The Federal Trade Commission (FTC) exists to protect consumers from unfair, deceptive, or fraudulent marketing. For various specific industries and business models (such as franchises), the FTC provides more precise information on how unfairness, deceptiveness, and fraud are defined and provides specific instructions for how businesses must act to stay on the right side of the law.

The FTC Franchise Rule is a regulation that specifies exactly what information a franchisor must disclose to every potential franchisee, how that information must be formatted, and what claims cannot be made by the franchisor, OR when a franchisor is exempt from those requirements.

The franchise rule is codified as regulation 16 CFR 436, but the whole thing is about 15,000 words, so the purpose of this post is to provide a much shorter summary of the most important requirements the rule imposes on franchisors.

The rule specifies that every franchisor must either satisfy one of several exemption criteria OR it must provide a disclosure document with 23 specific sections of information.

Exemptions

The franchise rule requirements for disclosure do not apply to a franchisor’s offer of sale to a potential franchisee if any of the following conditions are met:

1. The total payments or payment commitments made to the franchisor from the franchisee for 6 months after the franchisee commences operation of the franchisee’s business is less than $615.
2. The franchisee has at least 2 years experience in the same type of business, and the parties can reasonably anticipate that franchise sales will constitute less than 20% of the franchisee’s total dollar volume in sales during the first year in operation.
3. The franchise relationship is a “leased department” relationship. I.e. the relationship is the “franchisee” leasing space as a third party inside an establishment owned or leased by the “franchisor” without the franchisor acting as a supplier and without the franchisor controlling the franchisee’s choice of suppliers.
4. The franchise relationship is covered by the Petroleum Marketing Practices Act (15 USC 2801).
5. The franchisee’s initial investment, excluding any franchisor financing and excluding the cost of unimproved land, totals at least $1,233,000 AND the franchisee signs a certain boilerplate statement quoted in the regulation.
6. The franchisee (or its parent or affiliate company) is an entity that has been in business for at least 5 years and has a net worth of at least $6,165,000.
7. At least 50% of the franchisee business is owned by people who less than 60 days ago had been officers, directors, general partners, or managers of the franchisor for at least 2 years.
8. At least 50% of the franchisee business is owned by people who less than 60 days ago had been at least 25% owners of the franchisor.
9. There are NO written agreements of any sort describing the franchise relationship. (This may sound good for franchisors wanting to start quickly, but in reality it is not a good idea because any conflicts with your franchisee will be governed by default rules specified in other laws and regulations and these default rules are often not very kind to the franchisor).

If none of the exemption criteria are met, then the franchise rule requires that the franchisor must provide a disclosure document with 23 sections. The disclosure requirements for each section are summarized below.

1. Basic Details of Franchisor & Franchise Industry

This section must disclose:

• The franchisor’s business info (business name, business entity type, business address, registered agent)
• Whether the franchisor itself operates any businesses of the same type as the franchisee
• A general overview of the industry the franchisee will operate in (description of business activities, relevant laws and regulations, competition, customer profile, etc)

2. Business Experience

The franchisor must disclose the names, positions, and 5-year job histories of each principal employee (officer, director, general partner, manager, etc).

3. Any Past or Pending Lawsuits

Any pending criminal or relevant civil lawsuits, as well as lawsuits from up to 10 years ago, against the franchisor or its principal employees or agents, must be disclosed.

4. Bankruptcies

Any bankruptcy of the franchisor or its principal employees from the last 10 years must be disclosed.

5. Initial Fees & Refund Terms

Any initial franchise fees as well as any refund conditions must be disclosed.

6. Other Fees

Any other fees must be disclosed with due dates, fee type, fee description, fee amount, and any other material fee info.

7. Estimated Initial Investment

This section must disclose all estimated initial franchisee expenses such as initial franchise fee, training expenses, real property (whether purchased or leased), equipment, fixtures, fixed assets, initial inventory, security deposits, utility deposits, business licenses, etc. 

8. Restrictions on Sources of Products & Services

This section must provide comprehensive disclosure of the franchisee’s obligations to purchase or lease goods, services, supplies, fixtures, equipment, inventory, computer hardware and software, real estate, or comparable items related to establishing or operating the franchised business either from the franchisor, its designee, or suppliers approved by the franchisor, or under the franchisor’s specifications.

9. Franchisee’s Obligations

This section must provide a detailed table enumerating all of the franchisee’s principal obligations. Included in this table must be items on-site selection, pre-opening purchases / leases, site development, initial and ongoing training, fees, operating manual compliance, trademarks, insurance, advertising, indemnification, renewal, and many other similar topics.

10. Financing Arrangements

This section must disclose the detailed terms of every financing arrangement, including leases and installment contracts if applicable, that the franchisor or any closely connected people or companies offers to or requires of the franchisee.

11. Franchisor’s Assistance, Advertising & Systems

This section must describe the terms of any important assistance the franchisor promises to the franchisee. Obligations of both franchisor and franchisee related to any such assistance must be detailed and enumerated in this section.

12. Territory

This section must describe whether the franchisee will be granted any exclusive or nonexclusive rights to a particular territory. In addition, it must lay out the protocols for any territory changes, and it must describe any territory-based limitations on competition between the franchisee and other franchisees or the franchisor.

13. Trademarks

This section must disclose all relevant trademarks to be licensed from the franchisor to the franchisee. For each trademark, it must be disclosed whether the trademark has been registered, if there are any known infringements of the trademark, and any obligations of franchisee or franchisor to indemnify the other against trademark infringement claims.

14. Patents, Copyrights and Proprietary Information

This section must disclose any patents, copyrights, or trade secrets that are to be licensed to the franchisee, together with the registration status of any such patents or copyrights. Any known infringements of any patents or copyrights must also be disclosed by the franchisor.

15. Participation in Franchisee Operations

This section must disclose any obligations of the franchisee to personally participate in the direct operation of the franchisee’s business. If not, then the franchisor must disclose any training or other requirements that on-site supervisors will be subject to by franchisor rule.

16. Restrictions on what the Franchisee may Sell

This section must disclose any franchisor-imposed restrictions or conditions on the goods or services that the franchisee may sell, including any obligation to only sell goods or services authorized by the franchisor, whether the franchisor has the right to change the types of authorized goods or services, and whether there are limits on the franchisor’s right to make changes to such authorizations.

17. Itemized Relationship Description

This section must include a detailed table that enumerates and describes all key items defining the franchisor-franchisee relationship. Such items include franchise term length, term renewal, termination conditions and processes, franchise contract assignment, death or disability of franchisee, non-competition covenants during and after the term of the franchise agreement, dispute resolution, and choice of law.

18. Public Figures Involved in Franchise

This section must disclose any sponsorship, ownership, and management relationships that exist between the franchisor and any public figure. For purposes of this section, public figure means any person whose name or physical appearance is well known to the public in the geographic area where the franchisee business will be located.

19. Financial Performance Representations

This section is the only place where the franchisor can provide guidance to the franchisee about past or potential future financial performance of franchisee-type businesses. The franchisor is allowed to provide historical and/or future predictions of financial performance, but in either case the information must be backed by reasonable data, and the manner in which the performance was calculated or estimated must be disclosed.

20. Outlets and Franchisee Information

This section must disclose the number of franchised and franchisor-owned outlets in each of the past three years, ownership changes in those outlets over the past three years, and any projected new franchised or company-owned outlets.

In addition, the contact info of every franchisee who had an outlet terminated, canceled, or not renewed during the last year must be provided. If any franchisees signed confidentiality clauses during the past three years, that must be disclosed as well.

21. Financial Statements

The section must provide CPA audited and GAAP compliant balance sheets of the franchisor for the past two years. In addition, this section must provide audited GAAP statements of operations, statements of stockholders’ equity, and statements of cash flows of the franchisor for the past three years. Any subsidiaries or subfranchisors of the franchisor should be separately and specifically accounted for in the financial statements.

22. Contracts

This section must provide copies of all proposed agreements regarding the franchise offering, including the franchise agreement and any lease, options, and purchase agreements.

23. Receipts

This section must contain certain boilerplate statements that are described in regulation 16 CFR 436.5(w).

Additional Resources for Franchisors

This article provides a simplified overview of the franchise rule, but there are a lot of additional specific requirements and formatting rules for each section that you’ll need to be familiar with if you plan to take the next steps to become a franchisor. Those details are laid out in my longer article FTC Franchise Rule Disclosure Requirements (about 1/5 as long as the original regulation, and with less legal jargon and more explanation).

The FTC also provides a VERY comprehensive Franchise Rule Compliance Guide where you can find the answer to just about any question imaginable regarding franchisor compliance requirements in every possible situation. Fair warning though: the guide is 154 pages (~50,000 words) long, so it really is better used as a last-resort reference than as reading material.