Abstract
Theories of the firm so far applied to explain franchising struggle to enlighten its operational extensions, such as multi-unit franchise strategies. The corporate decision to grow via multiple franchising has not been yet analyzed with a view to accounting for how the flexibility to franchise or not (vis-à-vis the rigidity of investing into new own outlets), as uncertain market circumstances warrant, can drive performance. In this study, we seek to fill the gap by proposing a theoretical framework and empirically investigating about the real options that underlie multi-unit franchise strategies. Three are the key contributions to the franchising literature. First, an options-based classification of multi-unit franchise strategies is advanced in an effort to better explicate franchising and its performance consequences. Second, evidence drawn from the U.S. franchising industry is provided so as to both support classical findings on franchising and highlight the key source of extra value brought in by optionality associated with multi-unit arrangements and their impact on network performance. Third, “theoretical diversity” on franchising (Combs et al. In: J Manage 30:907–931, 2004) is enlarged by responding to the recent call for researchers to deliver complementary insights into what makes franchising work applying for the first time the real options theory to franchising. Implications of our findings for researchers, managers and policy-makers are discussed.
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Notes
In 2014, the U.S. franchising market consists of 3500 franchisors and 780,000 establishments (source: International Franchising Association–IFA).
Source: Franchise Business Economic Outlook 2014 (IHS Global Insight).
In the 2007–2014 period the capability of creating jobs by franchise businesses prevailed over that of other businesses by 0.5 % (on average). In 2015, 247,000 new jobs are expected still outpacing other businesses’ growth by 0.5 %. (International Franchising Association–IFA 2015).
The resource scarcity perspective suggests that firms use franchise arrangements to extend scarce corporate resources leveraging capital investments of external entities (franchisees) (Caves and Murphy 1976). Rooted in agency theory, the administrative efficiency perspective argues that a franchisee is more motivated and thus likely to perform better than a manager of a company-owned outlet because its compensation (rather than a fixed salary) is the residual claim on the outlet’s profits (net of royalties payable to the franchisor), which strongly depends on the amount and quality of its effort (Brickley and Dark 1987). Hence, in the absence of franchising, firms (principals) incur additional (agency) costs to monitor the behavior of corporate outlet managers (agents) (Mathewson and Winter 1985; Brickley and Weisbach 1991; Carney and Gedajlovic 1991; Castrogiovanni et al. 1995). The risk management view contends that firms seek to reduce their risk by using corporate ownership in reliable locations and managing franchised operations in more hazardous ones due to geographic distance or cultural differences. Franchising thus enables to test the waters of a particular locality without incurring significant upfront costs (Fladmoe-Linquist 1996). From the standpoint of franchisees, the benefits of joining an established franchised chain may instead be grouped into two categories: cost-reducing and demand-enhancing (Blair and Lafontaine 2011).
Franchising of plural form occurs when franchised units coexist with those directly owned by the parent company.
It has been only very recently that scholarly research (Gorovaia and Windsperger 2013; Windsperger 2012) has sought to weakly tie real options to multi-unit arrangements used as incentive provisions in franchise contracts to mitigate franchisee’s disincentive to invest in outlet-specific intangibles (e.g., local market knowledge), thus offsetting franchisor’s opposite motivation to make investments in its own intangible resources (e.g., brand), in the presence of call options granting the franchisor the right to acquire franchise units at the end of the contract period.
The subfranchisor may be an existing franchisee or an entity unrelated to the franchise system.
It differs from the area development agreement in that while under the latter arrangement the grantee establishes and operates the franchised units, under subfranchising the grantee is given the right to grant to others the right to establish and operate franchised units in a certain territory.
Besides being a function of the size of the exclusive territory or the history of success of the franchise system, the subfranchise fee is linked to the subfranchisor’s performance (e.g., number of units opened).
Subfranchising offers a flexible platform that permits to enter a new, unexplored market into a foreign country and achieve a fast market share growth by leveraging the subfranchisor’s knowledge of local economic conditions, presence and reputation. The risk of an uncertain foreign market entry is mitigated via sharing resources with local subfranchisors and their privileged position allows them to provide prompt adaptation of the franchise system to the local marketplace in the host country. Moreover, the granting of subfranchise rights for an entire country in exchange for a higher fee compared to that of the domestic arrangement, coupled with accelerated development of individual subfranchised units (which translates into an increased royalty stream), is financially beneficial to the franchisor. Hence, the benefits of subfranchising outweigh the disadvantages arising, predominantly in the domestic setting, from loss of control and income as well as increased regulatory burden.
Calculated as a percentage of the upfront fee.
The learning option offered to the franchisor may be remarkably valuable and then fairly compensated for to the subfranchisor by allowing it to retain a higher portion of the upfront and royalty payments made by the (sub)franchisees. Similarly, the amount of investments in marketing and training support to (sub)franchisees made locally by the subfranchisor may reduce the need for advertising expenditures by the franchisor with a positive net synergistic effect.
More in general, the franchisor resorting to subfranchising manages a portfolio of growth options (subfranchises) enabling profit and network control maximization by replacing failing subfranchisors with best performers and enlarging or reducing the number of subfranchisors to better influence the conduct of several (less powerful) ones vs. that of a few (more powerful) ones. The franchisor may flexibly stage the granting of subfranchise rights to a new subfranchisor by starting with a small territory and incrementally adjusting the related size as the counterparty is proven to be competent and committed. Oppositely, if pre-determined performance thresholds are not achieved by the subfranchisor, the franchisor may diminish the size of the exclusive territory.
Passive ownership is an example of passive business activity, in which the business owner (or investor) has the potential to profit without materially or physically participating in its day-to-day operations (source: Internal Revenue Service).
There are exceptions represented by franchisors operating small-scale chains (Srinivasan 2006).
As the franchisor has the right to revoke the franchise agreement without return of the franchise fee if the franchisee does not adhere to her contractual obligations, companies that intend to expand overseas are likely to have higher franchise fee to royalty ratios relative to those concentrating on domestic operations.
See Lafontaine and Oxley (2004).
Monetary terms are thus insensitive to variations in individual, outlet, or market conditions (while non-monetary ones are more subject to negotiations). Interestingly, contract standardization is not due to heterogeneity of disclosure requirements across U.S. States and abroad.
Typically, franchisors utilize franchisee fees as a means of financing the expansion of their service (or support) capabilities in favor of growing networks.
Franchisee fee variation is explained by the use of different types of fees for different types of transactions. Fees are set differently depending on: (1) the kind of franchised units (e.g., fast-food vs. food-court operation); (2) who pays (e.g., existing franchisees that bring additional units within their portfolios vs. existing businesses joining the franchisor’s chain via conversion franchise; (3) the way are calculated (e.g., formulaic).
The average royalty rate ranges from 3 to 6 % with one-quarter of franchisors charging the modal rate of 5 % (Blair and Lafontaine 2011).
Worldfranchising.com© is administered by Robert E. Bond, a leading U.S. authority on franchising and founder of Source Book Publications (which publishes Bond's Franchise Guide, considered as the “industry bible”).
The FDD is a document (with a cover page and 23 items) that franchisors have to disclose to a prospective franchisee in compliance with the Franchise Rule, enacted in 1979 by the Federal Trade Commission (FTC) to regulate franchises through mandating disclosure but not registration and successively amended in 2007 (with effect on July 1, 2008).
BrandFinance® is the world’s leading brand valuation consultant. Its work is frequently peer-reviewed by the big four audit firms and accepted by various regulatory bodies (e.g., UK Takeover Panel).
Franchise Direct® is one of the world's leading portals for franchise and business opportunities.
The Vector Inflation Factor (VIF) has been calculated for all regressors. The average VIF (1.63), being lower than 5, demonstrates that multicollinearity does not affect our analysis.
The average magnitude of the coefficient associated with royalty rates is 12 across all models.
The variable training is operationalized as the product between a dummy accounting for the provision of field training by the franchisor to franchisees and the length of the program (logarithm of the number of training days).
This is the only case, among those presented above and reinterpreted using real options lens, in which flexibility is dispersed across franchised operations.
The first interaction is that between the number of franchised units and the growth option that can be exercised via use of subfranchising. The relationship with performance is negative (with highest magnitude) due to the fact that the higher the number of franchised outlets the franchisor operates, the lower the control it can exercise over its network and the profit it can obtain as opposed to the situation in which all fees are fully paid by franchisees to the franchisor (with no need to compensate the subfranchisor for its service). Subfranchising should thus be employed when the network is small (but with a growth potential). The second interaction is that between the level of industry volatility and the expansion option embedded in area development. The relationship with performance is negative showing that the flexibility for moderate/incremental network expansion granted by such a clause is not compatible with highly volatile industries.
The Sargan (1958)’s test gives a p-value of 0.23 and 0.86, respectively.
When performing the Durbin-Wu-Hausman (1974)’s test for both 2-SLS IV estimations, the null hypothesis that variables are exogenous is not rejected under both circumstances (p-values are 0.23 and 0.13, respectively).
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The author thanks Marco Dominici for his valuable research assistance work.
Appendix
Appendix
Sample of 100 Global Franchisors
FDD | # | Franchisor | Industry | Macro-industry | Country |
|---|---|---|---|---|---|
2012 | 1 | Papa Murphy’s | Fast-food restaurants | Food-related | USA |
2012 | 2 | Jack in the Box Inc. | Fast-food restaurants | Food-related | USA |
2012 | 3 | Carl’s Jr. | Fast-food restaurants | Food-related | USA |
2012 | 4 | Arby’s | Fast-food restaurants | Food-related | USA |
2012 | 5 | Buffalo Wild Wings Grill and Bar | Fast-food restaurants | Food-related | USA |
2012 | 6 | Burger King Corporation | Fast-food restaurants | Food-related | USA |
2012 | 7 | Church’s Chicken | Fast-food restaurants | Food-related | USA |
2012 | 8 | Domino’s Pizza | Fast-food restaurants | Food-related | USA |
2012 | 9 | Jimmy John’s Gourmet Sandwiches | Fast-food restaurants | Food-related | USA |
2012 | 10 | KFC | Fast-food restaurants | Food-related | USA |
2012 | 11 | Long John Silver’s | Fast-food restaurants | Food-related | USA |
2012 | 12 | McDonald’s | Fast-food restaurants | Food-related | USA |
2012 | 13 | Papa John’s International | Fast-food restaurants | Food-related | USA |
2012 | 14 | Pizza Inn | Fast-food restaurants | Food-related | USA |
2012 | 15 | Subway Restaurants | Fast-food restaurants | Food-related | USA |
2012 | 16 | Taco Bell | Fast-food restaurants | Food-related | USA |
2012 | 17 | Papa Gino’s Pizzeria | Restaurants (Sit-Down) | Food-related | USA |
2012 | 18 | Denny’s | Restaurants (Sit-Down) | Food-related | USA |
2012 | 19 | Bennigan’s Grill and Tavern | Restaurants (Sit-Down) | Food-related | USA |
2012 | 20 | Big Boy Restaurant and Bakery | Restaurants (Sit-Down) | Food-related | USA |
2012 | 21 | Teriyaki experience | Restaurants (Sit-Down) | Food-related | Canada |
2012 | 22 | Coffee Beanery | Retail food | Food-related | USA |
2012 | 23 | 7-Eleven, Inc. | Retail food | Food-related | USA |
2012 | 24 | Circle K | Retail food | Food-related | USA |
2012 | 25 | General Nutrition Centers | Retail food | Food-related | USA |
2012 | 26 | Gloria Jean’s Gourmet Coffees | Retail food | Food-related | USA |
2012 | 27 | Baskin-Robbins | Frozen desserts | Food-related | USA |
2012 | 28 | Ben and Jerry’s | Frozen desserts | Food-related | USA |
2012 | 29 | Cold Stone Creamery | Frozen desserts | Food-related | USA |
2012 | 30 | Dairy Queen | Frozen desserts | Food-related | USA |
2012 | 31 | YogenFruz Canada Limited | Frozen desserts | Food-related | Canada |
2012 | 32 | Cinnabon | Baked goods | Food-related | USA |
2012 | 33 | Dunkin’ Donuts | Baked goods | Food-related | USA |
2012 | 34 | Panera Bread Company | Baked goods | Food-related | USA |
2012 | 35 | Sotheby’s International Realty | Real estate | Home, clothing, health, education and leisure | UK/USA |
2012 | 36 | Coldwell Banker Real Estate | Real estate | Home, clothing, health, education and leisure | USA |
2012 | 37 | Century 21 Real Estate | Real estate | Home, clothing, health, education and leisure | USA |
2012 | 38 | RE/MAX International | Real estate | Home, clothing, health, education and leisure | USA |
2012 | 39 | Re-Bath Corporation | Building and construction | Home, clothing, health, education and leisure | USA |
2012 | 40 | American Leak Detection | Building and construction | Home, clothing, health, education and leisure | USA |
2012 | 41 | Pirtek USA | Building and construction | Home, clothing, health, education and leisure | Australia |
2012 | 42 | RadioShack | Retail stores | Home, clothing, health, education and leisure | USA |
2012 | 43 | Snap-on Tools | Retail stores | Home, clothing, health, education and leisure | USA |
2012 | 44 | Ace Hardware | Retail stores | Home, clothing, health, education and leisure | USA |
2012 | 45 | Health Mart | Retail stores | Home, clothing, health, education and leisure | USA |
2012 | 46 | Matco Tools | Retail stores | Home, clothing, health, education and leisure | USA |
2012 | 47 | Aaron’s sales and Lease Ownership | Home-related | Home, clothing, health, education and leisure | USA |
2012 | 48 | Shoebox New York | Clothing and accessories | Home, clothing, health, education and leisure | USA |
2012 | 49 | EmbroidMe | Clothing and accessories | Home, clothing, health, education and leisure | USA |
2012 | 50 | Furla | Clothing and accessories | Home, clothing, health, education and leisure | ITA |
2012 | 51 | Plato’s Closet | Clothing and accessories | Home, clothing, health, education and leisure | USA |
2012 | 52 | Amramp | Health and fitness | Home, clothing, health, education and leisure | USA |
2012 | 53 | Caring Senior Service | Health and fitness | Home, clothing, health, education and leisure | USA |
2012 | 54 | Home Helpers/Direct Link | Health and fitness | Home, clothing, health, education and leisure | USA |
2012 | 55 | Anytime Fitness | Health and fitness | Home, clothing, health, education and leisure | USA |
2012 | 56 | Home Instead Senior Care | Health and fitness | Home, clothing, health, education and leisure | USA |
2012 | 57 | Pearle Vision | Health and fitness | Home, clothing, health, education and leisure | USA |
2012 | 58 | Mathnasium Learning Centers | Education-related | Home, clothing, health, education and leisure | USA |
2012 | 59 | Kumon North America | Education-related | Home, clothing, health, education and leisure | Japan |
2012 | 60 | Sylvan Learning Centers | Education-related | Home, clothing, health, education and leisure | USA |
2012 | 61 | Gymboree Play and Music | Child-development related | Home, clothing, health, education and leisure | USA |
2012 | 62 | Hilton | Lodging | Home, clothing, health, education and leisure | USA |
2012 | 63 | Choice Hotels International | Lodging | Home, clothing, health, education and leisure | USA |
2012 | 64 | InterContinental Hotels Group (IHG) | Lodging | Home, clothing, health, education and leisure | UK |
2012 | 65 | Motel 6 | Lodging | Home, clothing, health, education and leisure | USA |
2012 | 66 | Hilton Garden Inn | Lodging | Home, clothing, health, education and leisure | USA |
2012 | 67 | Homewood Suites by Hilton | Lodging | Home, clothing, health, education and leisure | USA |
2012 | 68 | Radisson Hotels and Resorts | Lodging | Home, clothing, health, education and leisure | USA |
2012 | 69 | Ramada Franchise Systems | Lodging | Home, clothing, health, education and leisure | USA |
2012 | 70 | CruiseOne | Travel | Home, clothing, health, education and leisure | USA |
2012 | 71 | Plan Ahead Events | Other professional services | Professional services | USA |
2012 | 72 | Martinizing Dry Cleaning | Other professional services | Professional services | USA |
2012 | 73 | Maid Brigade | Other professional services | Professional services | USA |
2012 | 74 | Maids, The (the Maids) | Other professional services | Professional services | USA |
2012 | 75 | UPS Store, The | Other professional services | Professional services | USA |
2012 | 76 | Allegra Print & Imaging | Printing | Professional services | USA |
2012 | 77 | Kwik Kopy Business Centers | Printing | Professional services | USA |
2012 | 78 | Minuteman Press International | Printing | Professional services | USA |
2012 | 79 | Proforma | Printing | Professional services | USA |
2012 | 80 | Sir Speedy | Printing | Professional services | USA |
2012 | 81 | Coffee News | Printing | Professional services | USA |
2012 | 82 | Spherion | Personal services | Professional services | USA |
2012 | 83 | Express Employment Professionals | Personal services | Professional services | USA |
2012 | 84 | ServiceMaster Clean | Maintenance services | Professional services | USA |
2012 | 85 | Maids, The | Maintenance services | Professional services | USA |
2012 | 86 | Weed man | Maintenance services | Professional services | Canada |
2012 | 87 | Vanguard Cleaning Systems | Maintenance services | Professional services | USA |
2012 | 88 | Jani-King International | Maintenance services | Professional services | USA |
2012 | 89 | Chem-Dry Carpet and Upholsery Cleaning | Maintenance services | Professional services | USA |
2012 | 90 | Stratus Building Solutions | Maintenance services | Professional services | USA |
2012 | 91 | Liberty Tax Service | Business-related | Professional services | USA |
2012 | 92 | Pronto Insurance | Business-related | Professional services | USA |
2012 | 93 | Jan-Pro Cleaning Systems | Business-related | Professional services | USA |
2012 | 94 | Padgett Business Services | Business-related | Professional services | USA |
2012 | 95 | AAMCO | Automotive | Professional services | USA |
2012 | 96 | Meineke Car Care Centers | Automotive | Professional services | USA |
2012 | 97 | Midas | Automotive | Professional services | USA |
2012 | 98 | Express Oil Change | Automotive | Professional services | USA |
2012 | 99 | Dollar Rent A Car | Automotive | Professional services | USA |
2012 | 100 | Thrifty Car Rental | Automotive | Professional services | USA |
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Baldi, F. Multi-unit franchising strategies: a real options logic. Econ Polit Ind 43, 175–217 (2016). https://doi.org/10.1007/s40812-016-0031-z
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DOI: https://doi.org/10.1007/s40812-016-0031-z