cost data to a prospective franchisee without having to include it in their Item 19 disclosure. This gives franchisors more latitude in the sales process to answer questions specific to expenses in their business. However, we also believe that this potentially opens the door to abuses by salespeople who are either not fully versed on the limits of what information they can provide, or who intentionally use this exemption to Item 19 as a method for providing information on revenues and profits without complying with the Rule and documenting that information within the FDD. In either case, franchisor management should ensure clear policies are established as to what, if any, information can be shared with prospects outside the FDD text.
• Another highly debated topic prior to the new Rule being introduced was whether franchisors could or should share revenue or profit information in media interviews. The new Rule clarifies that a franchisor can make financial performance representations in the media as long as the media in which such information appears is not directed or provided directly to a prospective franchisee audience.
• Updates to the FDD are now required within 120 days, rather than 90 days of the end of the franchisor's fiscal year. This gives the franchisor and its attorney more time to prepare and submit updated information that will be shared with prospective franchisees.
• Under the new Rule, sophisticated investor exemptions were added for the first time, based on either the size of the franchisee's investment or the net worth and experience of the franchise candidate. While this affects only a small subset of franchisors, the addition helped to bring greater consistency between the FTC Rule and various states that already had similar exemptions contained within their regulations.
• Changes to the Item 20 charts assist in the sales process by simplifying the way in which unit changes are tracked, and by avoiding the double-counting that often happened under the old Rule when units were subject to multiple transactions such as closing and subsequently being transferred to a new owner. Under the new Rule, the last event is the one that is ultimately recorded within the Item 20 charts.
• The new Rule clarifies that franchisors may use an electronic acknowledgement of receipt rather than receiving a hard-copy, handwritten signature. This change simplifies and expedites the process of obtaining receipts after the FDD is sent to candidates.

Perceived Limitations

Although a number of changes within the new Rule have potentially simplified the sales process, a number of changes made the sales process more complicated or confusing for some franchisors. Perhaps the biggest ongoing challenge is that the new Rule must still be interpreted in light of the various state franchise laws, which often conflict with the FTC disclosure requirements. For example, several states continue to require disclosure based on the old 10-business-day rule, and not all states allow a new franchisor to phase in its audit over its first year.

Other general challenges or limitations to the new Rule include the following:

• The new Rule requires franchisors to specify in what format(s) the FDD will be made available to franchise candidates. As a franchisor's delivery mechanism and policies may change over time, it must remember to update this portion of the disclosure.
• The new Rule also requires the franchisor to disclose to a candidate at any point during the sales process if the candidate requests a copy of the FDD. The details around this process are not clear, and candidates could potentially make this request during their initial call to the franchisor's office. Receipt of the FDD too early in the qualification process could also disrupt the process established by the franchisor and cause a candidate to lose interest based on its review of the FDD, rather than its ongoing interactions with the franchisor's development team.
• Because the new Rule has clarified the issue of electronic disclosure, this change has led to more franchisors providing the FDD electronically to candidates early in the sales process. Many franchisors we've spoken with would prefer to distribute the FDD at Discovery Day, but they feel compelled to send it electronically because that is what candidates have come to demand of them. If the FDD is sent out earlier in the process, it is important that the franchisor establish proactive follow-up with the candidate in order to educate the candidate on the FDD and how it should be used as part of its evaluation. Far too many franchisors send out the FDD and then lose candidates due to ineffective follow-up.
• Although the rules around electronic disclosure have been clarified, problems with the actual practice of disclosing to candidates electronically still persist. For example, Adobe 9.0 incorporates an editing feature that would potentially allow candidates to change terms of the legal documents. Issues such as this have caused some franchisors to revert back to sending hard copies of their FDD to candidates.
• The new Rule continues to allow new franchisors to phase in their audited financial statements over a three-year period. However, since several of the registration states do not permit this phase-in period, very few new franchise systems take advantage of this opportunity.
• Within Item 20 of the new FDD, franchisors must provide the names of any advisory councils or independent franchisee associations. If the franchisor has an adverse relationship with its independent association, this disclosure could enable candidates to learn more about the association's activities prior to meeting with the franchisor and gaining its perspective on the association.
• In Item 17 of the new FDD, franchisors must now specifically state if their renewal agreements are likely to contain materially different terms than the current form of agreement.
• The new negative disclosure language in Item 19 now clarifies for the candidate that the franchisor is able to provide information under the FTC Rule, but has elected not to. This creates a potential problem for the few less-than-honest franchisors who, in the past, had elected to tell candidates that they did not provide historical financial information within their UFOC because the “FTC Rule did not allow them to.”

Our perspective on the overall opinions of franchisors is that the new Rule has not had a major impact on their franchise sales process. If franchisors could make one wish, it would be that the FTC Rule and the state laws would be consistent in how they guide the franchise sales process.

David E. Hood is the president of the iFranchise Group (http://www.ifranchisegroup.com/), a management consulting firm specializing in franchising. The former president of Auntie Anne's Soft Pretzels, he has consulted with some of the world's most prominent franchisors over his 25+ year career. He can be reached at 708-957-2300 or via e-mail at [email protected].

Prior to the announcement of the revised Franchise Rule in January 2007, there was much speculation among franchisors as to how changes to the Rule would affect the sales process. The phase-in period between July 2007 and July 2008 was hectic for many franchisors as they worked with their legal counsel to transition to the new Franchise Disclosure Document (“FDD”) format and educated their sales teams on how the sales process would need to be adjusted to comply with the new Rule.

Little did franchisors know, of course, that the recession, which began about the same time, would be so devastating to their expansion plans. While the impact of the new Franchise Rule on the sales process has paled in comparison to that of the recession, franchisors have expressed their opinions as to how changes to the Rule have influenced their approach to the sales process. Based on what we have heard since franchisors have updated their FDDs, there are mixed feelings as to whether changes to the Rule have improved or complicated the sales process from the perspective of franchisors.

Perceived Benefits of the New Rule

Several aspects of the new Rule should simplify the franchise sales and disclosure process. Examples of this include:

• The disclosure of the FDD is now required at least 14 calendar days prior to signature or the receipt of monies by the franchisor. This change from the first personal meeting is more appropriate based on the variety of sales and qualification processes that franchisors now employ, given the use of technology. The old requirement that a candidate must receive an execution-ready copy of the franchise agreement at least five business days prior to signing has been eliminated under the new Rule, as franchisors are now only required to provide candidates with an execution copy of the documents (now seven calendar days in advance) if material changes have been made by the franchisor from the franchise agreement contained within the FDD they were disclosed with. This change streamlines the sales process and reduces the administrative work needed to support each sale.
• For those franchisors fielding inquires from candidates outside the United States, the new Rule clarifies that international transactions are not subject to U.S. disclosure requirements. While this was generally understood by most franchisors to be true under the old Rule, ongoing debate and questions about international transactions existed, and some franchisors adopted a conservative approach and disclosed international candidates with their UFOC.
• Under the new Rule, brokers no longer must be disclosed within Item 2. This change has simplified updates to the FDD for systems utilizing multiple broker organizations or making changes to their broker relationships throughout the year.
• Within Item 11, the new Rule lessens the amount of detail that must be provided on the franchisor's computer and point-of-sale systems. This change is more relevant to the current franchise environment, in which franchisors are likely to make updates to their technology on a more frequent basis than in the past.
• The new Rule now permits franchisors to provide expense and cost data to a prospective franchisee without having to include it in their Item 19 disclosure. This gives franchisors more latitude in the sales process to answer questions specific to expenses in their business. However, we also believe that this potentially opens the door to abuses by salespeople who are either not fully versed on the limits of what information they can provide, or who intentionally use this exemption to Item 19 as a method for providing information on revenues and profits without complying with the Rule and documenting that information within the FDD. In either case, franchisor management should ensure clear policies are established as to what, if any, information can be shared with prospects outside the FDD text.
• Another highly debated topic prior to the new Rule being introduced was whether franchisors could or should share revenue or profit information in media interviews. The new Rule clarifies that a franchisor can make financial performance representations in the media as long as the media in which such information appears is not directed or provided directly to a prospective franchisee audience.
• Updates to the FDD are now required within 120 days, rather than 90 days of the end of the franchisor's fiscal year. This gives the franchisor and its attorney more time to prepare and submit updated information that will be shared with prospective franchisees.
• Under the new Rule, sophisticated investor exemptions were added for the first time, based on either the size of the franchisee's investment or the net worth and experience of the franchise candidate. While this affects only a small subset of franchisors, the addition helped to bring greater consistency between the FTC Rule and various states that already had similar exemptions contained within their regulations.
• Changes to the Item 20 charts assist in the sales process by simplifying the way in which unit changes are tracked, and by avoiding the double-counting that often happened under the old Rule when units were subject to multiple transactions such as closing and subsequently being transferred to a new owner. Under the new Rule, the last event is the one that is ultimately recorded within the Item 20 charts.
• The new Rule clarifies that franchisors may use an electronic acknowledgement of receipt rather than receiving a hard-copy, handwritten signature. This change simplifies and expedites the process of obtaining receipts after the FDD is sent to candidates.

Perceived Limitations

Although a number of changes within the new Rule have potentially simplified the sales process, a number of changes made the sales process more complicated or confusing for some franchisors. Perhaps the biggest ongoing challenge is that the new Rule must still be interpreted in light of the various state franchise laws, which often conflict with the FTC disclosure requirements. For example, several states continue to require disclosure based on the old 10-business-day rule, and not all states allow a new franchisor to phase in its audit over its first year.

Other general challenges or limitations to the new Rule include the following:

• The new Rule requires franchisors to specify in what format(s) the FDD will be made available to franchise candidates. As a franchisor's delivery mechanism and policies may change over time, it must remember to update this portion of the disclosure.
• The new Rule also requires the franchisor to disclose to a candidate at any point during the sales process if the candidate requests a copy of the FDD. The details around this process are not clear, and candidates could potentially make this request during their initial call to the franchisor's office. Receipt of the FDD too early in the qualification process could also disrupt the process established by the franchisor and cause a candidate to lose interest based on its review of the FDD, rather than its ongoing interactions with the franchisor's development team.
• Because the new Rule has clarified the issue of electronic disclosure, this change has led to more franchisors providing the FDD electronically to candidates early in the sales process. Many franchisors we've spoken with would prefer to distribute the FDD at Discovery Day, but they feel compelled to send it electronically because that is what candidates have come to demand of them. If the FDD is sent out earlier in the process, it is important that the franchisor establish proactive follow-up with the candidate in order to educate the candidate on the FDD and how it should be used as part of its evaluation. Far too many franchisors send out the FDD and then lose candidates due to ineffective follow-up.
• Although the rules around electronic disclosure have been clarified, problems with the actual practice of disclosing to candidates electronically still persist. For example, Adobe 9.0 incorporates an editing feature that would potentially allow candidates to change terms of the legal documents. Issues such as this have caused some franchisors to revert back to sending hard copies of their FDD to candidates.
• The new Rule continues to allow new franchisors to phase in their audited financial statements over a three-year period. However, since several of the registration states do not permit this phase-in period, very few new franchise systems take advantage of this opportunity.
• Within Item 20 of the new FDD, franchisors must provide the names of any advisory councils or independent franchisee associations. If the franchisor has an adverse relationship with its independent association, this disclosure could enable candidates to learn more about the association's activities prior to meeting with the franchisor and gaining its perspective on the association.
• In Item 17 of the new FDD, franchisors must now specifically state if their renewal agreements are likely to contain materially different terms than the current form of agreement.
• The new negative disclosure language in Item 19 now clarifies for the candidate that the franchisor is able to provide information under the FTC Rule, but has elected not to. This creates a potential problem for the few less-than-honest franchisors who, in the past, had elected to tell candidates that they did not provide historical financial information within their UFOC because the “FTC Rule did not allow them to.”

Our perspective on the overall opinions of franchisors is that the new Rule has not had a major impact on their franchise sales process. If franchisors could make one wish, it would be that the FTC Rule and the state laws would be consistent in how they guide the franchise sales process.

David E. Hood is the president of the iFranchise Group (http://www.ifranchisegroup.com/), a management consulting firm specializing in franchising. The former president of Auntie Anne's Soft Pretzels, he has consulted with some of the world's most prominent franchisors over his 25+ year career. He can be reached at 708-957-2300 or via e-mail at [email protected].