Territorial Exclusivity in Franchisee Systems 1

Transcription

1 Territorial Exclusivity in Franchisee Systems 1 ANA BRANCA SOEIRO DE CARVALHO Instituto Politécnico de Viseu LUIS VÁZQUEZ Universidad de Salamanca Abstract This article shows that the higher the problems of hold-up and free-riding in franchise systems, the higher the probability that the franchisor will provide franchisees with territorial exclusivity. It therefore appears that territorial exclusivity is an assurance from a franchisor that the return on the sunk investments of a franchisee will not be subsequently held-up. Moreover, it appears that territorial exclusivity alleviates free-riding problem by making the franchisees local monopolists for the brand in question, which increases the probability that they will receive most of the benefits generated by their service provision. JEL Classification: L14, L22, L81. Keywords: franchising, hold-up, free-rinding territorial exclusivity. 1 Ana Branca Soeiro de Carvalho, Área Cientifica da Gestão, Escola Superior de Tecnologia e Gestão de Lamego, Instituto Politécnico de Viseu Tel Fax apina@estgl.ipv.pt Luis Vázquez. Departamento de Administración y Economía de la Empresa. Campus Unamuno, s./n. Salamanca, Spain, E Tel Fax lvazquez@usal.es 1

2 INTRODUCTION A key clause in franchise contracts is the right to add new franchisees to an existing franchise area. The choice is simple: either grant the franchisor the right to add new franchisees in the future or allow the existing franchisees the right to block the addition of new outlets. In the latter case, the franchise contracts provide franchisees with exclusive territories, geographical areas in which the franchisor agrees not to add any other outlet, either franchised or company-owned. This work studies this topic. First, section 2 defines the hypotheses on the adoption of territorial exclusivity. Section 3 describes the data. Section 4 presents the methodology used and discusses the results. Finally, section 5 concludes. THEORY Determinants of territorial exclusivity The economic literature mainly takes two perspectives regarding territorial exclusivity. This contractual clause either prevents franchisor holdup behaviour the appropriation of franchisee returns from the investment in establishing the local market or it corrects free-riding problems arising from competition among franchisees (Rubin, 1978; Mathewson and Winter, 1984; Winter, 1993). Therefore, the problems of hold-up and free-riding determine the franchisors decisions to provide franchisees with exclusive territories. Hold-up problem. The usual view is that exclusive territories are an assurance from a franchisor that the return on the efforts/investments of a 2

3 franchisee will not be subsequently held-up (Mathewson and Winter, 1984). This explanation implies that such protection will be offered where the threat of the hold-up is most severe. The division of activities between franchisors and franchisees generates incentives for the parties to renege on the terms of their contracts to take advantage of quasi-rents generated by each party s relation-specific investments (Williamson, 1985). In this sense, franchisees have to make initial investments to cover the costs of equipment, employee training, marketing, site/building development, the franchise fee, and so on. They also invest in human capital, often by attending offsite training provided by the franchisor (e.g., at the company s headquarters). Much of these investments made by a franchisee are relationship-specific. Since franchisors earn their profits on the basis of royalties on system-wide sales, whereas franchisees earn income based on net profits of royalties from outlets that they own, franchisors have an incentive to establish a greater density of outlets in a geographical area than do franchisees (Kalnins, 2004). Franchise contracts can mitigate franchisees worries of territorial encroachment by providing them with a protected territory. Such a guarantee commits the franchisor to the protection of the stream of quasi-rents appropriated by the franchisee (Azoulay and Shane, 2001). Therefore: Hypothesis 1. The higher the potential hold-up problem in a franchise system, the higher the probability that the franchisor will provide franchisees with territorial exclusivity. 3

4 Free-riding problem. Free-riding hazards appear in situations where the inputs of more than one party affect the value of the end-product and/or service, but where, due to incomplete contracting and measurement difficulties, no one party is able to catch the entire benefits (or costs) of their individual efforts (Mathewson and Winter, 1984). In the absence of safeguards that prompt the internalization of such externalities, transacting parties will, at times opportunistically, choose to supply effort at levels that optimize individual returns at the expense of joint (or system-wide) returns (Bork, 1978). In the franchising field, since some customers visit multiple outlets of a franchise system, the perceived value to an outlet s offering will be based on the customers general as well as local experience. As such, the benefits and/or damages resulting from the actions of any one franchisee will spillover and influence customers perception of both the individual outlet and all other outlets in the system. Under such conditions, the possibility of freeriding hazards arises (Rubin, 1978). Individual franchisees frequently provide services that can benefit other franchisees of the same franchise system. For example, selling situations that involve technical or complex products (Miracle, 1965) require that customers be given extensive presales services, in the form of product information or actual demonstrations (Lilien, 1979). Although such services are important to customers, they also represent potential problems in that a distributor that does not offer the services can free-ride on full-service distributors. For example, a discount dealer that does not provide technical 4

5 advice will have lower costs and can offer the product to end users at a lower price. In many situations, the discount dealer can pursue a low-cost strategy because there are full-service distributors available that perform the necessary customer services. However, to the extent that buyers can unbundle these presale services from the sale of the product itself or that the services cannot be charged for separately by the distributor, a free-riding potential exists (Mathewson and Winter 1984). Territorial exclusivity mitigates this problem. In effect, one of the goals of this contractual choice is to make a distributor a local monopolist for the brand in question, which increases the probability that the distributor will receive most of the benefit generated by the service provision (Mathewson and Winter 1984). Hence, I suggest the following proposition: Hypothesis 2. The higher the risk of free riding, the higher the probability of territorial exclusivity. DATA The empirical setting for testing the aforementioned hypotheses was the Portuguese and Spanish franchise sectors in To develop the questionnaire, we conducted a series of personal interviews with marketing and sales managers representing eight companies belonging to franchise sectors in Portugal and Spain. Using these interviews and previous measures, we developed a draft of the questionnaire. Then, we conducted three rounds of pre-testing. First, the initial draft of the questionnaire was administered personally to the set of marketing and sales 5

6 managers mentioned and refined on the basis of the feedback received. Second, we personally administered the revised questionnaire to a new set of marketing and sales managers of 20 franchise systems and corrected a few remaining ambiguities. Third, we conducted the mail pretest. No problems with the questions or response formats were revealed at this time. The questions of the questionnaire used in this research are displayed in the Appendix. According to Campbell s (1955) criteria, appropriate key informants are those who are knowledgeable about the phenomenon and are willing and able to communicate with the researcher about the phenomenon being studied. Because the quality of a given informant is not necessarily correlated with formal job titles or organizational positions (Seidler, 1974), we personally contacted each franchisor by telephone in order to locate a person within the company with the knowledge and motivation required. In most cases, the formal titles of the potential informants were directors of expansion and sales or marketing managers. Finally, questionnaires were sent to these potential informants of all members of the population 726 franchise chains identified in Tormo & Asociados guides and a supplemental telephone survey was carried out asking that the questionnaires be completed. A total of 138 companies (19%) responded, of which 17 responses were unusable owing to missing data. Finally, 121 usable responses were obtained. Table 1 contains the number of chains in each business format franchising sector. Insert table 1 about here 6

7 To test for a potential response bias in the sample of franchise systems, the sectors represented in the sample were compared to the population. The sample and population did not appear to differ by sectors. To further test for non-response bias, we also compared early respondents (first half) with late respondents (second half), following the Armstrong and Overton procedure (1977). No significant differences were found between the scores of early and late respondents. An additional approach to assessing non-response bias is to compare the characteristics of respondents with those of the population. Comparisons between respondents and nonrespondents were possible here because data reported in the Tomo & Asociados guides was used as the sampling frame. They were contrasted on franchise system age, average investment per outlet, proportions of company-owned versus franchised outlets in the franchise system, franchise chain size in terms of total number of outlets, franchise fee and royalty rate. These tests revealed no statistically significant differences (p >.05) across the two groups for all comparisons except for average investment per outlet (in this case, the test revealed no statistically significant differences at the 10% level), bolstering the confidence in the generalizability of the findings to franchise systems operating in Portugal and Spain. Dependent variables We used Territorial exclusivity as dependent variable. This is a dummy variable that takes value 1 if the franchisor provides their franchisees with exclusive territories (geographical areas in which the franchisor agrees 7

8 not to add any other outlet, either franchised or company-owned), and 0 otherwise. Independent variables We used the following independent variables: Hold-up. For each sample chain, the Tormo & Asociados guides have data on the average initial investment required for the franchisee to start the franchise (average investment per outlet plus initial franchise fee). Although many previous authors (e.g., Brickley and Dark, 1987; Scott, 1995) used total initial investments to proxy the franchisee s specific investment, this approach is questionable as many of the required investments are not relationship-specific. For instance, many chains are characterized by the widespread use of leased equipment in franchise operations. Therefore, to divide the initial euro expenditure into specific and non-specific investment, we estimated the level of specific investments of the franchisees by a specific item (level of specific investments; see Q2 in the Appendix). Consequently, we measured the risk of hold-up using the product of the average initial investment required for the franchisee to start the franchise times the level of specificity of these investments (initial investment required*level of specific investments). Free-riding. To estimate the level of free-riding hazard we measured the extent to which distributor services could benefit other distributors of the same franchise system (Blair and Kaserman, 1983; Rubin, 1978). We developed the specific item (free-rideable services; see Q3 in the Appendix) 8

9 using past research (Dutta, Heide and Bergen, 1999; Cady, 1982) and modified it on the basis of field interviews. Control variables. In addition to the independent variables specified, we used as control variables the size (chain size) and the longevity (chain age) of each franchise system, measured through the number of outlets and the age of each chain in In addition, since I would expect there to be substantial sector variation regarding the adoption of territorial exclusivity, regressions with sector fixed effects were included. To do this I discarded 40 observations, those where there are only three or less observations within the sector (see Table 1, sectors marked in italics). Finally, sector fixed effects were included in the regressions. To do this I discarded 40 observations, those where there are only three or less observations within the sector. Descriptive statistics for all variables used are shown in Table 2. Insert Table 2 about here METHOD AND RESULTS Because of the nature of the dependent variable, we used a probit model to specify the decision equation. Table 3 shows the results. Table 3 First, we found support for Hypothesis 1, which predicts that the higher the potential hold-up problem in a franchise system, the higher the probability that the franchisor will provide franchisees with territorial 9

10 exclusivity. Consistent with the prediction, we found that increases in the potential hold-up problem measured through the franchisee s initial investment requirement*level of specific investments result in a higher probability of territorial exclusivity. It therefore appears that franchisors mitigate franchisee fears of hold-up by providing them with exclusive territories. That is, territorial exclusivity is an assurance from a franchisor that the return on the sunk investments of a franchisee will not be subsequently held-up (Azoulay and Shane, 2001; Mathewson and Winter, 1984). The findings obtained also support Hypothesis 2. The parameters estimated for free-rideable services, which measures the importance of the free-riding problem, show a positive and significant effect on the adoption of territorial exclusivity. Given that in some franchise systems the franchisees offer presale services such as product information or actual demonstrations that can benefit other franchisees of the same chain, a free-riding potential exists. Territorial exclusivity alleviates this problem by making the franchisees local monopolists for the brand in question, which increases the probability that they will receive most of the benefits generated by their service provision (Mathewson and Winter 1984). Regarding control variables, we found the larger the size of a franchise system, the lower the probability that the franchisor will provide franchisees with territorial exclusivity. This evidence may be explained because the greater the size of a franchise chain, the higher the reputation of the franchisor and, therefore, the lower the risk of hold-up perceived by the franchisees, so the lower the franchisees demand for territorial exclusivity. 10

11 CONCLUSIONS The results of this study suggest that the adoption of territorial exclusivity restrictions in franchise relations follows an efficient rationale. Given that if franchisees do not succeed in appropriating the value of their investments, these investments would be reduced, the provision of territorial exclusivity may be an efficient solution for the protection of such investments. It therefore appears that private contracting provides an efficient method of governance. A possible limitation of this study is that the empirical setting is the franchise sectors in Portugal and Spain. Other possible limitations are the limited number of firms and time-periods studied. As a result, the findings may not be generalizable to other countries or firms. To complete the findings obtained in this work, future research should analyze the effects of the provision of territorial exclusivity on franchise chain performance. The findings of this future research would have important implications for practitioners, given that they seek to identify contractual and organizational decisions that franchisors can adopt to enhance the performance of their franchise chains. 11

12 REFERENCES Armstrong J. S., & Overton T. S Estimating nonresponse bias in mail surveys. Journal of Marketing Research, 14: Azoulay P., & Shane S Entrepreneurs, contracts, and the failure of young firms. Management Science, 47: Blair, R. D., & Kaserman D. L Law and economics of vertical integration and control. New York: Harcourt Brace Jovanovich. Bork, R. H The antitrust paradox: A policy at war with itself. New York: Basic Books, Inc. Brickley, J. A., & Dark, F. H The choice of organizational form: The case of franchising. Journal of Financial Economics, 18: Cady, J. F Reasonable rules and rules of reasons: Vertical restrictions on distributors. Journal of Marketing, 46: Campbell, D. T The informant in quantitative research. American Journal of Sociology, 60: Dutta, S., Heide, J. B., & Bergen, M Vertical territorial restrictions and public policy: Theories and industry evicence. Journal of Marketing, 63: Kalnins, A An empirical analysis of territorial encroachment within franchised and company-owned branded chains. Marketing Science, 23: Lilien, G. L Advisor 2: Modeling the marketing mix decision for industrial products. Management Science, 25: Mathewson, G. F. & Winter, R. A An economic theory of vertical restraints. Rand Journal of Economics, 12:

13 Miracle, G. E Product characteristics and marketing strategy. Journal of Marketing, 29: Rubin, P. H The theory of the firm and the structure of the franchise contract. Journal of Law and Economics, 21: Seidler, J On using informants: A technique for collecting quantitative data and controlling measurement error in organizational analysis. American Sociological Review, 39: Williamson, O. E The Economic Institutions of Capitalism. New York: The Free Press. Winter, R. A Vertical control and price versus nonprice competition. Quarterly Journal of Economics, 108:

14 TABLE 1 Distribution of sample chains by sector Sector Number of franchise chains Adventure 1 Automobile services 4 Beauty and personal hygiene 2 Cafés & ice-cream 3 Cleaning-interior restoration 1 Clothing-fashion 14 Computers 4 Consulting firms 5 Cosmetics 6 Drugstore 3 Dry-cleaning 4 Food and bakery 3 Furniture and decoration 4 Hairdresser s 1 Jewelry and costume jewelry 3 Leisure 2 Office-stationer s 2 Personalized editions 3 Photography 1 Printing and signs 2 Real estate agencies 5 Restaurants 15 Specialized products 1 Specialized services 8 Specialized shops 5 Sports 2 Teaching 6 Telephone stores 1 Textiles 2 Transport services 1 Travel 3 Vending 3 Total 121 Note: The sample consists of 121 Portuguese and Spanish business format franchising networks from Sectors with three or fewer observations are marked in italics.. 14

15 TABLE 2 Descriptive statistics and correlation coefficients Territorial exclusivity Initial investment required ( 100,000 )*Level of specific investments Freerideable services Chain size Chain age Mean S.D Territorial exclusivity * * * Initial investment required*le specific investments Free-rideable services Chain size Note: * Correlation statistically significant at 5% level. 25

16 TABLE 3 Probit estimates for exclusivity choice (1 = adoption of territorial exclusivity; 0 = otherwise) Independent variables Initial investment required*level of specific investments Free-rideable services Chain size Chain age 0.86 *** 0.72 *** 0.72 *** 0.59 ** ** * Sector fixed effects NO YES Observations Pseudo R Notes: Two-tailed tests. p <.10 * p <.05 ** p <.01 *** p <

17 APPENDIX: Survey Variable Questions Territorial exclusivity Q1 Franchisor provides their franchisees with exclusive territories Level of specific investments Q2 The level of specificity of the investments made by the franchisees is high (e.g., in case of relationship disruption franchisees will lose the value of such investments to a great extent. (Seven-point semantic differential scale). Free-rideable services Q3 The franchisees provide a high level of services that are free-rideable by other franchisees of the franchise system (e.g., due to the fact that the products/services traded require an important distributor promotion or they are technical or difficult to use). (Seven-point semantic differential scale). Chain size Q4 Number of outlets of the franchise system in Spain at the beginning of Chain age Q5 Age of the franchise system in Spain at the beginning of