Franchise Contracting and Organization.ppt

							Franchise Contracting and
      Organization
     Francine Lafontaine
    University of Michigan
               Organization
•   Introduction
•   Agency theory and franchising
•   Self-enforcement and franchising
•   Multi-tasking and complementarities
•   Conclusion
                 Introduction
• American Heritage Dictionary of the English
  Language:
• the word franchise comes from the old French
  word franche which means free or exempt
• In medieval times, a franchise was a right or
  privilege granted by a sovereign power -- king,
  church, or local government for various activities
  such as building roads, holding fairs, organizing
  markets, or for the right to maintain civil order and
  collect taxes
               Introduction
• In most cases, the grantee was required to
  make a payment to the sovereign power for
  this right or privilege usually a share of the
  product or profit
• that payment was called a royalty, a term
  still in use today
• government granted franchises still exist in
  road building and cable TV for example
                Introduction
• A (commercial) franchise however today is
  typically defined as
  – a contractual agreement
  – between two legally independent firms
  – in which the franchisee pays the franchisor for
    the right to sell the franchisor's product and/or
    the right to use its trademarks in a given
    location for a specified period of time
                 Introduction
• According to the Federal Trade Commission, in
  the USA the following three elements must be
  present for a business to be considered a franchise:
  1- the franchisor must license a trade name under
  which the franchisee operates
  2- the franchisor must exert significant control
  over, or provide significant assistance to, the
  franchisee
  3- the franchisee must have paid at least $500 to
  the franchisor during the first six months of
  operation
                Introduction
• In USA, franchising therefore includes both
  – traditional franchising, i.e. car and gasoline and
    soft-drink distribution
  – business-format franchising, where the
    franchisor sells a turn-key operation to its
    franchisees (McDonald’s and Burger King, but
    also Holiday Inn and Budget Rental car)
               Introduction
• In traditional franchising, franchisor obtains
  his revenues from markups on inputs sold
  (e.g. cars or gasoline) to franchisees
• In business-format franchising, mostly from
  royalties (a % of sales) and upfront
  franchise fees ; cannot use input sale
  requirements
              Introduction
• Interest of IO economists in franchise
  contracting spans the last 30 years.
• Reasons:
1. economic importance of franchising itself:
  franchised chains accounted for about 1.37
  trillion dollars in revenues in U.S.,
  representing 13.6 percent of nominal GDP
  in 2001
               Introduction
2. exemplar of long-term, contract-based,
  organizational forms that stand in between
  spot market interactions and complete
  vertical integration
  – Caves and Murphy (1976) : “The franchise
    relationship raises fundamental questions
    concerning the nature of the firm and the extent
    of its integration.”
                   Introduction
3. Can get data on organizational choices:
- Most chains contain both franchised and company
   owned units;
   - Thus can ask what determines the mix or how they
     choose which outlets to franchise or not
- Can get information on contract terms (because
  uniform at a point in time too!)
   - Here can ask what affects the choice of contract terms
     (share parameter)
              Introduction
• Much of the literature on franchising has
  emphasized incentive issues, from an
  agency or from a self-enforcement
  perspective
• (Some hidden info models on this too - also
  some asset specificity arguments; won’t
  emphasize these here)
                 Introduction
• Incentive problem arises because of distance:
  chains need to establish numerous outlets in many
  different locations to reach their geographically
  dispersed customers
• monitoring of day-to-day activities in outlets then
  is very costly
• Theories emphasize how chains offer ownership
  stakes and/or residual claims to operators to make
  them work hard
              Introduction
• Agency theory and self-enforcement
  literature emphasize different mechanisms
  to achieve solution to incentive problem
• Ultimately, I will argue that these
  complement one another (see Klein (1995)
  and Lafontaine and Raynaud (2002))
 Agency Theory and Franchising
• Caves and Murphy’s (1976) introduced a large
  number of the issues that have remained central
  themes in the literature since
• They note economies of scale differential that
  gives rise to chain structures
• then examine the difficulties inherent in pricing
  franchise rights when incentive issues dictate that
  franchising will be more efficient than centralized
  operations
 Agency Theory and Franchising
• Their discussion of pricing includes a
  comparison of various rent extraction
  mechanisms such as
  –   franchise fees
  –   royalties on sales
  –   taxes on inputs
  –   franchisor supply of fixed assets
  –   provisions in franchise contracts that facilitate
      franchisor recapture of franchises
 Agency Theory and Franchising
• They also analyze factors they expect will affect
  the proportion of company units in franchised
  chains, in particular
   – the franchisor’s initial need for capital
   – the importance of owner operators in some industry
     segments
   – the possibility that franchisees might, through various
     activities and spillover effects, damage the brand
• Mathewson and Winter (1985) formalize many of
  these insights
 Agency Theory and Franchising
• Rubin (1978) refers back to Alchian and Demsetz
  (1972) and Jensen and Meckling (1976) and notes
  the need to give franchisees residual claims in local
  outlet profits to ensure that they work hard
• but he also points to the role that franchisors play in
  developing and maintaining the value of their brands
  and the effect this has on outlet sales
• => double-sided moral hazard
• (see also Reid (1976) and Eswaran and Kotwal (1985) for
  similar two-sided moral hazard arguments for sharecropping)
 Agency Theory and Franchising
• Lafontaine (1992) uses data on franchise contract
  terms and % franchised to test some implications
   – Finds that importance of franchisee’s and franchisor’s
     effort are main determinants of contract terms and %
     franchised, in directions predicted by models
   – Finds contrary results for risk
   – Concludes data best fits double-sided moral hazard
• Bhattacharyya and Lafontaine (1995) formalize
  Rubin’s argument
• In the process solve a “puzzle” : show how two-sided
  moral hazard can explain uniformity and stability
  over time of “share parameter”
 Agency Theory and Franchising
• Caves and Murphy (1976) also mention role of the
  franchisee’s property rights in any goodwill
  accumulated in his location
• Lutz’ (1995) goes further, pointing out that asset
  ownership, and the stake that such ownership
  gives franchisees in the future profits of their
  outlets, is central in providing incentives to them
• Residual claims in current profits do not suffice
 Agency Theory and Franchising
• Rubin (1978) also discusses why he thinks
  royalties should be based on sales not profits
• he notes that the franchisor’s role mostly affects
  demand and outlet sales, so the contract should
  give her a share of what she can influence to
  entice her to put forth the right level of effort
• Note: See Maness (1996) for an incomplete contract
  explanation for sales-based royalties
Self-Enforcement in Franchising
• Klein (1980), (1995)
• paper entitled “Transaction Cost
  Determinants of ‘Unfair’ Contractual
  Arrangements”
• Provides a self-enforcement argument
  for the structure of franchise contracts
Self-Enforcement in Franchising
• Here the terms of the franchise contract do two
  things:
  1- they explicitly describe the behavior that the
  franchisor expects of the franchisee, making the
  contract terminable if the franchisor finds that the
  franchisee does not behave accordingly
  2- they guarantee that franchisees earn some
  ongoing stream of rent within the relationship, a
  stream of rent that they put at risk if they stray
  from the requested behaviors
 Self-Enforcement in Franchising
• The franchisor’s behavior here is controlled by her desire
  to maintain her reputation, a reputation that she puts at risk
  if she behaves opportunistically vis-à-vis her franchisees
• Presumes higher cost of finding franchisees once damaged
  reputation, and ultimately of operating the chain as a
  corporate entity – an option that the franchisor would have
  chosen from the outset if it were more efficient than
  franchising
• => The result is that franchise contracts are one-sided:
   – they explicitly constrain the behavior of franchisees but let
     reputation rather than contract terms govern the behavior of the
     franchisor. Klein (1995) further develops, clarifies, and refines
     these ideas.
 Self-enforcement in franchising
• Empirical evidence:
• Brickley, Dark and Weisbach (1991) show that
  state laws constraining termination reduce reliance
  on franchising and reduce shareholder value in
  franchised chains
• Kaufmann and Lafontaine (1994) examine in
  detail the profit and loss statements from “typical”
  McDonald’s outlets, and the resale prices of a
  small set of such outlets
• conclude that McDonald’s leaves rent with their
  franchisees, ex ante and ex post
           Multi Tasking and
           Complementarities
• Slade (1996) examines empirically how the
  incentives toward one task – here selling gasoline
  - are correlated with those for a second task, here
  backcourt operations
• She notes that the contract gives the agent full
  residual claims on these activities
• theory then suggests that the power of incentives
  for gasoline sales should be lower the more
  complementary backcourt operations are to
  gasoline sales. Slade’s results support this
  prediction
              Multi Tasking and
              Complementarities
• Lafontaine and Slade (1996) consider the case where
  several signals of agent effort might be available to
  principals (here franchisors), and analyze the
  circumstances under which principals will choose to rely
  relatively more on output-based versus input-based
  measures of effort in the compensation of their agents
• of interest here because in empirical analyses of the effect
  of monitoring costs, the type of monitoring considered
  increases the fit of sales data to individual effort. In others,
  it provides additional information about agent behavior
  that can be used as a substitute for sales data
             Multi tasking and
             complementarities
• Lafontaine and Slade (1996) show in a simple
  model with two signals of agent effort that
• when the information obtained via monitoring
  gives a better direct signal of effort, it reduces the
  need to use sales-based incentive contracting and
  thus firms are more vertically integrated
• when monitoring increases the value of sales data
  as a signal of agent effort by increasing its
  precision, it makes incentive contracting – that is
  franchising – more attractive
              Multi tasking and
              complementarities
• Bradach’s (1997) looks at the practices of five fast-food
  restaurant chains shows how the mechanisms and systems
  that franchisors rely on to govern their relationship with
  their franchisees interact with one another
• Same with the mechanisms employed within the
  managerial employment contract on the company-owned
  side of these firms
• Bradach also argues that the two separate forms of
  governance complement one another so that franchisors
  that use both company and franchised units can better
  address what he describes as the main managerial
  challenges that these firms face
            Multi tasking and
            complementarities
• Brickley (1999) is the first to expand the empirical
  analyses of franchise contract terms beyond the
  realm of the pure financial components such as
  royalty rates and franchise fees
• He shows that the occurrence of these provisions
  is positively correlated in his sample of contracts,
  which he notes is a sign that there may be
  complementarities among these contract clauses
              Multi tasking and
              complementarities
• Lafontaine and Raynaud (2002) review the agency and
  self-enforcement arguments and describe in some detail the
  set of clauses that support each in franchising
• they note that while residual claims and ownership stake of
  a franchisee give him reasons to work hard on the day-to-
  day operations of the business, they can also lead him to
  free-ride or cater to local customers too much from the
  perspective of the chain
• Lafontaine and Raynaud argue that the self-enforcing
  aspects of the contract give the franchisor an opportunity to
  control these “bad” behaviors that are in some sense the
  side effects from giving residual claims and ownership
  rights to franchisees
               Conclusion
• The literature on franchising has grown into
  a significant source of insights regarding
  franchising
  => how and why it works
  => into the various forms of vertical
  restraints usually embedded in these
  contracts (also important competition policy
  component of literature I did not cover here)
                    Conclusion
• franchising however is not unique except perhaps from the
  perspective of data availability
• => learning we can generate by studying franchise
  contracting applies to the study of its closest cousins,
  namely other types of distribution contracts and various
  forms of share contracts wherever they occur, be it in
  agriculture, real estate, or lawyers’ fees
• It also provides useful insights much more generally into
  other forms of contractual arrangements, including I would
  argue employment relationships and many issues
  surrounding the theory of the firm
                       Conclusion
• Yet even within franchising, much remains to be done.
• In particular, analyses of performance differentials are very few
• Some have used changes in regulatory regimes to get insights (e.g.
  Barron and Umbeck (1984) on divorcement in gasoline, Smith II
  (1982) with enactment of dealer in court day laws, Slade (1998) on
  divorcement in beer retailing in UK)
• Others compare results after controlling for various things: Shelton
  (1967) examined the effect on revenues and profits of switching from
  franchised to company owned within a chain, Muris, Scheffman and
  Spuller (1992) on organization of soft-drink distribution, Williams
  (1998) on survival of units, Michael (2000) on quality differences
                     Conclusion
• But any analysis of performance effects of organizational
  form must deal with selection issue! Not an easy task
  empirically!
• Still this is one place I think we need to go
• Also, go further on these complementarities…
• At the same time, understanding the diffusion of
  franchising internationally, and franchisor entry, exit, and
  growth, and so on…