Q. How do I handle the franchise disclosure document that I just received?

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Prospective franchisees can understandably find the task of reviewing a disclosure package daunting, if only because of the sheer mass of paper. In fact, when the Ontario government first enacted the Arthur Wishart Act (Ontario’s franchise legislation), the Act required that disclosure documents be delivered either in person or by registered mail. They did not anticipate, however, that the documents would be so thick that delivery by registered mail would be impossible. You should work with an experienced franchise lawyer and accountant to review the document but do not leave the review entirely to them. The disclosure document will contain information for further diligence that only you can pursue.

I suggest that you start by taking the document apart and breaking it down into pieces, either on your desk or living room floor. You will find that a considerable part of the document is really comprised of the franchise agreement and related agreements that you will be required to sign.  Put those aside for now, and focus initially on the smaller body of the disclosure document and the exhibits or schedules at the end.

One of those exhibits contains a list of current franchisees in the system and their contact information (this could be limited to a list of franchisees in a smaller geographic area depending on what province you are in). This is valuable information. You should be contacting franchisees on that list. The franchisor may have given you names of particular franchisees to contact and it would be a great idea to contact them. However, given that selection of contacts has been hand-picked by the franchisor, you should also contact a broader cross-section of franchisees. Some of the questions you should be asking those franchisees relate to information not likely contained in the disclosure document or readily available from the franchisor. You should be asking about financial returns. The cost of goods sold in a franchise can be dramatically affected by the level of rebates taken by a franchisor (in relation to purchases from third party suppliers to franchisees) or in the margin taken by the franchisor if the franchisor is supplying goods to franchisees. While the franchise disclosure document will tell you whether the franchisor receives rebates from suppliers and whether the franchisor shares any of those rebates with franchisees, it does not tell you how high the rebates are or the extent to which they impact the cost of goods sold. Current franchisees will be keenly aware of the costs of goods sold and whether they are appropriate.

The disclosure document will provide detailed information about the costs of establishing a franchise, which will be helpful in forecasting a rate of return on your investment. Ask current franchisees about the franchisor’s track record in predicting costs and opening new locations on budget.

You should also ask the franchisees about the state of the relationship between the franchisor and the franchisee community. Are there issues that have led to the creation of a franchisee association? If so, you should dig further into those issues.

The disclosure document tells you the number of franchises that closed (or were transferred) in the past three years. It also gives you the contact information for franchisees that left the system in the past year. Consider whether the number of closures or transfers appears high relative to the size of the system and if it does, dig into that issue through discussions with the franchisor and other franchisees. Also, contact the franchisees that left the system last year, find out what they have to say about the system,  and why they left. Again, dig into any warning signs.

The disclosure document will describe what rights, if any, you will have to an exclusive area and the franchisor’s policy concerning encroachment on your location and sales into your territory through alternate channels. Current and former franchisees can give you a sense of the franchisor’s past approach to opening new locations in proximity to existing locations, and whether the franchisor measures the potential impact of new locations on nearby locations. However, as retailers and other businesses grapple with the new and evolving world of ecommerce and delivery, and continually modify their businesses to respond to initiatives of their competitors, franchisees without strong contractual protections can become casualties. Find out what the franchisor’s plans are for ecommerce and work with your lawyer to ensure that you have sufficient protection in your franchise agreement.

A disclosure document is meant to convey to prospective franchisees all the information about the franchise and the franchisor that would reasonably be expected to have a significant effect on the franchisee’s decision to purchase the franchise or on the value or price of the franchise (referred to as “material facts”). Work through the disclosure document a piece at a time, then circle back to review the franchise agreements with your lawyer. Discuss the financial information with your accountant. The disclosure document will become a much more manageable document and you will very likely discover valuable information.

Darrell Jarvis
Partner
Fasken
djarvis@fasken.com