As an attorney who represents franchisors, a significant part of my practice is drafting franchise agreements and franchise disclosure documents. Once these documents are completed, I also help franchisors comply with state laws by filing and maintaining their registrations in the various states that have franchise registration laws. As a result, much of my time (particularly during the first half of the year) is spent dealing with franchise regulators in various states.
During my years of practice, I have seen a number of common mistakes made by both start-up and established franchisors in their Franchise Disclosure Documents (“FDDs”). Many of these mistakes, which can cause delays in a franchisor’s ability to obtain registration, are easily avoided. Make them, and state regulators will refuse to register your franchise offering – sending you a comment letter requiring you to correct your errors before issuing a registration permit. Avoid them, and your time to obtaining registration may be cut down by weeks, or even months.
The Disclosure Requirement
On the top of the list of these common FDD mistakes is the franchisor’s failure to comply with the requirements for Item 2. Item 2, entitled “Business Experience,” is where a franchisor must list employment history of certain of its key officers, managers, directors, and employees. The instruction for completing Item 2 is a simple one:
Disclose by name and position the franchisor’s directors, trustees, general partners, principal officers, and any other individuals who will have management responsibility relating to the sale or operation of franchises offered by this document. For each person listed in this section, state his or her principal positions and employers during the past five years, including each position’s starting date, ending date, and location.
That’s it – that is the entire instruction for Item 2. The instruction does not call for the franchisor to give the entire resume, or even a mini biography, for its key personnel. But that’s exactly what many franchisors tend to do.
Common Mistakes in Item 2
The franchisor’s natural tendency in Item 2 is to use it as a sales tool – explaining why and how its key people are well-qualified, outstanding individuals with a long history of leading successful companies, and why they are great human beings, to boot. Here’s an example of how a non-compliant, overly-descriptive Item 2 might look:
Jules Winnifield, President
Jules has been the President of Jack Rabbit Slim’s Franchising Company for six years, and has been the driving force behind growing our franchise system from two locations to seventy-five. Before coming to work for Jack Rabbit Slim’s, Jules was the Chief Operating Officer of Red Apple Security, one of the largest private security companies in the world. During his eight years at Red Apple, Jules was responsible for a 22% increase in revenue company-wide. Jules earned his Ph.D in Behavioral Psychology from the University of Santa Cruz in 1992. In addition to his hobbies, which include walking the earth and memorizing passages from important works of literature, Jules enjoys spending time with his wife, Mia, and his children, Marsellus and Lance.
So what’s wrong with the above description? A lot. First, it provides only a small portion of the information called for by the instructions in Item 2. While it does at least describe where Jules has been employed for the last five years, it doesn’t tell you the dates of employment or where those positions were located. Second, the listing reads like a sales pitch, telling the prospective franchisee why Jules is so well-qualified for his current position. Nothing in the instructions for Item 2 asks the franchisor to provide that information. Third, the franchisor has provided more than five years of work experience for Jules, going back more than thirteen years into Jules’s prior employment. Fourth, the Item 2 instructions do not call for educational experience – only work history. And in this situation, it’s not even clear that Jules’s doctoral degree is even relevant to his current line of business. Fifth, nothing in the guidelines asks a franchisor to provide information regarding the hobbies or family members of its key personnel.
You might think I’m exaggerating non-compliance with Item 2 when I list Jules’s hobbies, wife and children. I’m not. I’ve seen many franchisors provide exactly that type of information in Item 2 of their own FDDs.
How An Item 2 Disclosure Should Look
Here’s how an Item 2 disclosure should look:
Vincent Vega, Chief Executive Officer
Vincent has been our Chief Executive Officer since March 2012. Prior to becoming our CEO, Vincent was President of Butch’s Boxing Club in Inglewood, California, a position he held between December 2010 and March 2012. Before that, Vincent was the Vice President of Operations for McDonald’s in Amsterdam, the Kingdom of the Netherlands, a position that he held between October 2006 and December 2010.
The above Item 2 description is correct because it provides all of the information called for by the instructions, and only that information. Vincent’s work experience the location of each position he held is listed in the description, and his starting and ending dates with each employer (month and year are all that is necessary) are given. The disclosure gives enough information to cover his last five years of employment, and no more.
Avoid making these common mistakes in Item 2 of your own FDD, and you will have an easier time of getting registered in the registration states. While it may be tempting to include the extraneous information in Item 2, your doing so will increase the likelihood that you will obtain comment letters from those states, and that your registration will be delayed as a result.