Dual Distribution and royalty rates in Franchised Chains An Empirical Analysis Using French Data

Transcription

1 Dual Distribution and royalty rates in Franchised Chains An Empirical Analysis Using French Data Thierry Pénard * Emmanuel Raynaud Stéphane Saussier Forthcoming in the Journal of marketing Channels 2002 ABSTRACT: Most empirical studies concerning franchise systems have dealt with the monetary contractual provisions, especially with the determinants of royalty rates. But the organizational design of franchised chains has received less attention and dual distribution is still a misunderstood phenomenon in economic theory. What determines the proportion of company-owned units or franchised units within a chain? How does the level of the royalty rate interplay with the extent of company ownership? This paper supports the idea that dual distribution enables to mitigate contractual hazards due to information asymmetry and incomplete contracting. Thus a chain s efficiency should strongly depend on the correct balance between royalty rates and the extent of company ownership. The interdependence between these two strategic decisions is analyzed by using a panel data set of 745 French franchisors. Econometric tests show that brand name value has a positive impact both on royalty rates and the proportion of company-owned units. Moreover, we put forth evidence that royalties and company ownership are complementary variables for the organizational design of chains. KEYWORDS: dual distribution, royalty rates, panel data, franchising experience, brand name value. Thierry Pénard is affiliated with the University of Rennes and CREREG, 7 place Hoche Rennes Cedex, France ( thierry.penard@univ-rennes.fr). Emmanuel Raynaud is affiliated with the INRA-SADAPT and ATOM ( eraynaud@inapg.inra.fr). Stéphane Saussier is affiliated with the University of Nancy II and ATOM ( saussier@univparis.fr ). The authors would like to thank the French Franchising Federation (FFF) for its financial support. We would also like to acknowledge James Brickley, Eric Brousseau, Vivian Dos Santos Silva, Josef Windsperger, Joyce Young and two anonymous referees for their useful comments.

2 JOURNAL OF MARKETING CHANNELS INTRODUCTION Franchising has received significant attention in the empirical literature on contracting. The majority of empirical studies concerning franchising have focused on the determinants of contractual provisions, especially royalty rates (Lafontaine 992, Lafontaine and Shaw 999, Bercovitz 2000, Scott 995). A puzzling empirical regularity, mentioned in all these studies, is the coexistence of franchised and company-owned units within chains (sometimes defined as "plural form", or "dual distribution"). This dual distribution concerns 70% of the chains in France (see also Bradach 997, for evidence in the US). However, most of the literature deals with dual distribution as a transitory phenomenon or a side issue. For example, some authors defend the idea that franchising is more profitable than company ownership. At the beginning of their business, firms could operate some units directly either to signal their type to potential franchisees (Gallini and Lutz 992, Lafontaine 993) or to credibly commit to protecting the value of their brand name (Scott 995). One of the consequences is that the extent of company ownership should decrease with chain maturity. On the other hand, other authors assert that the reasons for franchising are transitory (Oxenfeldt and Kelly 969) and should disappear with chain maturity. Franchising only gives rise to temporary access to certain scarce resources, either capital (Caves and Murphy 976), managerial talent (Norton 988), or local information (Minkler 990) that eases their expansion. A testable implication is that as they become established firms, this should reduce their reliance on franchising. Recently however, dual distribution has been studied as an equilibrium strategy and a stable phenomenon. Several explanations have been explored. For instance Bradach (997), following Bradach and Eccles (989), emphasized the complementarities between the two contractual arrangements in order to maintain quality and homogeneity of the business concept throughout the units while, at the same time, promoting innovation. Lewin-Solomon (999) explained the existence of dual distribution as a commitment device used by a It should be note that this coexistence is not a regulatory requirement, at least not in France. The only regulatory requirement for a franchisor is to own at least one unit in the chain before starting franchising. Thus, the franchisor needs to "test" the business methods or format. This partly reduces asymmetric information on the value of the business concept for potential franchisees. 2

3 Pénard, Raynaud and Saussier franchisor to give franchisees incentives to innovate. Bai and Tao (2000) constructed a multi-task model à la Holmström and Milgrom (99) to show that, for homogeneous units, dual distribution is a way to induce effort towards brand name development. Sorenson and Sorensen (200) explained franchise mix as the result of a trade-off between exploration (franchising) and exploitation (company-owned units) in organizational learning. In all these explanations, dual distribution appears as an efficient solution in the mitigation of contractual hazards linked to information asymmetry, imperfect commitments and incomplete contracting. This suggests that chains with a stable proportion of company-owned units should be more efficient in the long run that fully franchised or fully owned chains. Since the organizational design of the chain influences its performance, the analysis of stable dual distribution is a first step toward a broader understanding of chain performance. By studying the evolution and determinants of dual distribution in North America, Lafontaine and Shaw (200) have certainly provided important empirical insights on this issue 2. They found that the proportion of company stores tends to decrease in the first years of franchise and then stabilizes. This stability is interpreted as evidence that chains target a given proportion of company and franchised stores, referred to as the managerial control target. Moreover, this target is rather specific to each chain, even if it is influenced by the activity sector and the experience acquired before franchising. Lafontaine and Shaw also showed that the value of a brand name increases the proportion of company owned units in chains. They interpreted it as a way to protect the brand name value from franchisees' opportunistic behavior. By limiting the number of franchised stores, a chain can enhance its brand name value. This article extends the North-American study of Lafontaine et Shaw (200) to French franchise chains using a panel data set with information from 994 to 2000 concerning 745 franchisors. This data set allows us to study the determinants of both royalty rates and company ownership. Thus we can measure the impact of different variables like the chain s experience (before and after franchising), the size or the number of outlets abroad and the organizational design targeted by the chain. Moreover, our data enables us to examine how royalty rates may interplay with the targeted proportion of company-owned units. Are these two strategic variables positively or negatively correlated? In other terms, are they substitutes or complements for the franchisor in the organizational design of its chain? Actually, all these issues are linked to the value of the chain s trademark. This value can not only positively influence the royalties, but also the 2 See also Azevedo & Silva (200) for a similar and interesting empirical study concerning the Brazilian franchising. 3

4 JOURNAL OF MARKETING CHANNELS company ownership and the internationalization of the chain. In this paper, we try to qualify and quantify these trademark effects. First we build a basic agency model where franchisors have to recruit their franchisees under information asymmetry. We derived several hypotheses that are tested econometrically. The econometric results confirm the positive effects of a brand name on royalty rates and company ownership. They also give evidence of complementarities between royalties and the proportion of company-owned stores. The paper is organized as follows. Section 2 presents a set of stylized facts about the organizational design of French franchise systems. Section 3 presents the theoretical framework. Section 4 gives the econometric results. Section 5 is devoted to refinements. Section 6 concludes. The Data STYLIZED FACTS The U.S. Department of Commerce categorizes franchise relationships either as "Product and Trade Name" franchises or "Business Format" franchises. In a Product and Trade Name franchise, the franchisor mostly sells a finished product to the franchisee who then resells it (for instance, car dealerships). In contrast, under the business-format type of franchising, the franchisor mostly sells the right to use his or her trade name and business methods to the franchisee. The legal definition of a franchise in the European Union is similar to the latter except that it is more constraining regarding the matter of transfer requirements 3 related to the franchisor s know-how. In France, as in the other European countries, business-format franchises have grown tremendously for the last three decades and now represent a significant weight in retail trades. France accounted for 34 franchisors in 97 whereas currently the number of active franchisors is around six hundred. Moreover France holds first rank in Europe for the number of franchisees (almost ). Detailed information on French franchising can be found in the franchises yearbooks published by the French Chamber of Commerce (ACFCI) since 982. These yearbooks contain only data on the franchise systems having accepted to fill in the questionnaire sent each year by the ACFCI. From these yearbooks, we have formatted a database. This database covers the period and contains 4758 individual observations from 3 See FTC, «Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures» (6 CFR 436. et seq.), and European Union rule 4087/88. 4

5 Pénard, Raynaud and Saussier 745 different franchisors. The available variables are the number of companyowned and franchised outlets in France and outside of France, the number of years of business and franchising experience, the royalty rates, the franchise fees and a set of variables describing the activities of the franchisor. Table provides statistics for the year 2000 [INSERT TABLE ] For the year 2000, the average size of franchised chains (the number of units) was approximately 74, with 5 franchised stores and 23 company stores 4. The proportion of company stores amounted to 33 % and the royalty rates to 4.42 %. The franchising experience (difference between year 2000 and the date of franchise starting) and the experience out of franchising averaged respectively 4 and 3,5 years 5. Franchise Mix and Experience Following Lafontaine and Shaw (200), our first concern is to try to exhibit a relationship between the level of company ownership and chain experience. As we have shown, many alternative theories have focused on how dual distribution should evolve with respect to chain experience. Experience may be viewed as a way for a franchisor to obtain easier access to capital (leading to a high proportion of company ownership) or as a proxy of reputation (leading to a high fraction of franchised units). We explore this link in figure by taking the number of years in franchising as a proxy of a chain s experience 6. The evolution of the fraction of company stores with respect to franchising experience follows a shape quite similar to the one exhibited by Lafontaine and Shaw (200), with some noticeable differences however. In Lafontaine and Shaw, the percent of company ownership falls sharply during the first years to then stabilize at a rather constant rate of 5% after eight 4 These statistics are based on the chains having filled in the questionnaire for the ACFCI yearbook However this sample is rather representative of all the franchise systems. 5 Thus the business experience (difference between the year 2000 and the year of company creation) is, on average, 24 years. The statistics used by Lafontaine and Shaw (200) showed that the North-American franchisors have larger size stores (207 outlets) and they tend to franchise more of them (22 % of company-owned stores). 6 This figure and those that follow use all the data and treat each observation as a separate piece of information. It does not distinguish between cross-sectional or longitudinal patterns and is therefore dominated by the cross sectional effects. 5

6 JOURNAL OF MARKETING CHANNELS years. In France, the decrease is not as fast but we can identify a relative stability after years in franchising. As with Lafontaine and Shaw, our data is compatible with the existence of a managerial control target (See figure ). This result is still obtained through a focus on different sectors of activities (See annex. for more details on this). For these reasons, franchising experience seems to be a relevant variable (more than business experience 7 ) when attempting to explain the stability of the chain s organization. [INSERT FIGURE ] To go further, we scrutinize how the interplay between franchising experience and company ownership is affected by the size of the chain and the experience before franchising. In figure 2, we separate all of the data into two sub-samples: (i) chains having below average size (8.2 units) 8 and, (ii) chains with an above average size. The extent of company ownership appears rather similar for firms of different sizes. Both large and small firms follow more or less the same overall pattern. We proceed similarly for the years before franchising, by splitting our data into two sub-samples 9. Figure 3 shows that firms, having stayed out of franchising for a long time, tend to exhibit a higher fraction of company-owned stores. This result is all the more interesting since years before franchising may reflect the value of the franchisor s brand name. [INSERT FIGURE 2] [INSERT FIGURE 3] 7 Chain experience can be measured alternatively by the number of years in business. But when the percentage of company-owned units is plotted with respect to business experience, no clear relation appears. Indeed, the correlation between these two variables is not significant. 8 This is the average size on the whole sample ( ). 9 As some chains are observed between 994 and 200, they can initially belong to the first sub-sample (experience less than.5 years) and then switch to the second sub-sample (experience of more than.5 years). 6

7 Pénard, Raynaud and Saussier Franchise Mix as a Result of an Active Policy As noticed in the previous figures, the proportion of company units becomes stable after several years of decreasing. Is this relative stability the result of an active policy to maintain the targeted company ownership with the chain pursuing its expansion? Or is this stability due simply to a stagnation of the chain? After a few years of franchising, the chain might well decide to stop its development. In such a case, a stable proportion of company stores stability could not be interpreted as an intentional policy, but rather as a sign of chain maturity. Figure 4 compares net variations in the number of company and franchised units. The pattern of changes contrasts sharply with Lafontaine and Shaw (200, p. 4-5). In their study, the opening of franchised and company units rises with the north-american chain s experience, whereas French franchise systems exhibit the inverse relationship. However, in the stable phase (after years of franchising), significant variations in company units are observed in French chains that are often counterbalanced by similar variations of franchised units. This could mean that franchisors have an active policy during this period, adding new company units and new franchised units in conformity with the targeted company ownership. [INSERT FIGURE 4] Franchise Mix and Royalty Rates A large part of the literature on franchising has analyzed contractual provisions and the ownership of units as devices for the franchisor to provide incentive for both parties (franchisor and franchisees). However, these two variables have mainly been explored separately (i.e. without considering the potential interactions). But contractual provisions in franchise contracts may well interplay with the outlets ownership. When looking at the impact of experience in franchising, on the level of royalty rates, a negative correlation can be exhibited (Figure 5). Royalty rates decrease with experience in franchising, even if it is not as straightforward as between company ownership percent and franchising experience. This does not necessarily mean that chains are always reducing their royalty rates as they become more mature. We can also interpret it as follows: the franchisors that claim lower royalty rates can expect a higher duration and thus are overrepresented in the high-experienced chains of our sample. Actually it is quite a puzzling fact that goes against intuition and contradicts several 7

8 JOURNAL OF MARKETING CHANNELS previous empirical studies (see Lafontaine-Shaw, 999). [INSERT FIGURE 5] Franchise Mix and Internationalization Our data set contains both French and foreign franchisors 0. Figure 6 establishes a comparison between the French franchisors without franchised units abroad and those with franchisees abroad. We observe that the chains that have exported their trademark exhibit a lower average percentage of company units. However, this result is less significant when the franchising experience increases. [INSERT FIGURE 6] This first section has enabled us to highlight several stylized facts that deserve better insights. First, why does the experience out of franchising seem to have a positive impact on the fraction of company stores (figure 3)? Second, why does the relationship between royalty rates and the proportion of company units chosen in franchise chains seem to be positively correlated (figure 5)? Third, why do chains with an international presence tend to franchise more (figure 6)? In the following section, we will attempt to analyze and measure the interplay between royalties, company ownership and internationalization of the chains. DETERMINANTS OF ROYALTY RATES AND FRANCHISE MIX A Theoretical Framework The majority of empirical studies dealing with franchising contracts agree that neither franchise fees nor royalty rates are finely tuned instruments that could be adjusted frequently (Lafontaine, 992, 993). Thus the proportion of company-owned and franchised units is usually viewed as a more flexible instrument in response to changing conditions. Moreover, franchise mix intervenes also in the franchisees and franchisors incentives, even 0 65 out of the 745 franchisors contained in our database are French Franchisors. For more details concerning Foreign chains, see annex 2. 8

9 Pénard, Raynaud and Saussier if franchising literature is more focused on the incentive properties of royalty rates. It is well-known that high royalty rates give strong incentives for the franchisor to control its units and preserve its brand-name capital. But, high royalty rates have less desirable incentive effects on the franchisees as they are less motivated to efficiently run their store. Company ownership may be an alternative means for the franchisor to commit to maintain the brand name value without downgrading the franchisee incentives (Scott 995). This theoretical explanation suggests that the proportion of company-owned units and high royalty rates could be substitute instruments in providing incentives to the franchisor. For a franchise system, the lower the proportion of franchisor-owned units, the higher royalty rates should be. However, such a negative interaction between royalty rates and franchise mix is not observed empirically. Previous econometric studies found that royalty rates have a positive impact on the proportion of companyowned units (Lafontaine 992, Scott 995, Lafontaine and Shaw 999). These empirical results suggest some complementarities between the level of royalty rates and the extent of company ownership. A possible explanation is that royalty rates are an efficient device to screen the more talented franchisees and to avoid adverse selection since the franchisor does not perfectly observe the ability of the franchisee applicants. A basic agency model under information asymmetry should allow grasping of the intuition. Assume that the franchisee applicants to a chain are characterized by some talent q, distributed on the interval [ q, q]. The expected turnover of an outlet is positively influenced by the talent of the franchisee. A high talented manager will achieve more sales than a low talented one. Moreover, the expected revenue of a store will depend positively on the value and reputation of the chain s trademark. This value is measured by an index X. Let V ( q, X ) be the expected turnover of a store managed by a talentedq franchisee, where V is an increasing function with respect to q and X ( Vq ( q, X ) > 0 and V X ( q, X ) > 0 ). Let C be the cost of running a store. Finally, V is the reservation revenue of the franchisee applicants, i.e; the warranted revenue they can obtain by investing their capital in an alternative business. If a is the royalty rates, then a franchisee will accept to integrate a franchise system if and only if ( - a) V ( q, X ) - C V Let ~ q be the franchisee type who is indifferent between adhering to this franchised chain and seeking an alternative business. ~ q is defined by: ~ ( - a) V ( q, X ) - C = V 9

10 JOURNAL OF MARKETING CHANNELS When the franchisor starts franchising his first units, it is in his own interest to set high royalty rates to attract the more talented franchisees (the higher the royalty rates, the higher the minimum talent of its franchiseesq ~ ). At the beginning, the royalties are overrated in comparison with what a franchisor under perfect information would have set. However, if the franchisor wants to pursue expansion and target a lower proportion of company-owned outlets, then he will be forced to decrease royalty rates so as to recruit less talented managers. Thus this theoretical framework enables a prediction of a positive relationship between the level of royalty rates and the extent of company ownership. As far as royalty rates are a screening device in selecting the more talented franchisees, we could also well conceive a negative relationship between franchising experience and royalty rates, because a more experienced franchisor is likely to better overcome the problem of adverse selection. First, it is reasonable to consider that the talent and quality of current franchisees are perfectly known when their contracts have to be renewed. Thus royalty rates should no longer play a screening role in the renewal of franchisee contracts. Similarly an experienced franchisor is more competent to directly screen the talent of his future franchisees in the process of recruitment. However this screening effect could be more than counterbalanced by a trademark effect. It is well-known that the size (the number of outlets) and the business experience (the chain maturity) of a franchise system contribute to the increase of its value and reputation. As business experience is the sum of franchising experience and experience before franchising, these two variables should positively influence the trademark value and thus the expected revenue per store. Let us return to our basic model and assume that the trademark value has been rising from X to X since the start of the franchise. Then for the same proportion of company-owned stores (for the same ~ q ), the chain has now the opportunity to increase royalty rates from a to a, as ~ ~ V ( q, X ) > V ( q, X ), wherea is defined by : ~ ( - a ) V ( q, X ) - C = V In summary, the royalty rates may increase or decrease with respect to franchising experience, depending on the strength of the two highlighted opposite effects (screening versus trademark). Our data should allow a disentanglement of these effects and testing of the predictions derived from our theoretical framework 2. Indeed franchising Experience is usually used to measure the development of the brandname capital in the previous empirical studies (Lafontaine 992). 2 For a formal model concerning the complementarity between royalty rates and franchise 0

11 Pénard, Raynaud and Saussier Used Variables Besides franchising experience, we have several variables at our disposal to explain the contractual and organizational design of French franchised chains. These variables can measure either the value of the trademark or the monitoring costs borne by the franchisor. Years out of franchising The number of years in the business before franchising is a good proxy for the value of the trademark 3 (Lafontaine 992 and 993, Lafontaine and Shaw 200). If company-owned units allow a protection of the value of the brand from franchisee free riding, one can expect the targeted fraction of company units to increase with the experience out of franchising. Moreover, the average abilities of company managers tend to increase with the experience out of franchising. If the chain can account for well-trained managers and a well-organized network, then it must be more selective with franchisee candidates. One way to select only talented and able managers is to set higher royalty rates. Consequently, one can expect the royalty rate to increase with the experience out of franchising 4 Franchise units outside of the country The number of franchised units outside of the country reflects the chain maturity and the value of the trademark. As the chain develops its network abroad, it increases the reputation of its trademark and can obtain higher royalty rates thanks to the prestige of the internationalization. The impact should be positive on royalty rates. Moreover, an internationalized franchisor is likely to operate more domestic stores himself in order to safeguard its high-valuable trademark (Minkler and Park 994). The impact is then supposed to be positive on the targeted fraction of company stores. Size (number of units) The size of the franchise chain may also have a positive impact on the royalty rates and the percent of company owned units as it is a proxy for the value of the trademark (Lafontaine 992). However, if the size of the chain is highly correlated with geographical mix, see Pénard, Raynaud and Saussier On the one hand, as pointed out by Lafontaine (992, p. 274), it may also measure the difficulty to franchise, to codify the business format or to transfer the know-how. The format can be complex and costly to transfer. It can involve costly training. If a part of theses costs are at the expense of the franchisee, then the latter can be reluctant to enter into such chains. Consequently, one can expect the chain s need to reduce the required franchise fees and royalties so as to compensate for this initial costs assumed by the franchisees. This policy is likely to be more active in the first years: when the franchising experience rises, then the chain can more easily transfer its know-how. 4 This prediction is also strengthened by the trademark effect that is enhanced by the experience before franchising

12 JOURNAL OF MARKETING CHANNELS dispersion, it can also be used as a measure for monitoring costs as pointed out by previous empirical studies (Brickley and Dark, 987, Lafontaine and Slade, 200). In such a case, the expected impact on the proportion of company owned units should be negative, since franchised managers have more highpowered incentives than salaried managers and thus require less intensive controls 5. Gap (franchised stores minus company stores) The variable Gap allows an estimation of franchisors difficulties in monitoring their franchised units. As shown by Bradach (997), locating a company-owned unit close to a franchised unit may be a good way to control franchisee behavior and performance (by benchmarking). We therefore expect this variable to have a negative impact on royalty rates as the franchisor substitutes a direct control on the franchisee behavior (by owning outlets close to franchised units) by an "indirect" one (residual claimancy). The franchisee, who is monitored more intensively, may efficiently run his store even if the claimed royalties are high 6. In the previous section, we have seen that the percent of company owned units is decreasing and then it becomes rather stable with respect to franchising experience. To take into account some possible non-linear effects, we cross this variable with the number of franchised units abroad and with the years out of franchising, Franchises Outside * Franchise Experience Actually franchisors might have several strategies for developing their trademark abroad. They might decide to operate in several countries at the beginning of their activity. In this case, internationalization is a means to increase their reputation in the domestic market. Conversely they may prefer to first develop their reputation in their own country, before trying to franchise outside of the country. In this case, internationalization will divert franchisor monitoring efforts from domestic franchisees to foreign ones. To compensate, the franchisor is forced to give more residual rights to his domestic franchisees. So we would expect royalty rates to decrease with foreign franchised units in high-experienced chains. Years Out of Franchising * Franchise Experience The idea is still to distinguish the first years of franchising from the maturity period. 5 That is why we control for costs of control in a chain using GAP variable. 6 We do not have any prediction concerning the effect of GAP on the percent of company owned units because GAP is, per definition, linked to the proportion of company owned units in a chain. 2

13 Pénard, Raynaud and Saussier [INSERT TABLE2] To resume, variables reflecting the value of the trade-mark (franchise units outside of the country, years out of franchising, size) are expected to have a positive impact on royalty rates and percent of company units, whereas variables reflecting costs of control (GAP, size) are expected to have a negative impact on royalty rates or company ownership. ECONOMETRIC RESULTS This section will present the regressions of both company ownership and royalty rates on the exogenous independent variables. Results concerning royalty rates are presented in Table 3 and those concerning the percent of company owned units are in Table 4. Royalty Rates Regressions Three different specifications are proposed. All of them are based on a Tobit model, well adapted when the dependant variable is left or right-censored 7. The estimations in models and 2 used the whole sample of French franchise systems, whereas model 3 does not take into account the small chains (having less than 50 units). [INSERT TABLE 3] First of all, Franchise Experience has a negative impact on royalty rates. This result confirms the hypothesis that more experienced franchisors have better information on the franchisee talent and can efficiently screen the applicants without being forced to distort or overrate royalties. Thus in experienced franchise systems, royalty rates are no longer used as a screening device and are more fitted to the trademark value. Results are confirmed using a between model estimation 8. 7 In this case, the dependant variable can only be left-censored when the royalty rate is equal to zero. 8 Between and within estimations enable better exploitation of the temporal dimension of our panel data. Results are not presented in this article, but they contrast sharply when looking at within and between estimators (results are available on request). We notice that general results are mostly driven by cross-section information as between estimators are not far from cross 3

14 JOURNAL OF MARKETING CHANNELS In the three specifications, GAP has a negative effect on royalty rates. If the number of franchised stores is high compared to company stores (this is the case if the chain opens more franchised stores than company stores over time), then the chain must reduce its royalty rate to attract franchisee candidates. Moreover, by decreasing royalties, it gives both positive incentives to potential franchisees and current franchisees and saves monitoring costs. Years Out of business has a positive direct impact on royalty rates in model. But the second specification enables us to be more precise regarding the effects of this variable. When we introduce the crossed variable Years Out * Franchise Experience, the sign of Years Out is reverted. However, the net effect of experience before franchising is negative in the first seven years and become positive afterwards 9 : This result suggests that the trademark effect overcomes the difficulties of franchising as experience grows. Otherwise, the table shows that internationalization leads to higher royalty rates. This result was expected and reflects a trademark effect. SIZE of the chain has also a positive effect on royalty rates. The number of units is a source of positive externality and thus improves the value of the trademark. Percent Company Owned Regressions Let us turn now to franchise mix regressions (See Table 4). First we have estimated the determinants of company ownership by means of a Tobit model on the whole sample (model 4) and on the sub-sample of the biggest chain (model 5). As we suspect endogeneity bias with royalty rates, a classical problem in the econometrics of contracting (Masten-Saussier 2002), we present two other specifications. First, we retained a 2SLS model 20, where the variable GAP was used as the instrument (model 6) 2. Second, we corrected the endogeneity bias by replacing the current royalty rate with the mean of the royalty rate over the period (Tobit model 7) 22. section estimators. This is not surprising as chains have only slightly modified their royalty rates over time. It also explains why the within estimation exhibits a very high R_ (R-squared rises from 26% to 98,5%), royalty rate differences being mainly due to specific firm effects (See Lafontaine & Shaw, 200, on this issue, especially p. 23 and 32). 9 Actually, from the estimated model 2, (Years out)*(-0,02+0,003*franchise experience)>0 if and only if franchise experience>7). 20 2SLS for two stage least-square. 2 Even if GAP is related to the percent of company ownership, the correlation is not high enough (r_ = 0, 3) to reject GAP as an instrument in the 2SLS model. 22 We did not explore the temporal dimension of our data. But preliminary results not reported here show that the between effect is the most important, simply because chains do not exhibit great changes concerning their PCO over time. Once again, the within estimator with firm specific fixed effect using OLS (not reported in table 4) exhibits a very high R_ 4

15 Pénard, Raynaud and Saussier [INSERT TABLE 4] The Royalty Rates variable has a positive impact on the percent of company owned units, even after controlling for endogeneity. These results confirm that royalty rates and company ownership are complements rather than substitutes. By reducing royalty rates, the franchisor can more easily recruit new franchisees and target a lower proportion of company-owned units. The Years out of franchising and the number of stores outside of France have a positive impact on the percent of company owned units, which is consistent with a trademark effect. Variable Size has a negative influence on the company-owned percent 23. It means that in France monitoring costs increase proportionally, more than trademark value, with the size of franchised chains. Consequently, the large chains tend to rely more heavily on franchised managers than salaried managers to run their outlets (Brickley and Dark, 987). Finally, Franchise experience has a negative impact on the percent of company owned units. As expected, the more the franchise experience grows, the more the percent of company owned units decreases. In the next section, we would like to go over the impact of Years out once again. We suspect the presence of mixed effects that can interfere with the estimations. EXTENSIONS The mixed effects of years out of franchising Previously, we showed that chains having stayed out of franchising for a long time tend to target a higher fraction of company-owned stores (see figure 3). This result was confirmed econometrically (see the coefficient of "Years out" in table 4). In fact, while estimating the relationship between the experience out of franchising and the proportion of company stores, we (R_=0,85). 23 Recall that for royalty rates estimation, we used GAP variable to disentangle the trademark effect and the monitoring effect embodied in the SIZE variable. To estimate company ownership, GAP cannot be introduced as it is used to instrument royalty rates. That is why SIZE represents both the costs of control and the value of the trademark in the models

16 JOURNAL OF MARKETING CHANNELS measured two different effects and the positive coefficient, reported on table 4, is the sum of these two effects. - The first effect is a transitory effect that appears only during the first years of franchising. This effect, as we will prove, is always positive. - The second effect is permanent and corresponds to the actual trademark effect on the targeted fraction of company stores. The sign of this effect is uncertain. It can be either negative or positive (or non significant). Unless we achieve an isolation of this second effect and measure it properly, we are unable to infer that the "years out of franchising" has a positive impact on the managerial control target. To understand it, we must go back over the franchisor s timing in designing his franchise system. After having developed its own stores, the chain can decide for different reasons to franchise some of its new stores. In this case, it has to choose a target in the proportion of company-owned stores that it wants to reach. The first years of franchising correspond to a transitory period in which the observed fraction of company-owned units is higher than the targeted fraction. The transitory phase ends as soon as the targeted fraction is attained. Thus, in our data, we can observe chains that have reached the phase of organizational stability, but also chains that are still in a transition phase. The latter can bias the regressions and overestimate the impact of experience before franchising on the fraction of company stores. This can be proven with a very simple model. Consider a chain that opens n new units each year, on average. m is the number of franchises and s the number of company-owned units, with n=m+s. Define t 0 as the years out of franchising. At the beginning of the franchise, the company owns nt 0 outlets. Moreover, even if the franchisor is turning now to franchise, it can keep on opening its own stores, managed by salaries. Let a be the proportion of company stores in the new stores opened during the franchising period. After t years into franchising, the observed proportion of company stores should be equal to: After arrangement, nt T 0 = s nt + 0 T s + ant nt 0 = ( -a) t + t + at We can see that this fraction increases with t 0, the experience out of 6

17 Pénard, Raynaud and Saussier franchising, and decreases with t, the franchising experience. Moreover, this rate is independent of n, under the hypothesis that the number of store openings is constant before and after turning to franchisees. 24. Let T S * be the managerial control target that the franchisor wants to reach. Let us define t * as the length of the transitory phase. Then, for such a length, the observed proportion of company stores is defined by: t0 + at Ts = t + t 0 T = T s * s if if t t t < t The observed rate of company stores will coincide with the targeted rate when the franchising experience attains t *. Thus the length of the transitory phase is defined by: (-T *) t s 0 t* = T *-a s This length increases with t 0 the years out of franchising and decreases with T, the managerial control target. * s Empirically, the probability of observing a chain in its transitory phase rises with the experience out of franchising. We observed this in Figure 3. A chain below the average years out of franchising tends to reach its target after 9 years of franchise experience whereas a chain above the mean reaches its target only after 4 years. As the transitory fraction of company stores is necessarily higher than the targeted fraction, it is normal to find a strong effect of the variable "years out of franchising" on the proportion of company stores. A way to isolate this transitory effect from the managerial or trademark is to split the panel into two sub-samples: a sample of chains having less than years of franchising experience that is a proxy for the length of the transitory phase 25, and a sample of companies having more than years of franchising experience. In the first sample, the estimated coefficient of the variable «years out of franchising» should measure the transitory effect (through t 0 ) and the permanent effect (through the target T* s ) and is supposed to be positive. In the second sample, the «years out of franchising» coefficient should measure only the permanent effect on the * * 24 Nevertheless, if franchising modifies its opening policy, then T s is no longer independent of the number of openings (intensity). For example, franchising can be a way to accelerate its development and improve its spatial coverage. 25 Within our data, we observe a stabilization of the proportion of franchisees after years of franchising experience. 7

18 JOURNAL OF MARKETING CHANNELS managerial target, and is supposed to be inferior to the previous one, (possibly negative). Econometric results Whether we used a Tobit specification or a 2SLS one, we found that the years out of franchising still have a positive impact after eleven years of franchising experience. But the impact is inferior to the one with less experienced chains (franchising experience of less than years). The permanent trademark effect is almost twice as small as the transitory effect. Franchise experience no longer has a negative impact on percentcompany owned units. It might reflect the fact that franchise experience impacts on PCO only indirectly, through its effect on royalty rates. Size plays a significant role when chains are unstable. But after eleven years of franchise experience, the size of the chain impacts is weaker. Royalty rates still have a positive influence on PCO, more significantly in the transitory period. Lastly, we found that sector dummies have a stronger impact on company ownership when the system is stable. [INSERT TABLE 5] CONCLUSION The goal of this article was twofold. First, we wanted to characterize the evolution of dual distribution in French franchising. Second, we aimed to investigate the interplay between contractual provisions (here the royalty rates) and organizational design of a franchised chain. First we gave evidence that firms tend to target a level of company ownership. After an initial period of decline, the proportion of company units stabilizes at a more or less constant rate. As pointed out by Lafontaine and Shaw (200), this result suggests that franchise mix is not a transitory phenomenon and might be a key instrument for the franchisor to efficiently monitor his chain. We also highlighted a positive relationship between royalty rates and the proportion of company units. We argued that franchise mix and royalty rates are complementary tools for franchisors, as organizational design is completely connected to contractual choices. Our argument that royalty rates and company ownership go hand in hand in the organizational design of chains fits in well with Holmstrom and 8

19 Pénard, Raynaud and Saussier Milgrom s (994) work on the role of complementarities in the design and workings of incentive systems (see Arrunda, Garicano and Vazquez, 200, Brickley, 999, and Lafontaine and Raynaud, 200, for an application to franchising). This is a promising area for future research and for practical understanding of the way chains perform over time. If one recognizes that complementarities exist in the overall design of a chain that influence the performance of chains the differential of chain performances can be partly explained by a more or less adequate alignment between monetary contractual provisions and organizational design of franchise systems. APPENDIX A. Activity Sectors Concerning activity sectors, we have a classification in eight general sectors (actually chosen by the ACFCI yearbooks). In Figure 7, we observe significant differences in the target proportion of company ownership with respect to activity sectors 26. Chains belonging to the body equipment sector (shoes, retail clothing,...) have a higher fraction of company stores (around 35 %) whereas the chains providing services (real estate, repair, rental, travel,...) are around 5 %. [INSERT TABLE 5] [INSERT FIGURE 7] A 2. French and Foreign franchisors [INSERT TABLE 6] REFERENCES 26 Interestingly, Azevedo and Silva (200) found the same sectoral patterns in Brazilian franchises. 9

20 JOURNAL OF MARKETING CHANNELS Arrunada, B., L. Garicano and L. Vazquez (200): "Contractual Allocation of Decision Rights and Incentives: The Case of Automobile Distribution", Journal of Law, Economic & Organization, 7(), Azevedo P.F., Silva V.L. (200), Contractual Mix Analysis in The Brazilian Franchising, Unpublished Manuscript. Bai, C.E, Z. Tao (2000), "Contract Mix in Franchising", Journal of Economics and Management Strategy, 9 (), Bercovitz, J.E. (2000), "An Analysis of the Contract Provision in Business Format Agreements", working paper, Fuqua School of Business, Duke University. Bradach, J.L. (997), "Using the Plural Form in the Management of Restaurant Chains", Administrative Science Quarterly, 42, Bradach, J.L., Eccles, R.G. (989): "Price, Authority and Trust: From Ideal Form to Plural Forms", Annual Review of Sociology, 5, Brickley, J.A. (999): "Incentive Conflicts and Contractual Restraints: Evidence from Franchising", Journal of Law & Economics, XLII, Brickley, J., Dark, F.H. (987): "The Choice of Organizational Form: The Case of Franchising", Journal of Financial Economics, 8, Caves, R.E., Murphy, W.F. (976): "Franchising: Firms, Markets and Intangible Assets", Southern Economic Journal, 42, Gallini, N.T., N. Lutz (992), "Dual Distribution and Royalty Fees in Franchising", Journal of Law, Economics & Organization, VIII, Holmström, B., Milgrom, P. (99), "Multitask Principal Agent Analysis: Incentive Contracts, Asset Ownership and Job Design", Journal of Law, Economics & Organization, 7, Holmström, B. and Milgrom, P. (994), The Firm as an Incentive System, American Economic Review, 84, Lafontaine, F. (992), "Agency Theory and Franchising: Some Empirical Results", Rand Journal of Economics, 23, Lafontaine, F. (993), "Contractual Arrangement as Signaling Devices: Evidence from Franchising", Journal of Law, Economics & Organization, 9, Lafontaine, F., Raynaud, E. (2002): "Residual Claims and Ongoing Rent as Incentive Mechanisms in Franchise Contracts: Complements or Substitutes?", in E. Brousseau and J-M. Glachant (eds.), The Economics of Contracts: Theories and Applications, Cambridge University Press. Lafontaine, F., K.L. Shaw (999), The Dynamics of Franchise: Evidence 20

21 Pénard, Raynaud and Saussier From Panel Data, Journal of Political Economy, 07, Lafontaine, F., K.L. Shaw (200), "Targeting Managerial Control: Evidence from Franchising", working paper, University of Michigan Business School. Lafontaine, F., Slade, M. (200): "Incentive Contracting and the Franchise Decision", forthcoming in K. Chatterjee and W. Samuelson (eds.), Advances in Business Application of Game Theory, Kluwer Academic Press. Lewin-Solomon, S.B. (999), "Innovation and Authority in Franchise Systems: An Exploration of the Plural Form", working paper, Iowa State University. Masten S.E., Saussier S. (2002), Econometrics of Contracts: An Assessment of Developments in the Empirical Literature of Contracting, in E. Brousseau and J-M. Glachant (eds.), The Economics of Contracts: Theories and Applications, Cambridge University Press. Minkler, A. (990), "An Empirical Analysis of a Firm Decision to Franchise", Economic Letters, 34, Minkler, A., Park, T.A. (994), "Asset Specificity and Vertical Integration in Franchising", Review of Industrial Organization, 9, Norton, S. (988), "An Empirical Look at Franchising as an Organizational Form", Journal of Business, 6, Oxenfeldt, A.R., Kelly, A.O. (969): "Will Successful Franchise Systems Ultimately Become Wholly-Owned Chains?" Journal of Retailing, 44, Pénard T., Raynaud E., Saussier S. (2002) : Dual Distribution and Efficiency under Information Asymmetry, Working Paper., 6 th Conference of the International Society for New Institutional Economics (ISNIE), MIT, Cambridge. Scott, F.A. (995), "Franchising vs. Company Ownership as a Decision Variable of the Firm", Review of Industrial Organization, 0, Sorenson O., Sorensen J. B. (200), Finding the Right Mix: Organizational Learning, Plural Forms, and Franchise Performance, Strategic Management Journal, 22 (6-7),

22 JOURNAL OF MARKETING CHANNELS TABLE Descriptive Statistics (Year 2000) Variable Name Observations Mean Standard Deviation Minimum Maximum Number of Franchised Units in France 58 50,92 2, Number of Franchised Units outside of France 58 78,9 35, Number of Company Units in France 58 22,62 92, Number of Company Units outside of France 58 34,22 370, Percent Company Owned 52 0,33 0,32 0 Percent Company Owned outside of France 228 0,2 0,34 0 Total Outlet 58 73,55 58, Royalties rate (when variable) 26 4,42 3, Rayalties (when fixed) Franchise fee Years of Franchising Experience 477 4, 2, Years Before Franchising 393 3,54 26, FIGURE. The proportion of Company Units as a Function of Franchising Experience 0,6 Average Percent Company Owned 0,55 0,5 0,45 0,4 0,35 0,3 0,25 0,2 0,5 0, 0, Years of Franchising Experience