Item Twenty of the Federal Disclosure Document

Item twenty is one of the most significant items in the Federal Disclosure Document; it is titled outlets and franchise information.¹ The franchisor is required to disclose the total number of franchises and company-owned franchise for the last three fiscal years,² the number of transfers,³ the status of franchisees and company-owned outlets located in each state,⁴ and projected openings of new franchises by franchisees and company-owned outlets.⁵ The information provided in item twenty is offered in a user-friendly tabular form.

Regarding the verification of the failure rate of franchisees, an excellent source to look at are the default rates of SBA loans for a specific franchise system and compare them to the failure rates located in item twenty of the Federal Disclosure Document. If there is no corroboration between the two, it may be an indication that the franchisor may be untrustworthy and should act as a deterrent for the investor.

In addition, the franchisor must disclose the contact information of the one hundred franchisees closest to the prospective franchisee;⁶ the contact information of franchisees who have terminated, not renewed, or canceled their franchise agreement during the last fiscal year;⁷ and for the last five fiscal years provide the contact information of the previous owner of a franchise outlet which the investor is interested in purchasing.⁸ The reasoning behind providing the contact information of other franchisees is to allow the investors to conduct their own due diligence in determining if this franchise system is right for them. Also, the reason for providing contact information of the franchisee whose outlet is now being sold again by the franchisor is to prevent the churning effect in which the franchisor continues to sell the same location again and again despite repeated franchisee failures (i.e., fraud).⁹

Furthermore, the franchisor needs to state if the franchisees have signed a confidentiality agreement.¹⁰ This requirement is a balance between allowing the franchisor to have franchisees sign confidentiality agreements and informing investors the reason why some franchisees who have left the franchise system are not willing to talk to about their experience within the franchise system.¹¹

Finally, the franchisor is required to disclose any franchisee organization associated with the trademark: specifically, if the franchisor has either created, sponsored, endorsed, or is incorporated under a requirement of state law. However, the franchisor does not need to disclose any independent franchisee organization that the franchisees have created.¹²

It is therefore recommended for the investor to investigate themselves if there is an independent franchisee association and ask their opinion about the franchise. Franchisee associations are an essential resource for the investor since the information received from the Federal Disclosure Document listed closest one-hundred franchisees are likely selected by the franchisor and might be misrepresentative of the franchise system as a whole.¹³ Also, franchisees who have left the system might have signed a confidentiality agreement which prevents them from speaking with the investor.¹⁴

For more information relating to the franchise agreement or Federal Disclosure Document, contact franchise attorney Mario Herman.