Research Results and Implications for Future Research

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FRANCHISING

Research Results and Implications for Future Research

Josef Windsperger

I. Overview of major research results

II. Research deficits and implications for future research

Josef Windsperger

Professor of Organization and Management University of Vienna

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I. Overview of Research Results

We discuss the different theoretical views regarding the

explanation of the institutional structure of the franchising networks?

- Royalties, initial fees, specific investments - Decision rights

- Ownership structure (PCO, MUF)

- Contract design (completeness, duration) - Informal governance (Trust, fairness)

Resource-based View TC- Agency- Signalling- Screening- Search Cost-View

Property Rights View

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1 Resource-based View (1)

Research question:

How to explain the ownership structure of the franchising firm?

(A) Resource Scarcity Theory (e.g. Oxenfelt, Kelley 1968/69;

Dant et al. 1996; Dant, Kaufmann 2004)

The franchisor has at least three resource constraints The franchisor has at least three resource constraints concerning the local outlets:

- Information resources - Managerial resources - Financial resources

(1) Ownership redirection effect during time: The proportion of company-owned outlets increases during the organizational life cycle.

(2) MUF increases with the franchisor‘s financial constraints.

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PCO

time Discussion question:

Which constraints are the most relevant?

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Resource-based View (2)

(B) Resource-based Theory (Penrose 1959; Wernerfelt

1984; Barney 1991; Thompson 1994; Teece et al. 1997;

Helfat et al. 2007)

The franchisor has specific resources and capabilities resulting in a competitive advantage:

- Coordination and control - Coordination and control - Brand name development

The higher these resources and capabilities of the

franchisor, the higher is the rent-generating potential

of these resources, and the higher is PCO (Combs et

al. 2012).

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2 Transaction Cost View Research questions:

(1) Explanation of the ownership structure Transaction-specific investments

(initial fees, initial investments) Self-enforcing contract view (Klein 1995, 1996)

Hostage model

(2) Explanation of the allocation of decision rights between the franchisor and franchisees (Mumdziev, Windsperger 2013) (3) Explanation of MUF: Transaction-specific investments

increase the self-enforcing range of contracts (Bercovitz 2003, Hussain et al. 2013).

(4) Contract duration: Transaction-specific investments and uncertainty

(e.g. Brickley et al. 2006, Garcia-Herrera, Llorca-Vivero 2010; CHAUDEY,

FADAIRO, PERDREAU 2011)

^•

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Transaction Cost Theory

TC

Market Network Hierarchy

Franchising

Specifity, Uncertainty

S

₁

S

₂

S

₃

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Self-enforcing Contract View (Klein 1995, 2000)

g

^AB

A B

g

^BA

D ^g

^AC

C

g

^BD

Franchisor

Franchisee

Licensor

A‘s quasi-rent: QR

^AB

= (g

^AB

– g

^AC

)

D ^g

^AC

C

A‘s profit with B: g

^AB

B‘s profit with A: g

^BA

B‘s quasi-rent: QR

^BA

= (g

^BA

– g

^BD

)

HOLD-UP Potential of A (H

^A

) Quasi-rent of B (QR

^BA

) =

Quasi-Rents of B (QR^BA)

>

H^B - cooperative behavior

Licensee

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Results

FEES and OWNERSHIP

The higher the transaction specific investments and the initial fees of the franchisee, the lower is the tendency toward company-owned outlets.

The higher the behavioral and market uncertainty, the higher is the The higher the behavioral and market uncertainty, the higher is the

tendency toward company-owned outlets (Mangolis et al. 1995).

DECISION RIGHTS

The higher behavioral and environmental uncertainty, and the higher

transaction-specific investments of the franchisees, the more decision

rights are transferred to the franchisees.

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3 Information Economics: Agency, Signalling and Screening, and Search Cost Theory

Research questions:

1. Explanation of the royalties and fees 2. Explanation of ownership

2. Explanation of ownership

3. Explanation of initial investments

4. Explanation of MUF

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3. 1 Agency Theory

Research questions:

1. Explanation of the royalties – initial fees 2. Explanation of the proportion of ownership?

(e.g. Lafontaine 1992; Latontaine, Shaw 2005; Vazquez 2007; Penard et al. 2011) (I) Performance-based incentives

Agency Costs: residual loss + incentive costs and monitoring costs Performance-based incentives for the agents (risk aversion):

Remuneration = Fixum (a) + Performance-based pay (ß) ß – commission rate

Optimum: ß = 1/1 + 2rσ² (r > 0, agent is risk avers) Performance pay is negatively related to risk .

Franchisee: Royality (R) = 1 – ß

Hence R is positively related with risk!

(Lafontaine, Shaw 2001; Lafontaine, Slade 2005; Blair, Lafontaine 2005)

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Empirical Results from Agency Theory

- The more important the franchisee‘s (franchisor‘s) efforts, the lower (higher) is the royality rate.

- The higher the uncertainty, the higher is the risk premium franchisees want to have, and the lower is performance

dependent proportion of his income (1 – R); hence the higher dependent proportion of his income (1 – R); hence the higher is R.

Therefore, firms choose to integrate when facing more uncertainty.

Empirical results do not confirm this relationship.

- The higher the royalties, the lower the initial fees (as rents).

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(II) Proportion of Company-owned Outlets (PCO)

- The higher the monitoring costs due to behavioral uncertainty, the higher is the tendency toward

franchising.

- The stronger the brand name value, the higher is the proportion of company-owned outlets.

Empirical Results from Agency Theory

- The stronger the brand name value, the higher is the proportion of company-owned outlets.

(III) MUF

- The higher the opportunism risk due to moral hazard,

free-riding and adverse selection, the higher the tendency

toward MUF (Gomez et.al. 2010, Gillis et al. 2011)

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3. 2 Screening Theory

Research questions:

Explanation of the royalties, fees and specific investments (Dnes 1992, 1993)

Initial fees and specific investments have a screening function – attracting competent franchisees

attracting competent franchisees

The higher ther initial fees and specific investments, the more likely franchisees with high entrepreneural capabilities are

attracted.

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3. 3 Signaling Theory

Research questions:

Explanation of royalties and company-owned outlets (Galini, Lutz 1992, Lafontaine 1993; Dant, Kaufmann 2003; Fadairo, Lanchimba 2013)

Assumption:

Franchisors have private information on the brand name value of the Franchisors have private information on the brand name value of the system that they intend to communicate to potential franchisees.

Royalties and franchisor-owned outlets have a signaling function regarding the quality of the system to attract potential franchisees at the beginning of the organizational life cycle.

The signaling effect of the PCO reduces during the organization life

cycle.

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PCO

time

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3. 4 Search Cost Theory

Research questions:

Explanation of company-owned outlets (Minkler 1990; 1992)

Franchisors have a search cost advantage in the beginning of the organizational life cylce, if they use franchisees.

organizational life cylce, if they use franchisees.

The degree of information asymmetry diminishes during the life cycle because the franchisor acquires local market knowledge.

Therefore, the porportion of franchisee outlet will be reduced

during time.

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4 Synergistic View of Franchising

Research question:

How to explain the stable mix between franchisee-owned and company owned outlets?

(Bradach 1997; Cliquet 2000, 2002; Cliquet, Penard, Saussier 2003; Cliquet, Penard 2012)

Economic Reasons

Different ‚exploitation‘ and ‚exploration‘ capabilities between the franchisor and the franchisees (Sorenson, Sorensen 2001).

franchisees (Sorenson, Sorensen 2001).

Franchisor: Higher exploitation capabilities (administrative capabilities, quality management)

Franchisee: Higher exploration capabilities (innovation, local market knowledge)

Synergy effects of the plural system

- higher innovation capabilities (mutual learning, adaptation) - higher monitoring capabilities (performance benchmarks) - higher local responsiveness

- stronger incentives (internal competition) - dual career path

PRT as solution

(Hendrikse, Jiang

2011)

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5 Property Rights Approach

Major contributions: Grossman and Hart (1986), Hart and Moore (1990), Baker, Gibbons and Murphy (2008, 2012)

Research questions:

1. How to explain the structure of residual decision and ownership/residual income rights in franchising?

(Windsperger 2001, 2002, 2003, 2004, 2006, 2007, 2013; Mumdziev, Windsperger 2011; Hendrikse, Jiang 2011)

Windsperger 2011; Hendrikse, Jiang 2011) 2. MUF (Hussain, Windsperger 2013)

Property Rights:

a. the right to use the good b. the right to change the good

c. the right to capture the profit or to bear the loss

d. the right to sell the good and to receive the liquidation value a + b = Residual decision rights

c + d = Residual income or ownership rights

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Property Rights-Explanation

Contractible Know-how

Contractible Know-how Non-contractible Know-how

B: Franchisee

A: Franchisor

Hierarchy Market Contract

Non-

contractible Know-how

Franchising Network A to B:

Licensing

Proposition: Contractibility (due to intangibility) of assets determines the structure of residual income, ownership and decision rights.

Assets characteristics:

Intangible system-specific and local market assets

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Intangible assets

System-specific und local market knowledge

Residual decision rights

‚

Governance Structure‘ of the Franchising Firm

H1

How is the knowledge distrubuted

between the franchisor and the franchisee?

Who is the residual decision maker

Proportion of company-owned Outlets (PCO)

Royalties/

Initial Fees Ownership rights

(Residual income rights)

H2

H3

Who is the residual decision maker (whose decisions influence

the residual income)?

How are the ownership rights allocated?

(

Windsperger 2004; Windsperger, Dant 2006; Windsperger, Yurdakul 2007;

Mumdziev, Windsperger 2011, 2013

)

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6 Comparison:

Agency Theory (AT), Resource Scarcity Theory (RST), Transaction Cost Theory (TCT) and Property Rights Theory

(PRT)

(1) AT and PR-theory: Distinction between performance

and ownership incentives is not possible under highly contractible assets (Hart 1995).

(2) AT predicts a negative relationship between royalties and intitial fees (2) AT predicts a negative relationship between royalties and intitial fees and PRT predicts a positive relationship (Windsperger 2001).

(3) TCT versus PRT: No distinction between intangible and tangible specific investments (Whinston 2003).

(4) RST versus PRT: No distinction of the local resources (information, managerial and financial) according to the degree of contractibility

(Windsperger, Dant 2006)!

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II. Research Deficits and Implications for Future Research in Franchising

(1) Governance structure:

Relationship between decision and ownership rights and performance:

Complementarity between DR and OR!

(2) Performance of governance mechanisms:

Impact of governance structure (decision and ownership rights) on performance!

on performance!

(3) Relationship between multi-unit franchising and the proportion of company-owned outlets:

Decision management rights are divided between franchisor and MU- franchisees; franchisor‘s DR are diluted under MUF.

Franchisor might get higher control rights by increasing PCO!

(4) Governance structure of the international franchise firm:

Wholly-owned subsidiaries, joint ventures, area developers and master

franchising – Organizational economics perspectives!

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Future Research in Franchising

(5) Relationship between firm strategy and governance structure:

Chandler: „Structure follows strategy“!

What is the impact of strategy on decision and ownership structure?

(standardization versus adaptation strategies) (6) Relationship between uncertainty and incentives:

(6) Relationship between uncertainty and incentives:

AT: Royalties as performance-based incentives and risk is positively related! Empirical results do not support this view!

According to James (2000), the relationship between risk and incentives depends on the underlying governance mechanism:

(a) Employment contract with more contractible assets: NEGATIVE!

(b) Franchise contract with less contractible local market assets: POSITIVE!

(c) Empirical studies do not differentiate between these differences!

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Future Research in Franchising

(7) Relationship between DR and knowledge transfer mechanisms:

Knowledge attributes (tacitness, noncontractible) determine DR-structure and the design of knowledge transfer mechanisms.

(8) Relational and formal governance mechanisms in franchising:

Trust (or fairness) as relational governance variables may influence the use of formal governance mechanisms, such as decision and ownership use of formal governance mechanisms, such as decision and ownership rights!

Differentiation between general trust and knowledge-based trust!

Research results show (Windsperger, Hussain 2013) that knowledge- based trust increases the tendency toward MUF and general trust

decreases the tendency towards MUF!

(9) Impact of alliance capabilities on ownership and DR:

Higher alliance capabilities increase delegation and decrease ownership.

(Kale et al. 2002; Ehrmann & Meiseberg 2013).

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Franchising Research: An Interdisciplinary Focus?

Integration of organizational economics (OE) and strategic management perspectives (in particular RBT)!

March (1991): Organizations have two entrepreneurial functions:

‚Exploitation of knowledge and exploration of knowledge‘!

OE based on AT, TCT and PRT applications focuses on the first question (i.e. coordination function)!

Given resources and capabilities of the firm, which governance modes reduce transaction and agency costs (TCT, ACT) or increase residual income (PRT), due to uncertainty/information

asymmetry, transaction-specific noncontractible assets?

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‚Core‘ of Theory

Organizational Economics versus Strategic Management Theories

‚Core‘ of Theory

TCT&PR&AT RBT&OCV

TCT: Transaction Cost Theory

PT: Property Rights Theory

AT: Agency Theory OCT: Organizational Capability Theory RBT: Resource-based Theory

Set of Intended

Applications

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Research Results and Implications for Future Research

FRANCHISING