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DISCUSSION PAPER SERIES IN ECONOMICS AND MANAGEMENT
Empirical Analysis of Contractual Relations and Organizational Structure in Franchising
– Evidence from Germany
Anna Rohlfing &
Philipp Sturm
Discussion Paper No. 09-25
GERMAN ECONOMIC ASSOCIATION OF BUSINESS ADMINISTRATION – GEABA
Empirical Analysis of Contractual Relations and Organizational Structure
in Franchising – Evidence from Germany
Anna Rohlfing†
Philipp Sturm‡
May 29th, 2009
In this paper, we employ a new dataset based on a sample of 117 franchise systems in Germany to empirically test hypotheses stemming from agency theory and capital scarcity considerations on the contractual relations and the organizational structure in franchising. We include proxies for the franchisor’s need for capital, moral hazard on the franchisee’s side, and moral hazard on the franchisor’s side as central explanatory variables in our analysis. Our results indicate that agency models based on double moral hazard do best explain the design of contract conditions and determine the ownership structure (i.e., the proportion of franchised outlets) in franchise systems. However, we find that the incentive component of the franchise contract (the royalty rate) is not influenced by moral hazard on the franchisee’s side, but rather by moral hazard on the franchisor’s side. Furthermore, and in contrast to existing empirical studies, we find evidence for the fixed fee of the franchise contract being influenced by franchisee moral hazard. Capital scarcity arguments, on the other hand, only influence the contract conditions, but have no influence on the decision about the proportion franchised. JEL Classification: D86, G32, L14, L22, M52
† University of Mannheim, Department of Managerial Accounting, [email protected] ‡ University of Tuebingen, Department of Banking, [email protected]
We would like to thank Christian Hofmann and Werner Neus for their ongoing support and helpful comments. The paper has also benefited from the comments of Jens Grunert, Daniel Gutknecht, Mirko Heinle, Andreas Walter, and seminar participants from the University of Mannheim and the University of Munich.
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1. Introduction
In Germany, franchising began to gain importance about 30 years ago. Today, more than 900
franchise systems are registered with about 121,000 franchise outlets, employing 664,000
people and generating sales of € 62.5 bn.1 Thus, the franchise sector has grown to be a
significant part of the German economy. In contrast to the United States where franchising is
mainly understood as building local business, franchising in Germany is predominantly used
as a means of advancing sales. Furthermore, the regulatory environment for franchising in the
U.S. differs from the one in Germany, which puts into question the transferability of the
findings of U.S.-based studies on franchising to Germany.
A franchise relationship is usually characterized by a contractual agreement between a
principal (the franchisor) who is in possession of a product or trademark and an agent (the
franchisee) who pays the franchisor a fixed fee and a sales dependent royalty rate for the right
to sell the product or use the trademark. Since the contract is defined by a linear payment
structure and the relation between franchisee and franchisor is associated with information
asymmetries and moral hazard, this suggests analyzing the contract design in franchising with
agency-theoretic models.2
Detailed information on a manager’s compensation contract is generally only provided for the
board of directors and the supervisory board of listed companies which are subject to certain
disclosure requirements. In contrast, data for small and medium-sized companies is usually
not available. Hence, franchise contracts provide the rare opportunity to analyze contractual
relations in agency settings for which data is usually unavailable.
We test hypotheses stemming from two different theoretical environments, capital scarcity
theory and agency theory, by empirically analyzing the contractual relations (i.e., the fixed fee
and the sales dependent royalty rate) and the organizational structure (i.e., the proportion of
franchised outlets) in the German franchising sector. Both theories are widely acknowledged
in existing literature as being explanatory factors for franchising; agency theory is an
important component because the franchisor is delegating decisions and tasks to the
1 Forum Franchise und Systeme (2009). 2 See, e.g., Brickley et al. (1991), Brickley (1999), Combs/Ketchen (1999), Hempelmann (2000), and
Blair/Lafontaine (2005).
2
franchisee, capital scarcity is said to be driving the decision whether to franchise or not.3 We
employ a new dataset from 2008 with a final sample of 117 franchise systems. Our main
research questions are: (1) How and under which conditions do capital scarcity arguments on
the franchisor’s side influence the contract design and organizational structure in franchise
systems? (2) What impacts do moral hazard considerations on the franchisee’s and the
franchisor’s side have on the contractual relation and the proportion of franchised outlets?
Some empirical studies have been conducted with respect to the contract conditions (Sen,
1993; Baucus et al., 1993; Lafontaine/Shaw, 1999; Brickley, 2002; and Seaton, 2003), while
we find several studies which deal with the organizational structure of franchise chains, i.e.,
the proportion of franchised outlets (see Brickley/Dark, 1987; Martin, 1988; Norton, 1988;
Brickley et al., 1991; Scott, 1995; and Castrogiovanni et al., 2006). To the knowledge of the
authors, Lafontaine’s (1992) analysis based on a U.S. dataset from the year 1986 has so far
been the only one to examine the contract conditions and the proportion franchised in a single
study. Our analysis refines the explanatory variables of existing empirical studies and
investigates the relevance of their results for the German market.
We structure our analysis according to the empirical tests of our hypotheses stemming from
two different theoretical environments. First, we analyze whether the franchisor’s need for
capital influences the contract conditions and the proportion of franchised outlets and, thus,
focus on the internal contractual relationships as well as the ownership structure of a franchise
chain. Second, we test for two main elements of agency models, namely franchisee moral
hazard and franchisor moral hazard by analyzing again the contract conditions and the
proportion franchised. This structure is different from existing studies which focus either on
contract terms or on organizational structures, the only exception being Lafontaine (1992).
However, she organizes her analysis along three different empirical models (royalty rate,
fixed fee, and proportion franchised). Hence, she takes a slightly different perspective on the
implications one can draw from the analysis of contract conditions together with the
organizational structure. In our opinion, the franchisor has two instruments in order to
motivate the franchisee to work diligently: the royalty rate of the franchise contract and the
proportion franchised, i.e., giving the franchisee the right to own the outcome of his outlet.
Consequently, both instruments have to be looked at simultaneously in order to explain the
contract structure and the proportion franchised.
3 See Rubin (1978) for agency arguments and Oxenfeldt/Kelly (1969) for capital scarcity.
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We find strong support for capital scarcity arguments in explaining the contractual relations,
i.e., the royalty rate and the fixed fee. However, capital scarcity does not seem to be a main
reason for the franchisor to adjust the ownership structure of his franchise system.
Surprisingly, the proportion franchised seems to be completely unaffected by capital scarcity
considerations in our sample. We cannot reject hypotheses dealing with moral hazard
arguments on the franchisor’s and the franchisee’s side. Hence, both the franchisor’s and the
franchisee’s input seem to be essential for the franchise system. However, with respect to the
royalty rate, we only find indications for the importance of the franchisor’s input which
supports the idea that the royalty rate is the opposite of an incentive rate and mainly serves the
role of motivating the franchisor to work diligently. The franchisee, on the other hand, is
already motivated to exert effort by owning the outcome. With respect to the fixed fee, we
find strong support for moral hazard on the franchisee’s side influencing the value of the fixed
fee, while it seems to be independent of franchisor moral hazard. The proportion franchised,
on the other hand, is influenced by moral hazard on both sides of the franchise contract.
We contribute to the existing literature in several ways. First, we provide a new and unique
dataset for Germany for the year 2008 by refining existing data sources. Second, we offer the
first investigation of the contract terms and proportion franchised based on agency theory and
capital scarcity arguments in franchising for Germany. Third, we refine previous studies in
this field of research by employing new and improved explanatory variables. Fourth, we
reassess different and to some extent inconsistent results of previous studies with the new
dataset. Finally, we shed first light on the question whether the characteristics of franchising
in Germany differ from the ones of U.S. franchise firms, which might be because of different
regulatory frameworks and cultural differences.
The remainder of the paper is organized as follows. In section 2, we discuss the related
literature, explain the basic model, and develop our hypotheses. Section 3 describes the
dataset and the employed empirical methodologies. In section 4, we present our results and
discuss the implications. Section 5 concludes.
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2. Perspectives on Franchising and Hypothesis Development
The nature of franchising
According to the German Franchise Association (Deutscher Franchise-Verband, DFV), a
franchise agreement is defined as “a partnership-based distribution system with the objective
to promote sales”4. More specifically, the European Franchise Federation (EFF) provides the
following description: “Franchising operates on the basis of a contractual agreement between
two independent business parties, the franchisor and the franchisee, in which the franchisor
grants the franchisee, for the term of the contract, the right to buy and operate the franchisor’s
branded and formatted business system for a fee and according to the prescribed rules and
procedures developed for the system by the franchisor.”5 The contractual agreement usually
stipulates that the franchisee pays the franchisor a fixed fee and a revenue dependent royalty
rate for the right to sell the franchisor’s product and the right to use his trademarks and
business format in a given location for a specified period of time.6
The EFF emphasizes the complementary roles of the franchisor and the franchisee which
means that both contracting parties have to exert effort in order to contribute to the success of
the business. Franchisee effort consists of activities with respect to the commercialization of
products and/or services and activities regarding the management of his firm. Franchisor
effort consists of supporting activities such as providing service, operation manuals, training,
and supra-regional promotion. The franchise contract serves to align the incentives of
franchisee and franchisor and helps to overcome moral hazard problems on both sides of the
franchise contract.
According to traditional arguments, a franchisee engages in franchising because he benefits
from increased survivability in the first years of setting up a business due to the franchisor’s
know-how and support. The principal motive for a franchisor, on the other hand, is the rapid
expansion of his trademark or product, which would otherwise not be possible due to capital
constraints.
4 Deutscher Franchise Verband (2009). 5 European Franchise Federation (2009). 6 See Blair/Lafontaine (2005) for a detailed definition of a franchise agreement.
5
Prior literature
The theoretical framework for explaining franchising typically relies on these two main
arguments: moral hazard on the franchisee’s and the franchisor’s side (also called double
moral hazard), and the franchisor’s need for capital. Rubin (1978) was the first to
conceptually develop a sharecropping argument for franchising. Lal (1990) and
Bhattacharyya/Lafontaine (1995) provide more formal analyses of the franchise relationship.
General work on double moral hazard models is provided by Demski/Sappington (1991) and
Baiman et al. (1995). More recent literature on franchising tried to combine the moral hazard
perspective with more sophisticated agency settings, e.g., Al-Najjar (1997) who considers a
franchisor having contractual relations with n agents instead of a single franchisor-franchisee
pair and Agrawal (2002) who assumes risk-averse contracting parties.
Empirical studies in franchising have been conducted in two main streams of research. The
first stream investigates the contract conditions. Lafontaine (1992) analyzes a dataset of 548
franchise systems from the United States of the mid-80s based on agency and capital scarcity
considerations, Sen (1993) investigates a sample from 1988 of about 600 franchisors
operating in the United States and Canada focusing on agency theory and labor economics.
Baucus et al. (1993) analyze a dataset of 249 U.S. franchise systems in the fast food,
automotive services, and business services industry from 1989 and focus on industry
comparisons. Lafontaine/Shaw (1999) examine a panel dataset of about 1,000 U.S. franchise
systems, however, only for 103 of them data is available for the full period from 1980 to
1992. Brickley (2002) focuses on the impact state franchise termination laws have on share
contracts and analyzes a sample of 711 U.S. franchise systems in 1997. Finally, Seaton (2003)
analyzes franchise contracts in the United Kingdom with a dataset of 161 franchise systems
from 1989 to 1999. The second stream of literature analyzes the organizational structure of
franchise chains in terms of the proportion franchised. Brickley/Dark (1987) analyze a sample
of 36 franchise systems from eight different industries in the U.S., Martin (1988) examines a
dataset of 949 U.S. franchisors with a focus on incentives and industries in the particular light
of risk management. Norton (1988) investigates 140 franchisors from three different industry
groups, restaurants & lunchrooms, refreshment places, and motels & tourist courts in the U.S.
from 1977. Brickley et al. (1991) employ different sub-samples of U.S. franchisors in 1985 to
test various models on cross-sectional implications on ownership structure and stock market
reactions to franchise buy-backs. Lafontaine (1992) investigates the proportion franchised
with a sample of 548 U.S. franchise systems from the mid-80s, Scott (1995) analyzes 681
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U.S. franchise systems from 1988, and Castrogiovanni et al. (2006) employ a sample of 439
franchisors from 1999 in the U.S. More recent work on franchising does not seem to be
available since with the analyses of Lafontaine (1992) and Martin (1988) the U.S. market was
covered by two very popular publications. For Germany we attribute the lack of similar
research in this field to the fact that data was not available until recently. Our study is closest
related to the work of Lafontaine (1992) who was the first to combine the analysis of contract
terms and organizational structure in a single study and based the analysis on agency theory
and capital scarcity theory arguments.
Theoretical considerations
The franchise relationship is generally described by a single-period LEN-setting where a risk-
neutral franchisor (principal) hires a risk-averse franchisee (agent) to provide personally
costly effort in return for compensation.7 Furthermore, the principal provides personally
costly effort himself. Both effort choices are not observable by the other contracting party and
both influence the non-contractible outcome and the performance measure. The franchisor
offers the franchisee a linear contract consisting of a variable component (royalty rate)
dependent on the performance measure (e.g., the sales) and a fixed component (fixed fee). In
contrast to the basic LEN-model established by Holmstrom/Milgrom (1987), the franchise
contract implies payments from the franchisee to the franchisor and not from the principal to
the agent. Consequently, the incentive rate in standard agency models is not intended to
motivate the agent but to motivate the principal to work diligently. Furthermore, the agent
owns the outcome, but the principal offers the contract. While the results are structurally
comparable to the standard model, the optimal royalty rate in the franchise model is now
positively influenced by the franchisor’s productivity (and not by the agent’s productivity).
The knife-edge case of a royalty rate of 0 percent can then be interpreted as completely
leasing the outlet to the agent in return of a fixed payment. On the other hand, a royalty rate of
100 percent is equivalent to assuring the agent completely against any performance measure
risk (i.e., sales) and paying him a fixed compensation in form of a negative entrance fee.
Oxenfeldt/Kelly (1969) established the capital market imperfection argument as an alternative
explanation for franchising. According to them, the franchisor faces a binding capital
constraint and thus needs franchising as a means of being able to expand his business. The
7 These are usual assumptions of risk preferences of agent and principal. However, they are not of particular
importance for our analysis.
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capital scarcity argument has some difficulties. First, franchisors generally provide financing
to their franchisees, not only in terms of negotiation support, but also in terms of leasing
agreements. Second, we should observe the tendency that with maturing franchise networks
and, consequently, an easier access to capital, the franchisor starts to buy back franchise
outlets. Hence, the proportion of franchised outlets should be lower in the case of mature
franchise networks. However, we do not observe this tendency (see, e.g., Caves/Murphy,
1976; and Martin, 1988). Finally, assuming that franchisees are risk-averse, they require a
higher risk-premium for investing in a single outlet instead of, e.g., having a claim on a
portfolio of shares from all outlets. This implies, however, that the single franchisor benefits
only marginally from increasing his effort. Consequently, there arises a free-riding problem
and each franchisee chooses a low effort. Hence, combining the capital scarcity argument
with a moral hazard problem on the franchisee’s side seems to contribute to the explanation of
franchising.8
Hypotheses on capital scarcity
Based on the previous theoretical considerations, we establish the following hypotheses. If a
franchisor’s main consideration for engaging in franchising is to raise enough capital, he
should demand a high fixed fee paid at the beginning of the contractual relation. If we assume
a competitive market for franchisees, we face binding participation constraints for the
franchisee and, thus, the fixed fee should extract the downstream surplus given the royalty
rate. This leads to the conjecture that the fixed fee and the royalty rate should be inversely
related.9 Hence, the contract requires a lower royalty rate (H1a) and a higher fixed fee (H1b)
when the franchisor’s need for capital increases. Furthermore, the proportion franchised is
positively related to the franchisor’s capital needs (H1c). Increased needs for funds by the
franchisor go then along with an increased reliance on franchising instead of company-owned
outlets. Since we suspect the capital scarcity argument being only of relevance in combination
with moral hazard considerations, the analyses corresponding to our group H1 of hypotheses
should reveal at least one significant influence of a variable indicating moral hazard on the
franchisee’s side.
8 See, e.g., Lafontaine (1992), p. 267. 9 See, e.g., Lafontaine (1992), p. 267f.
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Hypotheses on franchisee moral hazard
To overcome the moral hazard problem on the franchisee’s side, the franchisor chooses the
terms of the franchise contract. The royalty rate is lower (H2a) and the fixed fee is higher
(H2b) the more important the franchisee’s input for overall performance. Since a high royalty
rate paid by the franchisee is moving incentives to provide high effort away from him, the
franchisor will choose a lower royalty rate the more input is desired from the franchisee.
Finally, the proportion franchised is positively related to the importance of the franchisee’s
input (H2c). Since the franchisee owns the outcome of his own outlet, while a manager of a
company-owned outlet is only paid a salary based on his performance, a franchisee has
stronger incentives than a manager to work diligently.10 If the value of local inputs by the
franchisee is very high, the franchisor will rely more on franchising instead of establishing
company-owned outlets. Consider, for example, the educational business as tutoring centers.
Here, the local conditions differ significantly from country to country and even within a
country between different regions. Hence, the franchisee’s local expertise about the
educational system and learning habits is very central to the success of the business. This
coincides with the fact, that in the educational business, we find very high proportions of
franchised outlets. Furthermore, tutorial centers usually do not require very large initial
investments (usually, rooms are rented). Hence, we expect relatively low fixed fees and high
royalty rates, even if the franchisee’s input is important. Indeed, the royalty rates in the
educational business mainly lie between 8 and 20 percent, while the fixed fees vary from 600
to 11,000 euro. On the other hand, in businesses with very high investments and importance
of local expertise, e.g., fitness-companies, we find a very high proportion franchised and
relatively low royalty rates (about 5 percent). It is evident, that the franchisor has two main
instruments to motivate the franchisee to work diligently: franchising outlets and thus giving
the franchisee the right to own the outcome, and adapting the franchise contract conditions in
terms of low royalty rates.
Hypotheses on franchisor moral hazard
While in the single moral hazard model the incentive contract serves for giving incentives to
the agent, the franchise contract is also intended to commit the franchisor to exerting effort. In
this case, the royalty rate is the component of the contract giving ongoing incentives to the
franchisor. Consequently, the royalty rate will be larger the more important the franchisor’s
10 Of course, even with a manager there is an incentive problem, however, it might be less pronounced than for a
franchisee.
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ongoing input is for overall performance (H3a), while the fixed fee will be lower (H3b). The
opposite results are expected for initial franchisor input. If, e.g., the franchisor has a major
role in continuously ensuring the quality of his products, the franchisee is interested in giving
him incentives to work for this purpose by paying a higher royalty rate. Moreover, the
proportion franchised is negatively related to the importance of the franchisor’s ongoing input
for overall performance (H3c). Consider, for example, the retail business with gardening
equipment. These products are highly standardized and do not require local expertise. By far
more important is the franchisor’s input to ensure the quality of the offered products and to
coach the franchisees or managers in presenting them to potential customers. In this field of
business, we find relatively low proportions of franchised outlets (below 40% of total outlets
are franchised).
3. Data Description and Methodology
Sources of data
The main source for the data used in this study to test our hypotheses empirically is the
Franchise-CD 2006, sold by FranchisePORTAL GmbH, which also runs the corresponding
web-directory FranchisePORTAL.de. The Franchise-CD 2006 dataset consists of a list of all
franchise firms operating in Europe with the profiles of their business concept. In addition to a
verbal description of the franchisor’s product or service, the dataset contains detailed
numerical information on the franchise firms11. We limit our analysis to German franchisors,
because it facilitates the distinction between outlets in the franchisor’s home country
(Germany) and foreign outlets. The Franchise-CD 2006 contains the profiles of 678 German
franchisors of which 277 provide complete numerical information on franchisor contract
terms (i.e., royalty rate and fixed fee).
For methodological reasons addressed in more detail below and the fact that information on
the number of outlets was outdated or not available at all in many cases, up-to date (i.e., 2008)
information had to be gathered on the variables royalty rate, fixed fee and, most importantly,
the number of outlets. This information was collected by conducting telephone interviews12
with franchisor representatives and relying on public information provided by franchisors or 11 All information on Franchise-CD 2006 is based on voluntary disclosure of franchisors. However, since this
information is communicated to new potential franchisees, we expect that correct numbers are reported. 12 Telephone calls were conducted during September and October 2008.
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FranchisePORTAL. In some cases, firms listed in the Franchise-CD 2006 directory did not
offer franchising anymore or did not want to provide the information needed for our analysis.
Our final dataset consists of 117 detailed profiles of German franchisors with information on
the number of domestic company-owned outlets, the number of foreign company-owned
outlets worldwide, the number of domestic franchised outlets, the number of foreign
franchised outlets, the contract terms (i.e., the royalty rate and the fixed fee), the minimum
investment required for one outlet, the number of countries in which the franchisor is present,
the number of years in business, the number of years since the beginning of franchising, the
different types of initial management support offered to the franchisee, the different types of
ongoing management support offered to the franchisee, the different types of training offered
to the franchisee, the qualification requirements franchisees have to meet, and franchisor
membership in the German Franchise Association. On the basis of this information we obtain
the variables which we use for our regression analysis.
Since the general concept of franchise contracts is very well known, the interpretation of the
variables we use should be fairly straightforward. However, some of the variables in our
analysis might not be self-explanatory. Therefore, we will briefly describe the variables (or
the proxies we use to measure them) and the associated theoretical considerations.
Dependent variables: contract terms and proportion franchised
As mentioned above our analysis focuses on both, the contract terms and the contract mix (or
in other words the ownership structure). Therefore, the dependent variables or factors we are
trying to explain with our model are on the one hand the franchisor’s contract terms (i.e., the
royalty rate and the fixed fee of franchise contracts) and, on the other hand, the franchisor’s
propensity to franchise (i.e., the decision whether to manage stores as company-owned outlets
vs. to run them via franchise contracts). The variable royalty is a royalty on sales (i.e.,
expressed as a % of sales) paid by the franchisee to the franchisor. The variable fixed fee is a
(fixed) payment paid at the beginning of the contract by the franchisee to the franchisor. Most
franchisors operate some of their stores directly and franchise others. This phenomenon raises
the question what influences their decision about the contract mix. In order to analyze this
decision we use proportion franchised, i.e., the proportion of franchised outlets, as the
dependent variable in a regression model which can be interpreted as the extent to which
franchisors make use of franchising.
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Independent variables concerning franchisor’s capital scarcity
Franchisor’s capital scarcity depends on two factors: the franchisor’s access to capital and the
franchisor’s need for capital. Years in business is the number of years since the franchisor
started his operations. This is an indicator for the franchisor’s access to capital, because of the
convincing line of argumentation that the franchisor’s access to capital will be easier, the
more established the business concept is (or in other words, young franchisors will find it
harder to raise capital and to find new franchisees as well). Franchisor financing is a dummy
variable indicating whether or not the franchisor is offering financing to his franchisees
(yes=1 / no=0). Clearly, the franchisor can only offer financing to his franchisees, if he has
access to capital. Minimum investment is the minimum amount the franchisee is required to
invest when starting his business. Looking at minimum investment as the amount required to
open a new outlet it is a measure of the franchisor’s need for capital.13
Independent variables concerning franchisee moral hazard
Franchisee moral hazard is typically measured in two different ways: The first one is the
importance of the franchisee’s input and the second is the cost of monitoring these inputs. The
Franchise-CD 2006 provides detailed information on the qualification the franchisor expects
from franchisees, which we use as a proxy to measure the importance of the franchisee’s
input. Qualification of franchisee is a variable which can take on values between 0-7 counting
the different qualification requirements of franchisors which franchisees have to meet, e.g.,
professional skills, industry knowledge, technical knowledge, and team spirit. The remaining
variables we use to analyze franchisee moral hazard are indicators of the franchisors cost of
monitoring the franchisees input. The first one is the number of countries in which the
franchisor is operating. This indicator is typically used as a measure of geographical
dispersion, which is assumed to increase monitoring cost. The second indicator, foreign
outlets, is the percentage of outlets outside of Germany, which is used as another measure of
geographical dispersion14. The third indicator we use to measure franchisor’s monitoring cost
is the total number of outlets arguing that a larger system is more complex and therefore
13 Similar proxies for franchisor’s capital scarcity are used in other studies. See, e.g., Lafontaine (1992) and Sen
(1993). 14 Note that the two measures try to account for different types of geographical dispersion. A franchisor might
operate some of its stores in a relatively large number of foreign countries, while having the vast majority of outlets in its home country. In contrast, another franchisor might operate the vast majority of its outlets in only one foreign country.
12
monitoring is more difficult (and at the same time more important because of free-rider
problems).15
Independent variables concerning franchisor moral hazard
The different ways the franchisor is providing input in a franchise contract can be categorized
in assistance to the franchisees and system development. For the latter, we use % time not
franchising, i.e., the number of years the franchisor has not been franchising as a percentage
of the total number of years the franchisor has been in business. This is a proxy indicating
how much time and effort it took to setup the franchise system16. As for assistance to the
franchisee, we have three different indicators: initial management support, ongoing
management support, and training to the franchisee. Initial management support comprises a
detailed manual of the business concept, assistance in finding a location for the outlet,
analysis of outlet location, and planning of outlet equipment. The variable initial management
support is the number of different types of support offered and can therefore take on values
between 0 and 4. Since ongoing management support (e.g., accounting services, information
technology, and market analysis) and training to the franchise (e.g., training in marketing
techniques, administration, or quality control) are both a measure of ongoing franchisor input,
we condense this information by adding the number of different types of ongoing
management support and the number of different types of training to the franchisee,
constructing the variable ongoing franchisor input17. There are 7 different types of training a
franchisor might offer to his franchisee and 11 types of ongoing management support.
Therefore, the variable ongoing franchisor input can take on values between 0 and 18.18
Other independent variable
Member of DFV is a dummy variable indicating whether or not the franchisor is a member of
the German Franchise Association (yes=1 / no=0). Membership is typically seen as a sign of
15 Similar proxies for franchisee moral hazard are used in other studies. See e.g. Norton (1988), Lafontaine
(1992), and Sen (1993). 16 See Lafontaine (1992), p. 274. 17 Ongoing management support and training to the franchisee have the same implications with respect to our
hypotheses because they are both a measure of ongoing franchisor input. Moreover, they are positively correlated. Therefore including them in a regression equation as two different independent variables is not without problems.
18 Similar proxies for franchisor moral hazard are used in other studies. See e.g. Lafontaine (1992), Sen (1993), and Pénard et al. (2003).
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reliability and quality, thus reducing the risk for the franchisee19. Since we believe this might
influence contract terms, we include this dummy as a control variable.
After describing the variables we use in our analysis we will take a brief look at descriptive
statistics in order to get an idea how our dataset looks like (see Table 1). Interestingly, our
descriptive statistics for dependent variables are quite comparable to the results of existing
studies, even though they stem from totally different markets and decades. While, e.g.,
Lafontaine (1992) reports a mean for the proportion franchised of 82.75 percent (with a
standard deviation of 21.55)20, we find a value of 80.96 percent (and a standard deviation of
25.70) for the same variable. Moreover, she finds for the royalty rate a mean value of 6.54
percent (with a standard deviation of 3.42), while in our sample the mean royalty 2008 is 5.24
percent (with a standard deviation of 3.11). Finally, Lafontaine (1992) finds a mean value for
the fixed fee of $21,490 (with a standard deviation of 20,320), while our dataset provides
corresponding values of €10,900 (and 8,440), respectively.
Table 1: Descriptive Statistics for 117 Franchisors Variable Mean Standard
Deviation Minimum Maximum
Proportion franchised (%) 80.96 25.70 0.00 100.00 Royalty 2008 (%) 5.24 3.11 0.00 20.00 Fixed fee 2008 (1,000 €) 10.90 8.44 0.00 50.00 Royalty 2006 (%) 5.15 3.11 1.00 20.00 Years in business 18.82 25.10 2.00 260.00 Franchisor financing (yes/no) 0.79 0.41 0.00 1.00 Minimum investment (1,000 €) 75.08 101.24 0.50 620.00 Qualification of franchisee 5.79 1.90 1.00 11.00 Number of countries 2.07 2.39 1.00 15.00 Foreign outlets (%) 5.19 13.21 0.00 95.00 Number of outlets 83.33 158.58 1.00 951.00 % time not franchising 24.86 24.55 0.00 96.00 Training to franchisee 6.57 0.85 2.00 7.00 Management support initial 3.33 0.98 0.00 4.00 Management support ongoing 7.58 2.08 2.00 11.00 Ongoing franchisor input 14.15 2.62 5.00 18.00 Member of DFV (yes/no) 0.39 0.49 0.00 1.00 For the royalty rate, two variables (royalty 2008 and royalty 2006) are reported, since 2008 values are used in case the variable enters the regression model on the left hand side, while 2006 values are used in case the variable enters the model on the right hand side.
Similar results can be found in Brickley (2002) who reports mean values for the royalty rate,
the fixed fee, and the proportion franchised of 5.4 percent, $20,924, and 87.9 percent, 19 The German Franchise Association claims to check the business format of its members regularly. 20 See Lafontaine (1992), p. 272.
14
respectively, Sen (1993) with corresponding values of 5.36 percent, $19,290, and 82.12
percent, Lafontaine/Shaw (1999) who find corresponding mean values of 4.7 percent,
$22,100, and 77.0 percent, Scott (1995) with a mean royalty rate of 5.46 percent, a mean fixed
fee of $36,800, and a mean proportion franchised of 77.3 percent, and finally Castrogiovanni
et al. (2006) who report mean values of 5.16 percent, $24,260, and 85.09 percent for royalty
rate, fixed fee, and proportion franchised, respectively.
Methodological issues
We analyze our data using OLS and Tobit regression models. The circumstance that our
dependent variables are censored, suggests using a Tobit model in order to account for this
characteristic. However, since this problem is not very pronounced (i.e., only very few
observations are in fact limit observations21) we estimate our equations using OLS and
provide results from a Tobit model in the case of a considerable number of limit observations
as a robustness check. All OLS regressions are estimated with robust standard errors. Similar
to the problems discussed in Lafontaine (1992) some of the proxies used as explanatory
variables in our regression models have to be considered endogenous22. We address this issue
by using 2008 information for the explained variable and past values23 for all explanatory
variables except for the number of outlets, the percentage of foreign outlets24, the years in
business, and the proportion of the time the firm has not been franchising.
4. Results and Discussion
The results obtained by our regression analysis are reported in Table 2. Column A displays
the results for the OLS regression of royalty 2008 on the independent variables, column B
21 In fact there are only two franchisors in our dataset with a royalty rate of 0% and there is only one franchisor
with a franchise fee of 0. However, there are 35 franchisors franchising all their outlets (i.e., a proportion franchised of 100%) and two franchisors owning all their outlets. (i.e., a proportion franchised of 0%).
22 E.g. management support to franchisees may depend on the proportion of franchised outlets. 23 I.e. data stemming from Franchise-CD 2006. 24 One might consider using past values for the variable percentage of foreign outlets as well because of
endogeneity problems. Lafontaine (1992), for instance, argues that geographical dispersion may increase with the use of franchising. However, there are two reasons why we use current values for this variable: The first reason is simply incomplete data coverage on Franchise-CD 2006. Percentage of foreign outlets is calculated as the number of foreign outlets divided by the number of total outlets. As mentioned above, this information was not available on Franchise-CD 2006 in many cases. The second reason is that we find it somewhat inconsistent to use past values for the variable percentage of foreign outlets while using present values for the total number of outlets, since one variable is used to calculate the other.
15
shows the OLS regression results for fixed fee 2008. Finally, column C provides the OLS
regression results for proportion franchised.
Table 2: OLS regression results – reduced form Dependent variables A B C
Independent variables Royalty 2008 Fixed fee 2008 Proportion
franchised
H1a-c
Years in business -0.01 (-1.09)
1.49 (0.04)
0.22** (2.04)
Franchisor financing -0.93 (-0.94)
-536.54 (-0.29)
2.02 (0.44)
Minimum investment -7.10x10-6*** (-2.65)
0.03** (2.47)
8.37x10-7 (0.06)
H2a-c
Qualification of franchisee 0.01 (0.09)
394.39 (1.09)
-0.68 (-0.48)
Number of countries -0.08 (-0.50)
820.31** (2.32)
3.83*** (4.37)
Foreign outlets 0.02 (0.93)
0.62 (0.01)
-0.67*** (-3.06)
Number of outlets -0.00 (-0.32)
-9.62* (-1.75)
-0.02 (-1.49)
H3a-c
% time not franchising 0.01 (1.05)
-2.23 (-0.06)
-0.38*** (-3.20)
Management support initial -0.52 (-1.24)
-63.22 (-0.07)
-3.76 (-1.55)
Ongoing franchisor input 0.23** (2.23)
228.92 (0.72)
-0.06 (-0.07)
Member of DFV 0.42 (0.72)
62.39 (0.04)
8.17 (1.41)
R2 0.11 0.20 0.22 Prob>F 0.13 0.00 0.00 ***,**, and * indicate significance at the 1%, 5%, and 10%-level, respectively. Asymptotic t-values are given in parentheses. The variables years in business, franchisor financing, and minimum investment measure the franchisor’s capital scarcity. Qualification of franchisee, number of countries, foreign outlets, and number of outlets are indicators for franchisee moral hazard, while % time not franchising, management support initial and ongoing franchisor input are measures of the franchisor’s moral hazard. Member of DFV is a risk control variable.
Capital scarcity
With respect to the franchisor’s need for capital, we obtain the following results. The
coefficient of the variable minimum investment in the regression for the royalty 2008 (column
A) has the expected sign and is highly significant. In addition, the variable ongoing franchisor
input is also significant which indicates the existence of moral hazard. We do not find the
originally required moral hazard problem on the franchisee’s side, but provide evidence for
the general evidence of a moral hazard problem. Therefore, we do not reject H1a. With
respect to fixed fee 2008 (column B), the coefficient of the variable minimum investment is
highly significant and shows the expected sign. This result is also consistent with the findings
16
of, e.g., Sen (1993). Additionally, the variable number of countries is highly significant which
indicates the existence of a moral hazard problem on the franchisee’s side. Therefore, we
cannot reject H1b. We tested the specification for fixed fee 2008 based on two regression
models, one including royalty 2006, thus considering it exogenous (full specification), and the
second without the royalty rate (reduced form). While in Table 2, the results for the reduced
form are displayed, Table 3 reports the corresponding OLS regression results for fixed fee
2008 including royalty 2006 (column D). Note that results do not significantly change
dependent on whether the royalty rate is included in the regression or not. Remarkably, the
royalty rate is positively correlated (even if insignificant) with the fixed fee, which contradicts
theoretical considerations, but other empirical studies have not found negative correlation
either.25 This puts into question hypotheses being based on the assumption of a negative
relation between both contract components. Regarding the OLS regression for proportion
franchised, the coefficient of number of years in business is significant, but the sign is
contrary to what we expected. In addition, the coefficients of the variables financing and
minimum investment are far from being significant. This result corresponds to, e.g., Scott (1995)
who finds an insignificant negative relation between minimum investment and proportion franchised
as well. Therefore, we have to reject H1c. Similar to fixed fee 2008, we test proportion
franchised with the reduced form and the full specification including royalty 2006. The
corresponding regression results for the full specification are reported in column E of Table 3.
Furthermore, due to the circumstances that the dependent variable proportion franchised is
censored and that we find a considerable number of limit observations, we estimate the
equations using a Tobit model as robustness check. Results can be found in Table 4 (see
Appendix). Column F reports the Tobit results for the reduced form, column G the Tobit
results for the full specification. Notice that OLS and Tobit both produce almost identical results in
terms of significance. Likewise, results are very similar comparing the full and reduced form
specifications of a Tobit model.
Summarizing, we find support for the franchisor’s needs for capital influencing the contract
conditions, i.e., the royalty rate and the fixed fee, but no support for the proportion franchised
being influenced by capital needs. Hence, the traditional conjecture that capital scarcity is one
main reason for a franchisor for engaging in franchising rather than expanding his system by
company-owned outlets26 cannot be supported for the German franchise industry represented
25 See, e.g., Lafontaine (1992), Lafontaine/Shaw (1999), and Castrogiovanni et al. (2006). 26 See, e.g., Oxenfeldt/Kelly (1969).
17
in our sample. It is also contrary to what, e.g., Lafontaine (1992) finds for the U.S. franchise
industry.27
Table 3: OLS regression results – full model Dependent variables D E
Independent variables Fixed fee 2008 Proportion franchised
H1a-c
Years in business 2.97 (0.08)
0.22** (2.06)
Franchisor financing -232.66 (-0.12)
2.70 (0.56)
Minimum investment 0.03*** (2.63)
5.60x10-6 (0.35)
H2a-c
Qualification of franchisee 406.73 (1.15)
-0.66 (-0.47)
Number of countries 830.33** (2.48)
3.86*** (4.21)
Foreign outlets -0.94 (-0.01)
-0.67*** (-3.05)
Number of outlets -9.39* (-1.73)
-0.02 (-1.38)
H3a-c
% time not franchising -7.13 (-0.19)
-0.39*** (-3.27)
Management support initial 128.51 (0.14)
-3.22 (-1.31)
Ongoing franchisor input 150.83 (0.48)
-0.23 (-0.26)
Member of DFV -128.45 (-0.09)
7.74 (1.34)
Royalty 2006 294.77 (1.20)
0.66 (0.87)
R2 0.21 0.24 Prob>F 0.00 0.00 ***,**, and * indicate significance at the 1%, 5%, and 10%-level, respectively. Asymptotic t-values are given in parentheses. The variables years in business, franchisor financing, and minimum investment measure the franchisor’s capital scarcity. Qualification of franchisee, number of countries, foreign outlets, and number of outlets are indicators for franchisee moral hazard, while % time not franchising, management support initial and ongoing franchisor input are measures of the franchisor’s moral hazard. Member of DFV is a risk control variable.
Franchisee moral hazard
With respect to moral hazard on the franchisee’s side, our regression results suggest the
following: The coefficients of the variables proportion international, number of countries,
qualification, and total number of outlets are not significant. Hence, we find no support for
franchisee moral hazard having an impact on the choice of royalty 2008 leading us to reject
H2a. For the fixed fee 2008 (H2b), on the other hand, the variable number of countries is
27 See Lafontaine (1992), p. 276.
18
significant and shows a positive sign, while the number of outlets is significant with a
negative sign. Therefore, we reject our original hypothesis based on monitoring cost.
However thinking about number of countries as a measure of franchisee input (arguing that
local knowledge becomes more important in foreign countries) this finding seems less
surprising, especially in the light of the fact that empirically fixed fee and royalty rate are not
negatively correlated, which is a crucial assumption for the monitoring cost argument. In
addition, apart from any moral hazard considerations, internationally active franchisors may
be able to charge a higher entrance fee from franchisees (without changing the optimal royalty
rate). With respect to number of outlets and number of countries, our findings correspond to
the results of, e.g., Sen (1993). However, the negative sign of number of outlets seems quite
counterintuitive. One explanation is that a large franchise network with a high number of
outlets might be exposed to other considerations rather than moral hazard which are measured
by this variable. A franchisor might, e.g., wish to expand his franchise system very rapidly
with the aim of gaining market share. In this case, he should demand a low entrance fee in
order to alleviate potential barriers to entry for potential franchisees. Furthermore, one could
consider a larger franchise network as having easier access to capital than a smaller one. In
this case, we would even expect a negative sign on the number of outlets. Note that including
royalty 2006 in the regression equation does not change the results for the other independent
variables. Finally, taking a look at proportion franchised (H2c), the variables number of
countries and foreign outlets are highly significant and show the expected signs. While the
variable number of countries has the expected positive sign, surprisingly the coefficient of the
variable foreign outlets is negative. When entering a foreign country the franchisees input in
the form of local knowledge is crucial to the success of the business concept in the new
market. In addition, monitoring is more difficult if there is only one (or a few) outlet(s) in a
foreign country. However, as more and more outlets follow these arguments become less
convincing. Think of a franchisor, who has half of his outlets in one foreign country. On the
one hand, local knowledge will become increasingly less important as the franchisor gains
experience in the foreign market, on the other hand, monitoring will become easier as other
outlets may serve as a benchmark. Based on these considerations, the different signs of the
two variables are not as surprising as they may seem at first sight.
Summarizing, we find franchisee moral hazard having an impact on the fixed fee and the
proportion franchised, but not on the royalty rate. This result is also contradictory to
Lafontaine (1992) who finds that capital scarcity variables are the only factors having an
19
impact on the fixed fee. At first sight, it seems quite surprising that we have to reject H2a,
since we assumed the royalty rate being a component of the franchise contract the franchisor
can use in order to motivate the franchisee to work diligently. However, our results on H2a
(and H3b below) indicate that the royalty rate seems to be mainly an instrument to ensure the
continuous input of the franchisor. In a franchise relationship, the franchisee is hence not
motivated to work diligently by paying lower royalties, but rather by owning the outcome of
his outlet. Consequently, the proportion franchised is evidently influenced by moral hazard on
the franchisee’s side and seems to be the stronger instrument for the franchisor to motivate the
franchisee to exerting effort. This result is also supported by theoretic considerations, since
the royalty rate in double moral hazard franchise relations is mainly influenced by factors
being associated with the franchisor’s input rather than the franchisee’s input.28
Franchisor moral hazard
With respect to our hypothesis of franchisor moral hazard influencing royalty 2008 (H3a), the
coefficient of the variable ongoing franchisor input is clearly significant with a positive sign.
Therefore, we cannot reject H3a. Concerning fixed fee 2008 (H3b), the coefficients of
ongoing franchisor input, initial management support, and percentage of time not franchising
are not significant. Therefore, we have to reject H3b. Again, this is not surprising since the
argumentation underlying this hypothesis is based on a negative correlation of royalty rate and
fixed fee, which we do not observe in our data. Finally, with respect to proportion franchised,
percentage of time without franchising is highly significant and shows the expected sign.
Therefore, we cannot reject H3c.
Summarizing, we find that franchisor moral hazard has an impact on the royalty rate and the
proportion franchised, while it is not significantly influencing the fixed fee.
5. Conclusion
In this paper, we empirically test hypotheses stemming from agency theory and capital
scarcity considerations about the franchise contract components (fixed fee and royalty rate) as
well as the organizational structure in form of the proportion franchised with a new dataset
based on a sample of 117 franchise systems in Germany. Our analysis includes proxies for the
28 See, e.g., Rohlfing (2008).
20
franchisor’s need for capital, moral hazard on the franchisee’s side, moral hazard on the
franchisor’s side, as well as a control variable for internal risk. While descriptive statistics for
our dependent variables do not significantly differ from U.S.-based datasets, our regression
analysis yields different results for the German franchise market. We find that – contrary to
traditional arguments – capital scarcity does not explain the proportion of franchised outlets.
However, it contributes to the explanation of the design of franchise contracts. Agency
considerations, i.e., moral hazard on the franchisee’s and the franchisor’s side (double moral
hazard), in contrast, do explain the proportion of franchised outlets very well. In alignment
with our finding that the incentive component of the franchise contract, the royalty rate, is not
influenced by moral hazard on the franchisee’s side, this suggests the conclusion that of the
two instruments the franchisor has on hand in order to motivate the franchisee to work
diligently, the proportion franchised is the stronger one, while the royalty rate mainly serves
as a means to ensure ongoing input on the franchisor’s side. This also coincides with the
argument found in the literature on franchising, that a franchisee is higher motivated than a
manager. Moreover, our result with respect to the royalty rate, which is mainly explained by
moral hazard on the franchisor’s side, supports this idea. Finally, the fixed component of the
franchise contract is influenced by moral hazard on the franchisee’s side, which is contrary to
what existing empirical studies found.
Our findings have several implications. First, the capital scarcity argument established by
Oxenfeldt/Kelly (1969) does not seem to be a factor for German franchisors to decide upon
whether to franchise outlets or to open them as company-owned stores. Of course, one could
suspect that the reason for this is based on our sample which might include less capital
intensive businesses than other samples. However, a comparison of the descriptive statistics
of the variable minimum investment with the comparable variable capital required found in
Lafontaine (1992) does not support this line of thought. Another explanation for our finding
might be a more efficient capital market in Germany where entrepreneurs find easier access to
capital than in other countries. In this case, the reason for franchising might be rather ensuring
the input of local knowledge. Second, the royalty rate does not seem to serve as an incentive
instrument of the franchisor to motivate the franchisee to work diligently. In contrast, it is
used to ensure the ongoing franchisor input. Since the franchisor is the one who decides on
the contract terms, at first sight, this result seems quite counterintuitive, because he offers
take-it-or-leave-it contracts to potential franchisees and does not negotiate on the contract
terms. However, with a relatively high royalty rate the franchisor commits himself to
21
contributing to the success of the franchise system, thus, signaling favorable conditions to
franchisees. Third, we do not find a negative correlation between the royalty rate and the
franchised fee, which is a traditional argument on which hypotheses in existing studies are
based on. This suggests an alternative explanation for the relation between the two contract
conditions. One reason might be that a successful franchisor can charge a higher fixed fee and
a higher royalty rate on franchisees ignoring any incentive considerations. Hence, royalty rate
and fixed fee do not work as substitutes over time, but rather as complementary elements.
However, this line of argumentation only holds if the participation constraint for the
franchisee is not binding.
Our analysis suggests some interesting directions for future research. First, it might be of
interest to see whether the contract conditions of a single franchisor do change over time. The
data on royalty 2008 and royalty 2006 suggests that the contract conditions did not change
considerably over these two years. However, seen on a broader perspective of five to ten
years, this might be somewhat different. Second, it seems quite surprising that franchisors use
linear contract schemes for their franchisees, since existing work on agency theory regularly
criticizes the rather stringent assumption of linear contracts in LEN-models. Hence, it might
be interesting to ask franchisors for their reasons of choosing a linear contract. Finally,
franchisor’s offer their contracts as a take-it-or-leave-it offer to all potential franchisees and
do not differentiate between the franchisee’s preferences. From an agency perspective, this
seems quite counterintuitive and it might be insightful to explore whether this is efficient, i.e.,
whether the costs of designing different contracts are higher than the loss incurred by non-
efficient contracts.
22
Appendix
Table 4: Tobit regression results Dependent variables F G
Independent variables Proportion franchised Proportion franchised
H1a-c
Years in business 0.41** (2.24)
0.41** (2.26)
Franchisor financing 2.14 (0.27)
2.64 (0.33)
Minimum investment -0.00 (-0.43)
-9.28x10-6 (-0.29)
H2a-c
Qualification of franchisee -1.34 (-0.78)
-1.31 (-0.77)
Number of countries 6.53*** (3.39)
6.61*** (3.41)
Foreign outlets -1.19*** (-3.62)
-1.20*** (-3.27)
Number of outlets -0.02 (-0.69)
-0.02 (-0.68)
H3a-c
% time not franchising -0.46*** (-3.35)
-0.47*** (-3.40)
Management support initial -4.75 (-1.20)
-4.31 (-1.07)
Ongoing franchisor input -0.45 (-0.31)
-0.60 (-0.41)
Member of DFV 11.25 (1.62)
10.79 (1.55)
Royalty 2006 0.60 (0.60)
Pseudo R2 0.04 0.04 Prob>χ2 0.00 0.00 Censored observations 37 37 Uncensored observations 80 80 ***,**, and * indicate significance at the 1%, 5%, and 10%-level, respectively. Asymptotic t-values are given in parentheses. The variables years in business, franchisor financing, and minimum investment measure the franchisor’s capital scarcity. Qualification of franchisee, number of countries, foreign outlets, and number of outlets are indicators for franchisee moral hazard, while % time not franchising, management support initial and ongoing franchisor input are measures of the franchisor’s moral hazard. Member of DFV is a risk control variable.
23
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