Introduction

The benefits of joining an established franchised chain for a franchisee, and thus the reasons why franchisees are willing to pay fees to be part of a franchised chain, can be grouped into two broad categories: cost-reducing and demand-enhancing benefits. The cost-reducing benefits include established supply relations and economies of large-scale purchasing, comprehensive and ongoing programs to develop efficient production processes, management training and consulting, and so on. Demand-enhancing benefits arise mostly from the brand and the products associated with it. In other words, when franchisees join a chain, they do so under the expectation that the brand that they get to operate under will bring in customers who might otherwise not have visited their store. A rare case of a McDonald's franchisee who “lost his arches” illustrates how important the brand can be to franchisees: the restaurant in question was operated very similarly by the same individuals in the same place after terminating its relationship with the McDonald's system. Despite all that, its sales fell by 60 percent immediately. Sales continued to go down after the initial shock, and never again exceeded 35 percent of the level they had achieved as part of the McDonald's system. The restaurant closed for good some 12 to 18 months later.

Franchising has become a part of everyday life for most consumers in the United States today – it is everywhere. Numerous firms in a variety of industries have adopted franchising as a method of doing business. As a result, consumers now often purchase meals and hotel services along with car repairs, clothing, specialty foods, and many other types of goods and services through franchised companies. Why have so many firms involved in such different activities all chosen to organize themselves as franchised companies? We know that a combination of factors makes franchising desirable. On the one hand, the increased reliance of consumers on brand names, due in part to increased consumer mobility and greater time constraints, has played an important role in the development of retail and other chains. In addition, chains can benefit from lower costs through bulk purchasing programs and by realizing economies of scale in production, new product development, and advertising. These benefits, however, really explain why chains have become more prevalent in the economy, not why franchising has become so ubiquitous. After all, the stores in these chains could all be corporately owned, as is the case in many chains. Why then do we see so many other chains organized as franchises? The answer apparently lies in the capacity of franchising to combine the chain's comparative advantages in creating brand recognition and capturing economies of scale with the local entrepreneur's local knowledge and drive.

Introduction

Many of the business sectors where franchising occurs are mature, and franchising itself has become a fairly mature mode of organization in these industries. As a result of this maturity, competition has intensified and the issue of “impact” or “encroachment” has come to the forefront. In fact, as some industry analysts would have it, traditional encroachment – “the franchisor's placement of a new company-owned or franchised unit too close to an existing one – has emerged to be one of the most vexing, emotional and yet least understood [franchising] problems of today.” (Barkoff and Garner 1994a)

While encroachment is defined most often in terms of geographic competition, it can take many different forms. All alternative channels through which a franchisor can distribute its products or services to customers will potentially “encroach” on its franchisees' businesses and impact their profitability. For example, when Carvel sells its frozen desserts at the supermarket, customers who purchase them there might reduce the frequency of their visits to individual Carvel restaurants. Franchisees thus can claim that they are hurt by such sales. On the other hand, customer awareness of the Carvel brand may be increased by the availability of the product at non-franchised locations, thereby increasing traffic at the chain's franchised outlets. A similar set of potentially negative and positive impacts on franchisees can occur with internet sales, non-traditional franchised or company outlets, and any other alternative route used to reach the ultimate customer.

Introduction

This chapter covers a lot of ground, focusing as it does on the relationships among franchising, vertical integration, and various types of vertical restraints in both theory and practice. We begin with a description of the extent of company ownership in franchised chains. The vast majority of franchised firms operate at least some of their units themselves while franchising the rest. Thus, they choose some degree of vertical integration and then use contractual devices to organize the other units in the chain. There is considerable variation across franchised chains in the extent of company ownership, which in itself is worth exploring. In fact, why firms choose different proportions of company-owned units is a question that has received significant attention in the empirical literature on franchising.

Next, we describe a set of vertical restraints, many of which appear in franchise contracts. We show how, in combination or individually, these vertical restraints in theory allow franchisors to achieve the same results as vertical integration would permit. In particular, we examine the use of simple lump-sum fees, sales royalties, output royalties, input purchase requirements, resale price controls, and output quotas. We introduce these here, and then return to many of them in later chapters as we explore the sources of conflict between franchisors and franchisees. Finally, in the last section of this chapter, we review agency-theoretic arguments that have been used to explain variation in royalty rates across franchised chains.

Introduction

Franchise contracts stipulate the conditions under which a franchised outlet is to be operated and, in particular, the rights and obligations of both parties. In this chapter, we examine the terms of franchise contracts, with special emphasis on the monetary contract terms, namely franchise fees, royalty rates, ongoing fixed payments, and advertising fees. These fees, as mentioned in Chapter 1, are not used in traditional franchising and, therefore, this chapter is really about monetary contract terms in business-format franchising.

As we will see in more detail in Chapter 4, if the franchisor is to maximize its profit, economic theory generally suggests that it should tailor its franchise contract terms for each unit and franchisee in a chain. In practice, however, contracts are remarkably uniform within chains and thus insensitive to variations in individual, outlet, and specific market conditions. Indeed, a business-format franchisor most often uses a single business-format franchising contract – a single royalty rate and franchise fee combination – for all of its franchised operations that join the chain at a given point in time. In her survey of 130 business-format franchised chains, for example, Lafontaine (1992b) found that 42 percent of her respondents offered their contracts on a take-it-or-leave-it basis with another 38 percent allowing some negotiations, but only for non-monetary terms. Thus, uniformity, especially for monetary terms, is the norm.

Introduction

Prices vary somewhat from outlet to outlet in most franchised chains. This has been confirmed in several empirical studies, including Lafontaine (1995b), Graddy (1997), Thomadsen (2002), and Kalnins (2003), all of which examined price data they had gathered from the individual outlets of large fast-food chains within relatively small geographical markets. Moreover, Lafontaine (1999) has examined the relationship between the extent of franchising and the degree of price dispersion in local markets, namely the Pittsburgh and the Detroit metropolitan areas. She finds that several fast-food chains allow some price dispersion even within their set of corporate stores. The amount of price dispersion, however, is larger for fully franchised than for fully corporate chains. She finds the greatest total amount of price dispersion among those chains with a mix of corporate and franchised stores.

Although the quote above from the McDonald's Web site suggests that price differences across outlets are a normal and accepted part of franchising, it is not uncommon for franchisors and franchisees to disagree about the prices that the franchisees charge their customers.

Introduction

Franchising entails a symbiotic relationship between what are, in reality, legally independently owned businesses. Franchisees can only succeed when the system as a whole succeeds. At the same time, the franchisor's profits derive from the success of its franchisees. Their mutual interdependence is, therefore, readily apparent. But while the interests of franchisors and franchisees often coincide, it remains true that they are not entirely compatible. This, of course, gives rise to conflict.

Broadly conceived, there are two major sources of conflict between franchisors and franchisees. First, some franchisees are simply ill-suited to being part of a chain where uniformity is essential. These people are just too independent. They want to modify the menu, select a different location, have different hours of operation, and so on. Because franchise systems thrive on uniformity of quality, appearance, hours of operation, and the like, there is a tension between the franchisor and some of its franchisees who chafe under the franchisor's insistence on compliance with the business model. There is no obvious way to resolve this problem except to note that those individuals who seek significant independence should not invest in a franchise, and franchisors also need to develop franchise sales and franchisee selection procedures that will prevent the sale of franchises to such individuals. Not surprisingly, the franchising trade and management consulting literatures discuss this problem at length.

There are many misconceptions surrounding franchising in the United States and abroad. In our view, these misconceptions result from relying on casual impressions rather than a careful evaluation of the empirical evidence. In this chapter, we focus our attention on four such misconceptions. By summarizing the existing data, we hope to disabuse the reader of these misconceptions and thereby generate a more realistic appreciation of franchising.

We begin with the notion that franchising has been growing at a phenomenal rate in the U.S. for several decades. As we shall show, this impression is misleading: for the last two decades at least, our best estimates indicate that franchising in the U.S. has grown, at most, at rates commensurate with the rest of the economy. Interestingly, research conducted in the United Kingdom suggests that similar claims of tremendous growth in franchising in that country in the 1990s are also ill-founded. Second, we examine the extent of entry and exit for franchisors, and then also for franchisees. The data show that many firms indeed become new franchisors each year, a fact that is well-publicized in the trade press. But many firms also exit franchising or fail, and this generally receives much less attention. As for franchisees, we find that the notion that franchising poses substantially fewer business risks for franchisees than starting an independent business is not supported by the data. Third, we consider the size of franchised chains.

Franchising has become a very visible part of the economic landscape in the United States. Its role in distributing products to customers in the rest of the world has also grown considerably over the last several decades. In this book, we describe what franchising is and how it works. In most situations, franchising works very well for franchisors, franchisees, and consumers alike, which is why it has grown to the extent that it has. Because it works well most of the time, we expect that franchising will continue to flourish in the world economy. At the same time, however, we know from economic principles that franchise relationships are by their very nature fraught with many difficulties arising essentially from differences between the needs and goals of the franchisors and those of the franchisees. Economists and management researchers have made significant progress in the last twenty or so years toward increasing our understanding of the sources of these problems. We highlight much of their work in this book.

We had many goals in writing this book. First, from a managerial perspective, we hope that an improved understanding of the basic sources of friction in franchise relationships will allow franchisors and franchisees alike to develop better ways of dealing with each other's concerns, either through the franchise contract itself or through other means of their choosing.

Introduction

The strength of franchise systems typically does not lie in the absolute quality of the products offered. Instead, it resides largely in the capacity of the franchised chain to offer a uniform product at a reasonable price. Customers know what to expect when they patronize an outlet in a franchised chain, and it is important for the chains to successfully meet these expectations time after time. The importance of uniformity to mobile customers is clear. Speaking about airport restaurants, Nancy Kruse, of the restaurant consulting firm Technomic, notes: “Travelers love to see fast-food chains at airports. Even if they're 2000 miles from home, they can go into an airport McDonald's, order a Big Mac, and know exactly what they're getting and more or less what it's going to cost” (quoted in Frequent Flyer, March 1991). Similarly, the founder of Ember's America, a new franchise conversion concept for locally owned family restaurants, points out: “If Big Macs were different from McDonald's to McDonald's, people wouldn't stop at McDonald's very often.” In other words, it is the consistency of the system's operation, service, and product quality that attracts customers and induces loyalty: customers become loyal if the experiences they enjoy at diverse units of these chains routinely meet their expectations.

Franchisors are, of course, well-aware of the importance of consistency to their customers. Bradach (1998) interviewed several managers and franchisees in five major fast-food franchised chains to gain insight into how these firms were organized and why.

Introduction

A tying contract is a vertical restraint that involves a conditional sale. In its simplest form, the producer of product A agrees to sell that product, but only on the condition that the buyer also purchase product B. In this scenario, product A is the tying good while product B is the tied good. The situation can be more complicated, involving possibly a collection of tied goods rather than just one. Moreover, tying may involve services and other intangibles, or extend to leases as well as sales. Finally, the tying arrangement may involve third parties, that is, the buyer of A may have to buy the tied good B from a designated third party rather than from the seller of A. In all of these scenarios, however, the essence of tying is the condition that limits the buyer's freedom to purchase the tied good(s) wherever he deems optimal from his own perspective.

In the franchising context, the alleged tying good is usually the franchise license, which is normally subject to intellectual property protection. The tied goods may be other goods that are resold with little modification or they may be inputs into the production of a final good. An example of the former would be branded products such as Baskin-Robbins ice cream or Shell gasoline. The Baskin-Robbins franchisor licenses its franchisee on the condition that it buy Baskin-Robbins ice cream for resale.

Introduction

The vast majority of franchise contracts are of finite duration, but contract duration varies considerably across franchise chains: some contracts are as short as 5 years while others are as long as 20 or 30 years. The contracts also usually stipulate an option to renew and the duration of the potential renewal period(s). In their 1998 survey of franchise contracting practices, Frandata and the IFA found that 91 percent of franchise contracts included an option to renew. Moreover, most of the time, franchise agreements are indeed renewed. In a small number of cases, however, even franchisors who offer such an option choose not to renew a specific contract. Further, franchisors sometimes terminate a franchisee's existing contract within the contract period.

In this chapter, we first describe in more detail what we know about contract duration. We show in particular that franchise contracts are typically quite long-term. We also provide some information on termination and renewal rates. We then examine the role of contract duration, termination, and non-renewal in franchising, specifically the effect these have on franchisees' willingness to invest both capital and effort in their franchised unit. We also discuss the issue of franchisee and franchisor opportunism and how these relate to termination and non-renewal. Next, we examine how the common law treats the termination and non-renewal of franchise contracts in the United States, and then describe how several states within the United States further regulate termination and non-renewal in their franchise relationship laws.

Introduction

Franchising is a contractual relationship that has received a significant amount of attention in the empirical literature on contracting. In large part, this is because franchising is one of the few types of contractual relationships about which significant amounts of data are available from public sources. But franchising is also, as noted by Williamson (1991), a hybrid organizational form, which lies somewhere between complete vertical integration and spot markets. Thus insights gleaned from the study of franchise contracting have allowed researchers to develop a better understanding not only of this organizational form, but also of how firms organize their activities much more generally, both within and across firms.

Much of the literature on franchising has specifically been concerned with incentive issues and how these are managed in these contracts. This literature has identified two main categories of incentive mechanisms relevant to the franchise relationship: residual claims and self-enforcement. The former relates to the fact that franchisees get to keep their outlet's profits net of the fees they pay to their franchisors, giving them incentives to maximize those residual profits. The second relies on the presence of on-going rent at the outlet level, rent that the franchisee forgoes if his contract is terminated. Such rent is simply the difference between the (net present value of) returns that the franchisee earns as a result of being associated with the franchise network and the returns he could garner in his next best alternative. If the rent is positive, and franchisors can terminate franchisees, franchisees will have incentives to perform according to the standards set by the franchisor to reduce their chances of termination and protect their access to the rent.