INTERNATIONALIZATION THROUGH FRANCHISING. SELECTED ISSUES.

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1 Zięba K.: Internationalization through franchising: selected issues, in: Prace Naukowe Katedry Ekonomii i Zarządzania Przedsiębiorstwem / Gdansk University of Technology, vol. 6, 2007, pp KRZYSZTOF ZIĘBA INTERNATIONALIZATION THROUGH FRANCHISING. SELECTED ISSUES. 1. Research on franchising It has been more than thirty years when first scientific papers dedicated to franchising were published. Although the phenomenon of franchising is presented in those works from many different perspectives, one may be tempted to try and classify all those various approaches into some more general categories. Such a classification can be as follows 1 : - limited resources, - administrative efficiency, - risk management. Obviously, the classification is not completely satisfactory, since some of the aspects cannot fall into the above-mentioned categories. Nevertheless, this division can be found very useful, as it puts some order into franchising research issues and with some exceptions most of the important publications on franchising are included in it. Limited resources perspective, adopted by many researchers (such as S.D. Hunt, R.E. Caves or W.F. Murphy), initially suggested that franchising is used by franchisors to overcome difficulties imposed by capital scarcity. Initial fees and capital investments made by franchisees allowed franchisors to expand the markets they operated on without the need to use own capital to a great extent. This approach was challenged later on by a number of studies which were not very supportive for the capital scarcity theory. As a consequence, the idea of scarcity was extended to resources other than capital only. Nowadays resource scarcity theory applies to management skills, tacit knowledge of local markets, etc. As for the administrative efficiency, the central problem solved with the use of franchising is the issue of monitoring managers of the outlets. This approach is based on agency theory. The reasoning behind applying this theory to franchising is as follows: paid managers are not motivated to perform their duties in the optimal way, as they are paid a generally fixed salary. This status quo can be changed in three ways: - by intensive and direct monitoring carried out to prevent franchisor from additional costs imposed by shirking managers. This solution may be effective, but rather 1 Fladmoe-Lindquist K.: International franchising: Capabilities and development, Journal of Small Business Venturing vol. 11, 1996

2 costly in terms of not only money, but also time. Additional staff is required, especially in case of large franchising systems. - by additional incentives for managers, such as higher salaries (in comparison with the general level of salaries in the industry), system of bonuses depending on outlet performance or greater responsibility for the outlet by increasing decision-making power of the manger. Major disadvantages include higher costs and partial loss of control over the company outlets. - by franchising outlets to franchisees who act as residual claimants. Shirking is not a problem here, as it would adversely affect primarily the shirker. This approach is, however, not ideal, as instead of shirking problem the issue of free rider effect appears. Initially, both approaches - limited resources perspective and administrative efficiency - were seen as two competing explanations, but in the early nineties first attempts to reconcile them were made. Carney and Gedajlovic 2 worked out a path model of franchising, integrating to some extent findings of both perspectives. Risk management perspective is relatively new, but some of its elements were present in franchising research earlier, especially the agency theory approach. If franchisors are risk-averse, they may try to share (or manage) the risk with their franchisees 3. From such a perspective, franchisors will run their company owned outlets only in the locations which are associated with lower level of risk. Locations that seem to be not so reliable (because of geographical distance, cultural differences, etc.) would be franchised to franchisees. There is some evidence that franchisors tend to buy back the locations characterised by high sales level. This is highly supportive for the risk management perspective, indicating that franchising is used as a kind of reconnaissance, after which franchisor decides whether the outlet is attractive enough to be repurchased or not. The above mentioned strategy can be explained by location based theory of franchising, developed later by Chaudhuri et al 4. Even at present, the question why to use franchising remains unanswered in an explicit way. Some studies 5 offer support to agency theory and risk management perspective, others offer alternative explanations. However, the former group seems to have dominated the latter by far. What should be noticed here is the fact that most of the studies on franchising (and actually all before mentioned) are focused on domestic context only, predominantly ignoring international aspects of franchising operation. This shows a significant discrepancy between the importance of franchising in international expansion and its poor theoretical understanding. Both aspects creating this inconsistency will be discussed in the next part of this paper. 2. International expansion through franchising 2 Carney M., Gedajlovic E., Vertical integration in franchise systems: Agency theory and resource explanations, Strategic Management Journal vol.12, Martin R.E., Franchising and risk management, The American Economic Review vol.78 no.5, December Chaudhuri A., Ghosh P., Spell Ch., A location based theory of franchising, Journal of Business and Economic Studies, vol.7 no.1, Spring See for instance: Combs J.G., Castrogiovanni G.J., Franchisor strategy: A proposed model and empirical test of franchise versus company ownership, Journal of Small Business Management, April

3 In traditional market economy, international expansion of businesses used to be widely perceived through a typical example of a domestically based producer of goods, who was expected to increase gradually the involvement in foreign operations. Initial interest in foreign market could be followed by first attempts to export; at first on more irregular base. Then a decision was to be made whether to become involved in export as a regular part of business or to use FDI (foreign direct investment) instead of exporting activities. This was the reality described by stages models once very popular, but nowadays usually mentioned only in historical context 6. Over the last twenty five years the world has changed dramatically. Stages models are no longer considered to be relevant to explain how businesses go international. What is more, international expansion ceased to be the domain of goods producers. Internationalization of business operation becomes to be equally important for retailers and companies from the service sector. If international expansion were to be typical for producers only, franchising would never be an important part of this phenomenon. Product franchising is of hardly any significance nowadays, but retailing and services they are both different stories. Along with globalization and internationalization processes, franchise systems started to change. Many franchisors began to seek opportunities on markets other than domestic ones. Some rapid changes can be seen in the figure presented below. However, it is worth noticing that this tremendous in fact increase in the scale of international operations took place even before intensive globalization processes Canada Europe UK Japan Australia Asia New Zealand Figure 1. Internationally franchised outlets of US franchise systems [source: US Departament of Commerce, in: Huszagh S.M., Huszgh F.W., International franchising in the context of competitive strategy and the theory of the firm, International Marketing Review vol.9 no.5, 1992] What made US franchisors to become so involved in international operations? There are a few possible answers 7 : - firm experience 6 For instance see: Daszkiewicz N., Internacjonalizacja małych i średnich przedsiębiorstw we współczesnej gospodarce, Wydawnictwo Politechniki Gdańskiej Gdańsk Huszagh S.M., Huszgh F.W., McIntyre F.S., International franchising in the context of competitive strategy and the theory of the firm, International Marketing Review vol.9 no.5,

4 Firm experience, which can be well reflected by the time in operation criterion, possibly contributes to cost reduction. In fact, time in operation means time and opportunities to learn, develop procedures and improve the existing know-how. Accumulating knowledge over time, disseminating and using it in a franchising system may result in a better site selection, operating policies adjusted to particular environment properties, etc. Internationalization exposes the whole system and particularly the franchisor to additional risks and adds more complexity to the environment it operates in. Experienced franchisors are able to perform better, to gain maximal benefits from centrally managed marketing activities, to control quality in the system in a more effective way, etc. Therefore, experience can be the value critical for the decision to expand internationally. After a couple of years after franchising boom in the USA, American franchisors gathered enough experience to used it as a valuable asset in operations on foreign markets. - economies of scale Some of the benefits resulting from economies of scale are obvious. In case of franchising, two of those benefits are particularly important. Firstly, it is monitoring activity performed by the franchisor. Well developed systems with a large number of outlets create sophisticated procedures and routines to ensure that products/services are of uniform quality standards and performance of the outlets is optimal. Secondly, large scale of operation may increase the concentration of outlets and bring about all its consequences. The right concentration results in good trade name recognition, high popularity of the system, easier recruiting of franchisee candidates, etc. On the other hand, it may also result in lowering outlet profit, if concentration is too high 8. - lack of product differentiation barriers Late entrants into new markets often find it difficult to differentiate their products form those already existing on the market. In the early seventies American franchisors had a lot to offer in this sense, as American life style was significantly different from the European one. This feature of American entrants, however, gradually ceased to be important as a result of customer tastes and fashion convergence a very visible consequence of globalization processes. Globalization also influenced all other issues mentioned here, but none of them was affected so seriously. Other effects of globalization will be discussed further on. - lack of capital requirements barriers Capital requirements can be one of the central problems when making decision to expand internationally. It is widely believed that franchisors are able to cope with this problem using capital provided by franchisees. Yet, this view has never been proved. Several studies bring about serious doubts regarding franchisees as a source of cheap capital resources. Moreover, franchisors who decide to internationalize their operations must face the fact, that financial information in the international environment may not be of uniform quality, posing an additional risk factor. Rapid expansion of US franchisors in early seventies may be explained by easier access to capital resources in the USA over this period 9. - incentives and support for internationalization Internationalization of franchising operations can be supported by several undertakings realized by government agencies, regional development agencies and other institutions. Activities performed by them can reduce both actual and perceived barriers for 8 Zięba K., Franchising w ujęciu dynamiki systemów in: Małe i średnie przedsiębiorstwa wobec wyzwań współczesnej gospodarki (ed. Dominiak P.), VM Group, Gdańsk Huszagh S.M., Huszgh F.W., McIntyre F.S, op.cit. 4

5 internationalization. Another aspect worth mentioning here are educational structures. Franchising is perceived as an example of knowledge-intensive business system and abundant well educated workforce is very important for both booming operation on the domestic market and successful international expansion. The trend towards internationalization of franchising operations is neither limited to US companies nor to the described period of seventies and eighties. There is nothing controversial in saying that international expansion of franchising systems becomes a common tendency 10. And so the question appears: what drives this process nowadays? There are, certainly, some changes to the factors mentioned above. The importance of firm experience is currently diminishing. New technologies, expert system applications and software offering screening criteria for franchisors regarding site selection or recruitment procedures decreased the value of experience. Therefore, on one hand experienced franchisors have no longer a vast competitive advantage over their less experienced rivals. On the other hand, low level of experience ceased to be a very important barrier for internationalization. Technological advancement introduced also improvements in the monitoring activities, substituting to some extent for the economies of scale. Globalization of financial markets erased the advantage of US franchisors over other nationalities. Financial markets become more and more effective. In many cases it means easier access to capital resources and reduced barriers for international operations of franchising systems. 3. Theoretical aspects of internationalization of franchising Early research into international franchising focused mostly on two issues: general governmental policies of host countries as well as their possible influence on franchisors situation and uncertainties resulting from monetary policy discrepancies between host country and franchisor s country of origin. Chief issues in the first above-mentioned aspect are connected mostly with ownership protection offered by host country legal system as well as control of corporate assets and intellectual property. Possible regulations affecting franchisor s financial performance may be connected with some limits imposed on initial fees or loyalty payments. Such regulations make it necessary to change the structure of franchising contracts and they also create a danger of operating on the basis of contracts containing illegal clauses. This danger can be eliminated as necessary information is usually available in governmental agencies or franchising associations. What remains here is the problem of awareness (whether franchisor knows that the problem exists) and costs of gathering necessary information. Intellectual property protection is a crucial problem especially for service franchising, where the general concept of franchised business cannot be protected by patent law regulation. The use of brand name, trade marks, etc. must be monitored by franchisor and the latter must be able to correct for any misuse or misconduct that is discovered. However, for effective monitoring franchisor s efforts must be supported by existing law. It proves rather difficult in many cases, especially in developing countries or some countries in transition. Exchange rate fluctuations affect financial situation and overall performance of franchisor in a few ways. First of all, it should be noted that frequent and deep changes of host country currency exchange rate usually reflect macroeconomic problems and 10 For data evidence see: European Franchise Survey August 1997, European Franchise Federation

6 economic weakness of the economy. Since it is quite frequent that some of inputs are imported from franchisor s country of origin and some of revenues generated by franchisees operations are transferred to franchisor s home country, any major change in exchange rates can be harmful for both parties franchisor and franchisees. Nowadays, such dangers can be reduced to a great extent with the use of hedging transactions, non-delivery forwards, currency options and other similar tools. Due to technological changes those tools are commonly available and many of them can be used provided that business owner (either franchisor or franchisee) have the Internet access. A typical example of FX trade platform is shown in the screenshot below. Figure 2. FX Trade application example - Such platforms are often completely free of charge and they are very user friendly. They can serve both advanced users and absolute beginners. Some later studies of this subject indicate some more possible issues that should be considered as important for internationalization of franchising systems, such as cultural differences or distance management. However, most of those studies focus on firm characteristics and external factors influencing franchisor s situation. It seems necessary to include franchisor the person of business owner in the analysis. Personal traits are often ignored in franchising research, even in general issues considerations 11. The decision to expand internationally or remain domestic often is made on the basis of personal beliefs, opinions, perceived and not actual barriers, benefits, etc. The ability to adapt to cultural differences, elasticity regarding business 11 Dant. R.D., Motivation for franchising: Rhetoric versus reality, International Small Business Journal vol.14 no.1,

7 format, which can be essential for successful expansion in foreign markets, ability to evaluate opportunities and threats posed by international context of franchising operation they are all at least equally important for successful internationalization as those previously mentioned and explained. This path in the international franchising research domain is being explored. As a good example a framework of international franchisor types can serve 12. Table 1. Framework of international franchisor types [source: Fladmoe-Lindquist K.: International franchising: Capabilities and development, Journal of Small Business Venturing vol. 11, 1996] Existing International Franchising Capabilities Capacity for Developing International Capabilities High Low Low Integrating franchisors - pursuit of cautious growth - use of multiple forms of franchising - proactive evaluationn Constrained franchisors - locally international - limited involvement in international markets - reactive evaluation High Worldwide franchisors - focus on global markets - use of multiple forms of franchising - both proactive and reactive Conventional franchisors - focus on several foreign markets - use of fewer forms of franchising - often reactive with some proactive efforts The proposed framework is also an example of attempts to integrate well established trends of administrative efficiency and risk management theory with dynamic capabilities of franchisor that can evolve over time. 4. Concluding remarks The complexity of franchising internationalization requires a lot of attention and thorough research. There is no doubt about the fact that in order to expand internationally franchisor needs to posses or develop capabilities different from those necessary for domestic operation. The willingness of franchisor to develop those capabilities and the awareness of this necessity are certainly crucial for successful internationalization. What is more, that is not only the question of working out some routines and procedures useful for foreign contacts, but also to develop ways of continuous support and improvement of those routines and procedures. In other words, decision to go international should be backed up with learning and relearning activities over the whole franchisor s lifetime. Another aspect worth considering is the influence of host franchisees or prospective franchisees on franchisor s decision whether to go international or not. Future relations are dependent on bilateral attitudes and this factor should be investigated to a far greater extent. Finally, standardization within franchising systems should be given more attention in international context. Some modifications may be crucial for successful expansion due to cultural difference. On the other hand, however, national character can be a great advantage and source of competitive advantage over companies from host country. 12 Fladmoe-Lindquist K.: International franchising: Capabilities and development, Journal of Small Business Venturing vol. 11,

8 BIBLIOGRAPHY [1] Brickley J.A., Dark F.H., The choice of organizational from: The Case of Franchising, Journal of Financial Economics vol.18, 1987 [2] Carney M., Gedajlovic E., Vertical integration in franchise systems: Agency theory and resource explanations, Strategic Management Journal vol.12, 1991 [3] Caves R.E., Murphy W.F., Franchising: firms, markets and intangible assets, Southern Economic Journal, April 1976 [4] Chaudhuri A., Ghosh P., Spell Ch., A location based theory of franchising, Journal of Business and Economic Studies, vol.7 no.1, Spring 2001 [5] Combs J.G., Castrogiovanni G.J., Franchisor strategy: A proposed model and empirical test of franchise versus company ownership, Journal of Small Business Management, April 1994 [6] Combs J.G., Castrogiovanni G.J., Franchisor strategy: A proposed model and empirical test of franchise versus company ownership, Journal of Small Business Management, April 1994 [7] Dant. R.D., Motivation for franchising: Rhetoric versus reality, International Small Business Journal vol.14 no.1, 1996 [8] Daszkiewicz N., Internacjonalizacja małych i średnich przedsiębiorstw we współczesnej gospodarce, Wydawnictwo Politechniki Gdańskiej Gdańsk 2003 [9] European Franchise Survey August 1997, European Franchise Federation 1997 [10] Fladmoe-Lindquist K., Jacque L.L., Control modes in international service operations: The propensity to franchise, Management Science vol.41 no.7, 1995 [11] Fladmoe-Lindquist K.: International franchising: Capabilities and development, Journal of Small Business Venturing vol. 11, 1996 [12] Hunt S.D., The Trend Towards Company-Operated Units in Franchise Chains, Journal of Retailing vol.49 no.2, 1973 [13] Huszagh S.M., Huszgh F.W., McIntyre F.S., International franchising in the context of competitive strategy and the theory of the firm, International Marketing Review vol.9 no.5, 1992 [14] Martin R.E., Franchising and risk management, The American Economic Review vol.78 no.5, December 1988 [15] Mathewson G.F., Winter R.A., "The economics of franchise contracts", Journal of Law and Economics vol.28, October 1985 [16] Zięba K., Franchising w ujęciu dynamiki systemów in: Małe i średnie przedsiębiorstwa wobec wyzwań współczesnej gospodarki (ed. Dominiak P.), VM Group, Gdańsk