A STUDY IN PROPERTY RIGHTS 9.

FRANCHISING MALONEY

9. Franchising: The Nature of the Contract

The franchise is an organizational structure that lies on the spectrum between independent
business units and multiple business units owned by a single corporation. In the franchise the units
are operated as independent profit centers with the owner claiming the residual profits. The
association between the units occurs through the contract with the franchisor. As we move away
from independent units along the organization spectrum, the problem of shirking grows. To
compensate for this increased management cost, there must be some benefit.

Franchising is a ubiquitous phenomenon in business today, and seemingly it has grown in

The question raised in the theory of franchising is, What service is being supplied by the
franchisor? Arguably it could be managerial expertise. Both McDonald’s and Burger King have
hamburger schools. There is a lot of value in having the knowledge of how to profitably run a
business. Even so, this argument seems to evaporate upon close inspection. If it were nothing but
start-up services provided by franchisors, then the franchise relationship would terminate after a
point. These kinds of contracts do happen, of course. (The Clemson golf course had such an
arrangement with a golf course management company.) But we don’t think of them as franchises.

The thing that makes a franchise is an on-going, infinite horizon association between an outlet and
a central agent. The think that characterizes a franchise is a brand name that is identifiable to the
consuming public. The social value of a franchise seems to be the information conveyed to
consumers by this brand name.1 Brand names are unquestionably of growing importance and
value in marketing and many brand named products are distributed through franchised outlets.

That benefit in the franchise setting is the value of the information conveyed to the consumer by
the brand name associated with multiple business units. The franchise organization is a way of
contracting among the business units to enhance and protect the brand name while minimizing the
costs of shirking at the individual sites.

The contracting problem that must be confronted in this organizational setting it that each
franchise unit has an incentive to shirk on quality. Quality reductions by one franchisee are partly
offset by the quality expectations generated by other franchise units. Presumably this is more
important in businesses where there are a lot of non-repeat customers, but it will also come into
play even in repeat business endeavors. Brand names are quality assuring devices. If the
McDonald’s where you eat everyday serves you a cold hamburger, you will still go back the next
day expecting it to be hot because the unit is still a McDonald’s. Either by a little or by a lot, the

1
I say “seems” because there is always great debate about whether information is valuable and about whether
consumers are duped into consumption patterns. For the most part, I dismiss this view of the world. However, there
is no incontrovertible evidence that brand names are valuable because of information.

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franchise units have an incentive to reduce costs by cutting quality because it will increase their
profits.

 Termination
Mechanisms for Quality Control

The main leverage that the franchisor has for promoting quality is the cancellation of the franchise
agreement with a franchisee.2 This has to cost something. One way to make the franchisee post a
bond that is forfeited if the franchise is canceled is to require a large lump-sum payment. Many
franchises do this. Another is to make the franchisee rent from the franchisor. In this way the
building and improvements are taken over by the franchisor if the franchisee is terminated. Court
records from the McDonald’s and Baskin-Robbins cases (1980 and 1982, respectively) indicate
that both were the primary leaser of locations to their franchisees. Finally, the franchisor may
make the franchisee build a funny looking building that has little value if the franchise agreement is
canceled.

Why are there quite often queues of potential franchisees?3 Why doesn’t the franchisor charge a
price high enough to clear the market? One argument focuses on the variance in the return to the
franchise investment. If a potential site has uncertain value, then the franchisee must make enough
in the bad times to cover the franchise investment. Hence under the expected outcome, there are
excess returns. For instance, there may be a cost to shutting down a franchise. The empty unit or
renamed facade creates a negative externality for the franchise. To insure the value of the brand
name, the franchisees must make an extra return.

A more important factor is that the franchisor must share some of the wealth of the franchise as a
bond of its (the franchisor’s) behavior. If the franchisee posts a bond that equals the harm
imposed on other units if it cuts cost, the franchisee must fear that the franchisor will
opportunistically terminate it and expropriate the bond. The franchisor can make termination
costly to the franchisee without putting the franchisee at risk by sharing some of the value of the
franchise with the franchisees. This generates a queue of potential franchisees.4

The franchisor allows the franchisee to share in the profits by restricting the number of units
below the level that would exist if there were no threat of cancelation. The fact that the franchisee
makes extra-profits by having some monopoly power has implications about store hours and
prices. The franchisee will be tempted to raise prices and cut store hours in order to increase
profits more than royalties. Hence, franchisors will impose price and hours restrictions.

2
Brickley, James A., Frederick H. Dark, and Michael S. Weisbach. "The Economic Effects of Franchise
Termination Laws," Journal of Law & Economics, April 1991, 101-132.
3
Mathewson, G. Frank, and Winter, Ralph A. "The Economics of Franchise Contracts," The Journal of Law &
Economics, October 1985, pp. 503-526. Kaufman, Patrick J. and Francine LaFontaine, ”Costs of Control: The
Source of Economic Rents for McDonald’s Franchisees,” Journal of Law & Economics, October 1994, p 417.
4
It would seem that a problem is created when franchisees buy their right from an existing franchisee and pay the
full value of the franchise. These repurchased franchisees won’t make excess profits or at least not as much as does
the original owner.

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Tie-in Sales

In many franchise settings, the franchisor requires that the franchisee buy products from the
franchisor.5 There are two arguments for this. First, it is a way of monitoring quality. Second, it is
a way of collecting the royalty. The first argument seems fairly straightforward. We expect that
the franchisor will either sell supplies to the franchise, force the franchisee to buy from approved
distributors, or inspect the supplies used. The franchisor must inspect even if it sells the supplies
to make sure that the franchisee is not substituting product. It must also inspect the quality of the
alternative suppliers to assure that they do not go into cahoots with the franchisees. To the extent
that the franchisor can promote high quality by monitoring inputs, it can reduce the threat of
termination as a quality control. Hence, it can reduce the amount of franchise profits it must share
with the franchisee.

The second idea is problematic. If the franchisor prices the supplies at cost, then there is no
royalty payment associated with the supply sales. If the supplies are priced above cost, then it
increases the franchisee’s incentive to substitute produce; in this way the franchisee can lower the
royalty and quality. On the other hand, royalties based on supply sales can have the effect of
varying the royalty payments based on relative demands. For instance, Chicken Delight charged
higher markup on supplies for single dinners than for large-order items (chicken buckets). The
advantages and disadvantages of such a royalty scheme are discussed below. At all events, the
court in the Chicken Delight case took a dim view of such tie-in sales when used to extra royalty
payments. Recent cases seem to be returning the viability of tie-in sales to promote quality.
Furthermore, we expect the franchisor to offer supplies to the franchisee below cost in order to
encourage them to produce high quality.

Royalty Payments

The franchisee pays the franchisor for the right to be part of the franchise. The form of this
payment may vary.6 It can be a lump-sum, up front fee or it can be a royalty constant through
time, or a royalty based on some measure of business activity. Of course, it may be a combination
of these.

If franchises exist to monitor shirking at the local level by residual claimant status and to monitor
the externality effect by the efforts of the franchisor, then we would expect the franchise fee to
have some component tied to sales. It is important to recognize that the fee is tied to sales as
opposed to other business indicators. Each franchisee is concerned about quality protection at all
the other stores. Each wants the franchisor to have the strongest possible incentive to stop quality
depreciation at the other stores. Since sales will be directly and negative affected by quality
declines, the royalty to the franchisor goes down when the franchisor shirks on its monitoring
duty. Contrast this to the effect of having the royalty paid as a function of franchisee profits.

5
Klein, Benjamin, and Saft, Lester F. "The Law and Economics of Franchise Tying Contracts," The Journal of
Law & Economics, May 1985, pp. 345-362.
6
Rubin, Paul. "The Theory of the Firm and the Structure of the Franchise Contract," Journal of Law & Economics,
April 1978, 223-234.

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Note that the more important is the monitoring function of the franchisor, the more the royalty
should be calculated on sales. The more the production of the franchise involves managerial
oversight, the more the franchise fee should be lump sum. The more the franchise involves
advertising and centralization of ordering and supplies, the more the franchise fee should be based
on recoupment of franchisor expenses.

Shopping Malls as a Franchise Problem.

The organization of shopping malls are remarkably similar to franchises. Here there is additional
twist to the problem: The units are heterogeneous. The mall developer’s problem is to put
together a package of rental rates that correctly internalize the external benefits generated by the
anchor stores. The anchor stores bring customers into the mall some of whom are satisfied by the
smaller stores. The package includes design, beautification, and maintenance of the facility.

We expect that the smaller stores pay higher rent than the anchor stores. More interestingly, we
expect that this is a function of not only square footage but also sales. The sales component of the
rent paid by the small stores gives the mall operator the incentive to beautify and maintain the mall
in front of the small stores, which themselves have an incentive to shirk in this regard, free riding
on the efforts of others. The large store will have an incentive to maintain its own location and it
is affected much less by the common areas. Hence the large store is less likely to pay rent on the
basis of sales.

Commonly the rent paid by the small stores is based on sales and this component kicks in only
after sales have reached some base level. This means that the sales-effect payoff to the mall
operator only occurs if they do a good job. Also stores commonly pay a maintenance fee that is
based on a charge back of actual expenses of the operator.

Addenda

In summarizing the franchising issue, let’s return to the organizational spectrum that runs from
independently owned and operated sites, through franchised units, to company owned stores.

Independent operations need management information, advice, and consulting; they also need
capital. Independent operations are efficient in that there is almost always a close relation between
ownership and management that improves the quality of management by reducing shirking.

Franchising may be a contractual structure that provides management consulting. It may also be a
way of lowering the cost of capital because lenders are more confident in the viability of the
operation given the oversight and managerial input of the franchisor.

On the other end of the spectrum we have chains of company owned stores. Chain stores are a
vehicle that can be used to capture the gains from brand-naming. Brand names are valuable to
final consumers because they provide information. Franchising is also a way to promote brand-
name value.

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The conclusion, then, is that we expect to see franchising in situations where (1) there is a
significant amount of on-site production at dispersed outlets; and (2) there are significant gains
from brand-name recognition on the part of consumers.

Empirically, what are the observable causes and consequences of franchising. Some propositions
are worthy of consideration:

(a) The form of the franchise payment should be predictably related to the productive function
performed by the franchisor. The more important is brand name, the more the franchise payment
should come from royalties as opposed to a lump-sum payment. Royalties efficiently align the
incentives of the franchisees and franchisor when the principal function of the franchise is to
create and protect a brand name. On the other hand, when managerial advice is more important,
more of the franchise payment should come up-front in a lump-sum.

This royalty payment prediction is different from a theory that says that the franchise payment is
just efficient two-part pricing of the license. Efficient two-part pricing would charge a low royalty
price, possibly as a function of profits instead of sales and a high fixed fee. The fixed fees would
vary directly with the value of the brand-name license being sold. On this theory, we would expect
that a very successful franchise like McDonald’s would have the highest initial charge of all.
However, it doesn’t.

(b) When companies have both franchise outlets and company owned stores, there are two
forces at play. One is that the incentive to free-ride on the chain-wide brand name quality is more
keen where there are fewer repeat customers. Hence, outlets with a larger proportion of repeat
business should more likely be franchised than outlets with a larger proportion of non-repeat
customers. The other force, operating independently, is that company owned outlets require more
managerial oversight from the company. Where this is more costly to supply, the outlets are more
likely to be franchised. To what extent these two separate forces are positively or negatively
correlated may vary from one line of business to the next.

(c) The factors that are the strongest in tipping the contractual scales toward company owned
outlets as opposed to franchised ones are: 1) the capital requirement of the outlet; 2) the degree
of the control of the product by the central agent or main office; and 3) the variation of
profitability of outlets across time. The first is obvious. Outlets that require more capital are more
likely to be company owned because a large corporation is a more efficient institution for raising
capital. Furthermore, if the outlet has a large capital requirement, the management of the site with
necessarily have a smaller residual claim anyway.

The second point may be somewhat more obscure. Product control takes away discretion from
the on-site manager. Hence, it is less valuable to have franchisee-manager. By product control, I
mean things like inventory and buying decisions. In department stores and super markets, a large
portion of the economic decision-making concerns what to sell and how much to inventory.
Indeed, in department stores, quite often the clerks work on commission so that shirking problems

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among the work force are minimized by the labor contracts. Moreover, forcing inventory and
product line changes on franchisees is fraught with contention.7

Finally, the third point reflects the problem of monitoring quality at the outlets. To the extent that
termination is a penalty, the threat of which sanctions quality shortfalls at franchises, variability in
profitability mitigates this benefit. The more variable are profits, the larger the average expected
quasi-rent to the franchisee must be to enforce quality standards. Furthermore, if failed franchises
have a negative effect on brand name, the expected franchisee quasi-rent must be higher the larger
is the variability in profit. Finally, if the chain finds value in operating some outlets that lose
money for some periods of time, franchising is a problematic contractual structure.8

7
It is said that McD’s tries out all of its new products at company owned stores before forcing them on franchised
outlets.
8
Here I am thinking of situations like the Winn-Dixie in Clemson when the new Bi-Lo opened. For several
months, the W-D store must have been losing a substantial amount of money. It is not clear that it would have
survived if it had been a franchise.

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