Trust, Transaction Costs and Contractual Incompleteness in Franchising George Hendrikse Rotterdam School of Management, Erasmus University P.O. Box 1738, 3000 DR Rotterdam, 00-31-10-4088660, The Netherlands ghendrikse@rsm.nl Patrick Hippmann Department of Business Administration University of Vienna Oskar-Morgensternplatz, 1090 Vienna, Austria patrick.hippmann@univie.ac.at Josef Windsperger Department of Business Administration University of Vienna Oskar-Morgensternplatz, 1090 Vienna, Austria josef.windsperger@univie.ac.at Small Business Economics, December 2014 (forthcoming) Abstract The aim of this study is to address empirically the degree of contractual completeness in franchising by combining transaction cost and relational governance perspectives. First, the ratio of specific and residual decision rights is developed as a measure of contractual completeness. Second, we extend the transaction cost perspective of contractual completeness in franchising by arguing that franchisor’s and franchisees’ investments have a negative effect on contractual completeness under bilateral dependence and a positive effect under unilateral dependence. Third, we complement the transaction cost perspective by developing new hypotheses regarding the impact of general and knowledge-based trust on contractual completeness. General trust of the franchisor reduces the franchisor’s perception of relational risk and hence the necessity to control the network relationship by more complete contract planning, and knowledge-based trust increases information sharing between the partners and hence the knowledge base for specifying more detailed contracts. The data from the German franchise sector provide some support of the hypotheses. Keywords: L24, D23 1 Introduction Interfirm networks, such as strategic alliances, joint ventures, consortia, cooperatives and franchise relationships, are governed by formal and relational governance mechanisms. Formal governance mechanisms refer to contractual, authoritative and ownership rules (Hansmann 1996; Hu and Hendrikse 2009; Hippmann and Windsperger 2013; Zhang and Zhou 2013) and relational governance mechanisms refer to the role of trust and norms in interorganizational relationships (Macneil 1983; Zaheer and Venkatraman 1995; Thorgren and Wincent 2011). In recent years, research on governance of interfirm networks has focused on three main research streams: The first research stream investigates the relationship between formal contract and trust, which can be divided into two groups (Cao and Lumineau 2015): Some authors (e.g., Lui and Ngo 2004; Li et al. 2010) suggest that trust may be a substitute for formal contracts as a more effective safeguard mechanism against opportunism risk. On the other hand, trust and formal contracts may be complements (e.g., Poppo and Zenger 2002; Liu, Luo and Liu 2009). Trust increases communication and knowledge sharing and hence the knowledge base for designing more specified formal contracts. Second, more recently, few studies focus on the impact of formal contract on trust by distinguishing contract provisions according to their major functions (control, coordination and adaptation) and separating different dimensions of trust (e.g., Malhotra and Murnighan 2002; Malhotra and Lumineau 2011). For instance, Malhotra and Lumineau (2011) show that control and coordination provisions have a positive effect on competence trust, and control provisions have a negative effect on goodwill trust. The third research stream investigates the impact of trust on the use of formal governance mechanisms (e.g., Gulati 1995; Zaheer and Venkatraman 1995; Hoffmann, Neumann and Speckbacher 2010; Ryu, Min and Zushi 2008; Mumdziev and 1 Windsperger 2013). They show that trust as transaction cost savings mechanism increases the tendency towards interorganizational cooperation and delegation. In this study, we add to the third research stream by examining the impact of trust and transaction cost variables on franchisor’s choice of completeness of franchise contracts. Designing efficient contracts is one of the most important organizational tasks in interfirm networks. However, the theory and practice of contracts exhibit a huge gap (e.g., Lyons 1996; Lafontaine and Slade 1997; Masten 2000; Saussier 2000; Hendrikse 2003; Kaplan and Strömberg 2003; Furlotti 2007; Reuer and Ariño 2007; Eckhard, Mellewigt and Weller 2009; Lumineau and Quélin 2012). On the one hand, contract theory has developed by analyzing either contracts covering all possible contingencies in the complete contracting models in the form of agency relationships (Hölmstrom 1979), or contracts assigning only residual decision rights in the property rights theory (Grossman and Hart 1986; Bolton and Dewatripont 2005; Baker, Gibbons and Murphy 2008). On the other hand, actual contracts are incomplete (Klein, Crawford and Alchian 1978; Williamson 1979; Klein 1995; Hadfield 1990; Scott 2006) and contain both, they specify various clauses covering certain contingencies and assign residual decision rights regarding the issues left open (Grandori and Furlotti 2009). Specific decision rights formulate in detail what the parties have to do in specific circumstances during the contract period. Residual decision rights specify the identity of the party who has the power to decide on the course of action in circumstances not covered by the specific rights (Hansmann 1996; Arruñada, Garicano and Vázquez 2005; Higgins 2007; Hu and Hendrikse 2009; Hippmann and Windsperger 2013). A contract is more complete if the ratio of specific to residual decision rights provisions is relatively high. For instance, applied to franchising, the franchise contract contains two types of clauses (Hadfield 1990; Scott and Triantis 2006): specific decision rights provisions 2 which formulate in detail what the franchisor and franchisee has to do under certain circumstances during the contract period, and residual decision rights provisions which specify the franchisor’s and franchisees’ rights to make certain decisions during the contract period. For example, the franchisor has to regulate the advertising tasks in the contract. He has two possibilities: He can specify in detail the payment of certain advertising fees based on sales and the different promotion and advertising measures, or he can specify who has the right to make certain advertising decisions. In order to determine the degree of contractual completeness of the franchise agreement, the franchisor has to regulate the different tasks (such as training, pricing, advertising, product design, promotion, procurement, recruiting, and investment) by formulating specific and residual decision rights. The more specific decision rights provisions are included in a franchise agreement relative to residual decision rights provisions, the higher is the degree of contractual completeness. In this study, we examine the impact of transaction cost and relational governance factors on the franchisor’s choice of contractual completeness. We argue that the franchisor will choose less complete contracts under high environmental uncertainty and low free-riding risk as well as under a strong bonding effect of franchisor’s and franchisees’ transaction-specific investments. Furthermore, the franchisor’s choice of contractual completeness will be influenced by his/her trust propensity (general trust) and his/her knowledge of the franchise partners’ ability and intention derived from the interaction history (knowledge-based trust). The franchisor will choose less complete contracts when his/her level of general trust is high requiring lower control by formulating less refined contract terms. On the other hand, if the franchisor has a positive interaction history with the network partners, the knowledge base regarding their ability and intention will enable him/her to formulate more 3 complete contracts. We empirically test the effect of these transaction cost and relational governance variables on contractual completeness using data from the German franchise sector. What is the contribution of the study? First, the study develops a new concept of contractual completeness which is defined by the ratio between specific and residual rights included in the contractual agreements. Thereby we provide a precise criterion of differentiation between contractual completeness and contractual complexity; the latter is mainly used in the strategic management literature (e.g., Barthélemy and Quélin 2006; Reuer and Ariño 2007; Lumineau and Quélin 2012). Second, previous research has not investigated the role of trust as determinant of incompleteness of franchise contracts. Based on the relational governance view (e.g., Macneil 1980; Zajac and Olsen 1993; Gulati 1995; Zaheer and Venkatraman 1995; Dyer and Singh 1998; Baker, Gibbons and Murphy 2002), we formulate new hypotheses regarding the impact of knowledge-based trust and general trust on franchisor’s choice of contractual completeness. General trust of the franchisor reduces the franchisor’s perception of relational risk and hence the necessity to control the network relationship by more complete contracts, and knowledge-based trust increases information sharing between the partners and hence the franchisor’s knowledge base for specifying more detailed contracts. Third, we extend the transaction cost view of completeness of franchise contracts (e.g., Solis-Rodriguez and Gonzalez-Diaz 2012) by developing and testing new hypotheses regarding the impact of transaction-specific investments and environmental uncertainty on contractual completeness. Compared to Solis-Rodriguez and Gonzalez-Diaz (2012), we argue that the effect of franchisor’s and franchisees’ transaction-specific investments on contractual completeness is influenced by the dependence of the network partners. Franchisor’s and franchisees’ investments have a 4 negative effect on contractual completeness under bilateral dependence and a positive effect under unilateral dependence. Based on our results, we can conclude that adding trust to the transaction cost model of contractual completeness significantly increases the explanatory power of the research model. The rest of the paper is organized as follows: Section two investigates the concept of contractual completeness. In section three we develop hypotheses to explain contractual completeness in franchising. Finally, we present and discuss the results of the empirical study. 2 The Concept of Contractual Completeness 2.1 Relevant Literature Recent empirical studies show that contractual completeness is a very heterogeneous concept without sufficient theoretical foundation (e.g., Crocker and Reynolds 1993; Saussier 2000; Ariño and Reuer 2005; Luo 2002; Hensher 2010; Mesquita and Brush 2008; Solis-Rodriguez and Gonzalez-Diaz 2012; Chao 2014). Completeness is closely related to other concepts developed in the strategic management and marketing literature: contractual complexity, contract extensiveness and contract specificity. Contractual complexity is measured by the number of key contractual provisions (e.g., Parkhe 1993; Poppo and Zenger 2002; Reuer and Ariño 2002; Barthélemy and Quélin 2006; Reuer, Ariño and Mellewigt 2006; Reuer and Ariño 2007; Hagedoorn and Hesen 2009). Recently, Mellewigt, Madhok and Weibel (2007), Lumineau and Quélin (2012), Malhotra and Lumineau (2011) and Benaroch, Lichtenstein and Wyss (2012) differentiate contractual complexity according to the 5 major functions of the contracts: control/safeguarding and coordination function. For instance, Lumineau and Quélin (2012) operationalize the control function through five key clauses, such as right to audit/inspection, safeguarding the system, control by a third party, having a penalty and resolution clause, and the coordination function through five key clauses, such as assignment of roles and responsibilities, indication of duration and conditions of renewals, organizational and strategic coordination and dispute resolution. Similarly, contract extensiveness, that is, the extent to which obligations and processes are specified in the contract (Anderson and Dekker 2005; Susarla, Subramanyam and Karhade 2010), refers to different types of contractual provisions regarding roles and responsibilities, decisions and control rights, dispute resolution, contingency planning and communication (Mayer and Argyres 2004; Argyres and Mayer 2007). Recently, Chen and Bharadwaj (2009) used four categories of contract provisions to operationalize contract extensiveness: monitoring provisions, dispute resolution, property rights allocation/protection and contingency provisions. The first three cover the control function and the fourth the coordination function. Furthermore, Mooi and Ghosh (2010) use contract specificity to operationalize contractual completeness. Contract specificity indicates the extent to which contract terms with respect to technical specifications of the product, implementation of procedures, financial and legal considerations and overall contractual features are specified in detail. This is similar to those used by Lusch and Brown (1996) and Wuyts and Geyskens (2005). Although these studies explain important aspects of contract design in interfirm networks, they do not provide an answer to the question how to define and operationalize the degree of contractual completeness. This is due to the fact that they 6 do not distinguish contract clauses according to two key features: Does a contract clause precisely define a specific decision action under certain circumstances (Demsetz 1998) or does a contract clause define a specific decision procedure as residual right (Grossman and Hart 1986; Chen 2000; Elfenbein and Lerner 2003; Higgins 2007; Hu and Hendrikse 2009)? The law and economics literature on incomplete contracts already provides some important results regarding the meaning of incompleteness of contracts (Kaplow 1992; Scott 2003; Scott and Triantis 2005, 2006). According to this research, contract clauses refer to rules and standards. The process of specifying contract terms proceeds along a continuum that extends from narrow rules as substantive provisions (or specific rights) to standards as procedural provisions (or residual rights) (Scott 2006). In the following, we develop this concept of contractual completeness in more detail. 2.2 Completeness and Specific versus Residual Rights Three types of contracts can be distinguished in the theory of contracts. First, complete contingent contracts were introduced by Arrow and Debreu in their models of market equilibrium (Hendrikse 2003). These contracts can be made contingent on all the relevant contingencies because all relevant information is known to all parties and costlessly available. Second, complete contracts started to be analyzed in the late 1960s and 1970s. The introduction of private information and hidden actions (e.g., moral hazard problems) prevents contracts being based on all relevant contingencies. However, contracts are still complete because they specify an action for each information set, that is, complete contracts are made contingent on all the observable information. Finally, Williamson (1975; 1979; 1983), Klein, Crawford and Alchian (1978) and Grossman and Hart (1986) started the analysis of incomplete contracts. 7 Incomplete contracts are to be positioned at the other extreme in terms of the costs of writing contracts because it is assumed, due to cognitive boundaries, that writing contracts is prohibitively expensive or not possible. A contract which only specifies who has the right to decide when a certain contingency arises is incomplete. It consists only of residual rights specifying the person with decision authority. Actual contracts consist usually of specific as well as residual rights, that is, some contractual clauses regarding decision actions are specified, while the remaining contingencies are covered by assigning residual right(s) to the contract parties. There are various reasons for residual rights due to non-contractibility of decision actions. Examples of this are: a lack of insight of the people involved, the costs of writing contractual clauses and determining the optimal course of action, measurement costs, the imprecision of language, and environmental uncertainty. The above observations argue in favor of defining the incompleteness of contracts in terms of specific decision rights (sDR) and residual decision rights (rDR). Contractual completeness is defined as the number of specific decision rights divided by the sum of specific decision rights and the residual decision rights. It follows immediately from sDR/(sDR+rDR) = 1/(1+rDR/sDR) that a change in the completeness of contracts is the same as a change in the ratio between specific and residual rights (sDR/rDR). The higher the fraction of specific rights compared to residual rights specified in the contract, the higher the degree of contractual completeness; and the higher the fraction of residual rights is compared to specific rights, the lower the contractual completeness. sDR/rDR depends on the contractibility of knowledge. When contractibility is low, the use of assets is primarily regulated by assigning residual decision rights, and when contractibility of knowledge is high, the use of assets is primarily regulated by assigning specific decision rights to the contract 8 partners. For example, the franchisor has to regulate the procurement tasks in the contract. He has two possibilities: He can specify in detail the procurement of the input goods by specifying product quality and suppliers, or he can specify who has the right to make the procurement decisions. A franchise contract is more complete when the ratio between specific and residual rights is high. This view is compatible with the adaptation view of governance (Simon 1951; Williamson 1975; Gibbons 2005; Tirole 2009) that formulates a trade-off between preplanning of decision actions (as specific rights) and the planning of decision procedures (as residual rights). To summarize, we can conclude that contractual completeness is defined by the relationship between specific and residual decision rights. The lower the contractibility of knowledge (e.g., due to high asset intangibility of and uncertainty), the lower is the probability to formulate specific rights and the more residual decision rights regarding the different value chain activities are assigned to the contract partners, and hence the lower is the degree of contractual completeness. 2.3 Completeness versus Contractual Complexity After defining contractual completeness, we address the question what is the relationship between contractual complexity and contractual completeness. Although recent studies differ widely in their approach and definition of complexity (e.g., Parkhe 1993; Kole 1997; Reuer and Ariño 2007; Barthélemy and Quélin 2006; Reuer, Ariño and Mellewigt 2006; Mellewigt, Madhok and Weibel 2007; Hagedoorn and Hesen 2009; Malhotra and Lumineau 2011; Benaroch, Lichtenstein and Wyss 2012; Lumineau and Quélin 2012), the main characteristics of contractual complexity can be defined as follows: Complex contracts have detailed specification of promises and obligations, responsibilities to be performed, procedures for monitoring, dispute 9 resolution and adaptation and determine in detail outcomes or outputs to be delivered. The more clauses are specified in a contract, the higher is its degree of complexity. Compared to our completeness concept, complexity refers to the sum of specific decision rights and residual decision rights (rDR + sDR). Hence completeness and complexity are related as follows: A more complex contract can be both more or less complete (Eggleston, Posner and Zeckhauser 2000), depending on the attributes of the transactions. If, under a low level of uncertainty (i.e., high contractibility situation) the contract has a higher number of detailed provisions regarding the partners’ actions in different environmental situations and a low number of provisions regarding residual decision rights, the contract has a high degree of completeness and complexity. On the other hand, if, under a high level of uncertainty (i.e., low contractibility situation) the contract has a high number of provisions regarding the assignment of residual decision rights and a low number of provisions regarding specific rights, the contract has a high degree of complexity, but a low degree of completeness. Therefore, complexity and completeness only go hand-in-hand when the use of assets can be specified in detail in the contract due to high contractibility. On the other hand, complexity and completeness are negatively related when the use of assets is costly and difficult to specify in a contract due to low contractibility of knowledge but the contract specifies in detail the assignment of residual decision rights. Consequently, consistent with the view of Williamson (1985) and Ariño and Reuer (2005), we can conclude that complexity is a design feature of a contractual agreement and contractual completeness is relative to the attributes of the transaction (i.e., uncertainty and asset intangibility). For instance, a franchise contract with a simple transaction (e.g., standardized system know how under product franchising) may not be complex but relatively complete, while a franchise contract with a complex transaction (e.g., complex and intangible 10 system know-how under business format franchising) may be complex but very incomplete. 3 The Impact of Transaction Costs and Trust on Contractual Completeness in Franchising In recent years, few researchers in organizational economics and regulatory theory have examined questions of contract design in franchising (e.g., Lafontaine and Slade 2014). In organizational economics, most of the authors have studied interaction effects between different contract provisions. Wimmer and Garen (1997) have shown that specific assets act as an implicit bond and substitute for a reduced royalty rate in inducing franchisee efforts. Brickley (1999) presented an agency cost explanation of the complementarities between mandatory advertising and area development plans, restrictions on franchisees’ outside activities and area development plans, and between mandatory advertising and restrictions of outside activities. Bercovitz (1999) applied transaction cost reasoning to analyze interactions between contract provisions. She found that the initial fees and the duration of franchise contracts are positively related with the relationship-specific investments. In addition, she argued that the hostage function of specific investments could be increased by including termination conditions. By applying Klein’s self-enforcing contracts view (Klein 1995, 1996), Lafontaine and Raynaud (2000) examined complementarities between residual claimancy rights and self-enforcement mechanisms, such as exclusive territory clauses, multi-unit ownership guarantees, contract renewal and termination rights. They argued that the dilution of the franchisee’s residual income rights requires the use of selfenforcement mechanisms to increase the franchisee’s incentive to maximize the residual surplus of the network. Furthermore, Arruñada, Garicano and Vázquez (2001; 11 2005) and Windsperger (2003) advanced the literature by analyzing the entire system of rights in franchise contracts. Arruñada, Garicano and Vázquez (2001) found some complementarities between completion and termination rights, and between monitoring rights and incentives in the automobile distribution, and Windsperger (2003) found complementarities between residual decision rights and ownership rights. In regulatory theory, Steinberg and Lescatre (2004) and Spencer (2006; 2008a) investigated regulatory and contract design issues in franchising. Although these studies offer explanations of certain contract clauses in franchise relationships, they do not explain the factors that influence incompleteness of franchise contracts. An exception is Solis-Rodriguez and Gonzalez-Diaz (2012) who examine the determinants of contractual completeness in franchising from transaction cost economics and capability perspectives. They show that contractual completeness varies positively with transaction-specific investments, franchisor reputation and interorganizational experience. First, we extend the transaction cost view of SolisRodriguez and Gonzalez-Diaz (2012) by arguing that the impact of franchisor’s and franchisees’ transaction-specific investments depends on the symmetry or asymmetry of transaction-specific investments. In addition, we add environmental uncertainty as transaction cost variable. Second, we complement the transaction cost view by examining the impact of knowledge-based trust and general trust on the franchisor’s choice of contractual completeness. 12 3.1 Transaction Cost View of Contractual Completeness According to the transaction cost theory (e.g., Williamson 1979, 1985; Joskow 1990; Saussier 2000; Blumberg 2001), transaction-specific investments and uncertainty (environmental and behavioral uncertainty) influence contractual completeness. Transaction-specific investments Based on transaction cost economics reasoning, transaction-specific investments influence the network partners’ quasi-rents which can be expropriated by the less dependent partner (Heide and John 1988; Windsperger 1996; Klein 1995, 2000). According to Klein (1996, p. 449), an agreement is within the “self-enforcing range” if the quasi rents of the partners exceed the potential hold-up gains from opportunistic behavior. What is the impact of franchisor’s and franchisees’ transaction-specific investments on completeness of franchise contracts? We distinguish two cases: (I) Bilateral dependence. When both the franchisor and franchisees have to undertake high transaction-specific investments (Heide and John 1988), both partners’ quasi-rents are likely to exceed the potential hold-up gains from opportunistic behaviour. In this case, the franchise agreement is within the self-enforcing range. The bonding effect of transaction-specific investments motivates both partners to behave cooperatively in order to realize the relationship-specific quasi-rents (Williamson 1983; Katz 2008). Additionally, inside the self-enforcing range of contracts, the parties frequently disregard verifiable contract terms (e.g., measures of performance) in favour of nonverifiable contract terms in order to enhance the relationship-specific surplus (Scott 2003, p. 1676; Baker and Krawiec 2005). Consequently, the value-creating effect of bilateral specific investments increases the self-enforcing range of franchise contracts and reduces both franchisor’s and franchisees’ necessity for control by 13 specifying detailed contract terms. Hence the network partners will use more incomplete contracts (Scott 2003). We can derive the following hypotheses: H1a/H1b (Bilateral dependence): Franchisor’s and franchisees’ transactionspecific investments will negatively influence contractual completeness. (II) Unilateral dependence. When the franchisor’s transaction-specific investments are high (e.g., expenses for training, site selection, technical support) relative to the franchisees’ investments, he/she is subject to increasing hold-up risk since the franchisees may exploit the higher quasi-rent stream of the franchisor. In this case, the relationship is outside the self-enforcing range of contracts. Hence the franchisor will protect his/her investments against opportunistic expropriation on the part of franchisees by using more complete contracts (Goldberg and Erickson 1987; Joskow 1988; Saussier 2000). On the other hand, when franchisees’ transaction-specific investments are high relative to the franchisor’s investments, he/she is subject to increasing hold-up risk by the franchisor. In this case, the franchisee wants to protect his/her relationship-specific quasi-rents against opportunistic expropriation on the part of franchisor by using more safeguarding provisions. However, it is important to note that if there are diverging interests between the franchisor and franchisees with regard to contractual completeness, the franchisor’s greater bargaining power may not support the inclusion of contract clauses to safeguard franchisees’ investments against expropriation risk (Spencer 2008b; Ozmel et al. 2013). We formulate the following hypotheses: H2a/H2b (Unilateral dependence): Franchisor’s and franchisees’ transactionspecific investments will positively influence contractual completeness. 14 Environmental Uncertainty Environmental uncertainty refers to market, competitive and institutional uncertainty. Based on transaction cost economics reasoning several studies investigate the impact of environmental uncertainty on interorganizational networks (e.g., Heide and John 1990; Noordewier, John and Nevin 1990; Stump and Heide 1996; Geyskens, Steenkamp and Kumar 2006). According to the adaptation view of contractual governance (Simon 1951; Gibbons 2005; Tadelis and Williamson 2013), higher environmental uncertainty prevents the franchisor from setting up detailed contract terms and increases the need of ex-post adaptations by allocating residual decision rights (Gilson, Sabel and Scott 2009; Kosnik 2014). Ex-post adaptation problems result in high ex-post transactions costs under high environmental uncertainty when highly specified contracts are set up at the beginning of the contract period. Therefore, the higher the environmental uncertainty, the more difficult and costly is the planning of decision actions by formulating specific decision rights in the ex-ante period, and the more residual rights are assigned to the franchise partner. This is summarized in the following hypothesis. H3: Environmental uncertainty will negatively influence contractual completeness. Free-riding Risk Agency problems arise from behavioral uncertainty due to shirking and free-riding. Hence one major issue in franchise relationships is free-riding on the part of franchisees (Klein 1980; Lal 1990; Kidwell, Nygaard and Silkoset 2007). The franchisor may use specific contract provisions to protect against potential opportunistic behavior through free-riding (Bercovitz 1999; Solis-Rodriguez and Gonzalez-Diaz 2012). Free-riding 15 hazards are positively related to the value of the brand name of the franchise system (Klein 1995). The higher the brand name value, the higher the franchisor’s free-riding risk due to behavioral uncertainty, and the more specific decision rights clauses are included in franchise contracts. We derive the following hypothesis: H4: The brand name value will positively influence contractual completeness. 3.2 Relational Governance View on Contractual Completeness Based on Macneil (1980; 1983), Heide and John (1992), Dyer and Singh (1998) and Dyer (1999), the relational governance view focuses on the role of trust, norms and solidarity in interfirm relationships to reduce relational risk and facilitate information sharing between the contract partners. Recent research results on interfirm alliances show that trust is an important relational governance mechanism leading to higher relational rents due to savings of transaction costs and/or an increase of transactional value (e.g., Zajac and Olsen 1993; Dahlstrom and Nygaard 1995; Dyer and Chu 2000; Puranam and Vanneste 2009; Hayter 2013; Gurcaylilar-Yenidogan and Windsperger 2014). Although several studies investigate the role of trust in franchise relationships (e.g., Cochet, Dormann and Ehrmann 2008; Croonen 2008, 2010; Dickey, McKnight and George 2008; Bertrandias, Fréchet and Lumineau 2010; Dant et al. 2013; Davies et al. 2011; Mumdziev and Windsperger 2013), no study examines the impact of trust on completeness of franchise contracts. In the following, we try to close this gap in the franchise literature. The concept of trust used in previous research is heterogeneous, due to the multidisciplinary focus of trust research (e.g., Williamson 1993; Mayer, Davis and Schoorman 1995; Nooteboom 1996; McKnight and Chervany 2006; Colquitt, Scott and LePine 2007; Chua, Roy Yong Joo, Ingram and Morris 2008; Robert, Denis and Hung 16 2009; Malhotra and Lumineau 2011). However, the various types of trust can be differentiated into two main facets (Yamagishi 2011; Yamagishi and Yamagishi 1994): knowledge-based trust and general trust. Knowledge-based trust is based on “information accumulated over a […] history of interactions with the partners” (Yamagishi and Yamagishi 1994, p. 194). More specifically, it refers to the ability/competency and the goodwill/intention of the partner (e.g., McAllister 1995; Nooteboom 1996; Das and Teng 2004; Malhotra and Lumineau 2011). On the other hand, general trust exists without having an interaction history with the trustee and is mainly influenced by the trustor’s personality traits. In the following, we examine the impact of trust on the franchisor’s choice of contractual completeness by differentiating between the two types of trust. Knowledge-based Trust and Contractual Completeness Knowledge-based trust refers to trust that evolves over a period of repeated interactions with an exchange partner. It has a cognitive effect by increasing the trustor’s knowledge base about the ability and intention of the trustee derived from the interaction history (Gassenheimer, Baucus and Baucus 1996). Repeated positive interactions signal credibility and increase the ‘relationship-specific’ reputation and trust in the exchange partner (Anderson and Weitz 1989; Ganesan 1994). Therefore, knowledge-based trust facilitates information sharing and increases the knowledge base for designing more complete contracts as formal governance mechanism (Lazzarini, Miller and Zenger 2008). Applied to the franchisor-franchisee relationships, franchisor’s positive experience with franchisees during the contract relationship signals high credibility and increases the franchisor’s trust in his/her network partners. In particular, knowledge- 17 based trust improves information exchange between the franchise partners and enables the franchisor to formulate more detailed contract terms as “reference points” (Hart and Moore 2008; Bozovic and Hadfield 2012) that specify the self-enforcing range of contracts (Klein 2000). Consequently, under a high level of knowledge-based trust the franchisor uses more complete contracts. We formulate the following hypothesis: H5: Franchisor’s knowledge-based trust will positively influence contractual completeness. General Trust and Contractual Completeness General trust means that an individual has a positive view of the others and considers the others as trustworthy, even if he/she has no experience with those other people (Yamagishi 2011; Yamagishi and Yamagishi 1994). Therefore, general trust leads to the perception of lower relational risks by the trustor (Das and Teng 2004) and results in the use of less specified contracts as formal governance mechanism. Applied to the franchisor-franchisee relationship, under a high level of general trust the franchisor perceives lower relational risk and hence lower agency and monitoring costs, under given exchange hazards, which leads to a lower propensity of the franchisor to control the franchise partners. When applied to the choice of contractual completeness, a hightrust franchisor expects lower agency and monitoring costs, under given exchange hazards. Therefore, a high level of general trust reduces the franchisor’s necessity for formal contract planning. Consequently, a high-trust franchisor is likely to use less specified contracts by formulating fewer specific decision rights provisions. We derive the following hypothesis: H6: Franchisor’s general trust will negatively influence contractual completeness. 18 Our research model based on transaction cost and the relational governance perspectives of contractual completeness can be summarized as follows (see Figure 1): First, by applying transaction cost theory, contractual completeness varies negatively with bilateral transaction-specific investments of the franchisor and franchisees and environmental uncertainty, and positively with unilateral transaction-specific investments and the brand name value. Second, according to the relational view, general trust mitigates contractual hazards due to the perception of lower relational risk and reduces the franchisor’s necessity to preplan decision actions by formulating more specific contract terms. Conversely, knowledge-based trust increases information sharing and the knowledge base about the franchise partners and hence enables the formulation of more refined contract terms. Insert Figure 1 4 Empirical Analysis 4.1 Sample and Data Collection Empirical data to test the hypotheses were collected from the German franchise sector. The directory of the German Franchise Federation (DFV) and “Franchise Wirtschaft” (a Bond’s Franchise Guide type directory published in Germany) list all franchise systems operating in the country. Various demographic data (i.e., year system was established, number of outlets, business sector, etc.) is also listed regarding each system in the “Franchise Wirtschaft”. These directories list 837 franchise systems operating in Germany and served as the sampling frame for this study. The judgmental 19 sampling was employed and the sample was drawn on the basis of the following two criteria: (1) The system should have at least five outlets in Germany. (2) If the data about the number of outlets is not listed in the directory, the system should have started franchising in Germany before year 2008. The final sample consisted of 491 franchise systems. The data were collected via a self-administered questionnaire which was developed in several steps. After several preliminary refinements, we conducted indepth interviews with franchise professionals from the Austrian and German franchise associations and a pre-test with 20 franchisors in Austria. The respondents were selected on their expertise and relevance to the subject under investigation. This demonstrates the use of the key informant approach for data collection (John and Reve 1982). Accordingly, the key informants for this study were senior managers (general managers or franchise expansion mangers) who are mainly responsible for the franchise expansion. The information about the key informants was retrieved from the “Franchise Wirtschaft”. The personally addressed questionnaires were mailed to the key informants of all 491 relevant franchise systems in Germany. We received back 137 filled-out questionnaires with a response rate of 28%. To check for non-response bias, we use two methods. First, non-response bias was estimated by comparing early versus late respondents (Armstrong and Overton 1977), where late respondents serve as proxies for non-respondents. Second, the respondents were compared to non-respondents in terms of age, size, advertising fee, and royalties to determine whether non-response was a serious problem for the data. These variables are available in the “Franchise Wirtschaft” for all of the listed systems. We used these data to run independent sample t-tests in order to check whether the 20 sample is representative. We found no significant difference between the respondents and the non-respondents (see Table 1). Based on Podsakoff et al. (2003), we used Harman’s single-factor test to examine whether a significant amount of common method variance exists in the data. After we conducted factor analysis on all items and extracted more than one factor with eigenvalues greater than one, we felt confident that common method variance is not a serious problem in our study. Insert Table 1 4. 2 Measurement To test the hypotheses the following variables are important: contractual completeness, transaction-specific investments, environmental uncertainty, franchisor brand name, and knowledge-based and general trust (see appendix). Contractual completeness Previous research uses very different measures for contractual completeness (e.g., Crocker and Reynolds 1993; Saussier 2000; Luo 2002; Ariño and Reuer 2005; Hensher 2010; Solis-Rodriguez and Gonzalez-Diaz 2012; Chao 2014). A large number of studies use an index of clauses or subjective indicators (multidimensional constructs), and some studies use the number of words (Kosnik 2014) or index of contingencies (Solis-Rodriguez and Gonzalez-Diaz 2012) as measure for contractual completeness. In addition, many studies do not explicitly distinguish between completeness and complexity which is due to the fact that they do not differentiate the contract clauses according to the feature of specific and residual rights (Chen 2000). Based on our concept of contractual completeness, we use indicators for specific decision rights and residual decision rights to measure contractual 21 completeness. Hence completeness addresses the extent to which provisions regarding specific and residual rights of the franchisor and the franchisee are included in the contract. Specific decision rights (sDR) are contract provisions which formulate in detail what the contact partners have to do under certain circumstances, and residual decision rights (rDR) are contract provisions which specify the contract partners’ rights to make certain decision during the contract period. The general managers were asked to rate specific and residual rights with a two-item seven-point Likert scale: (a) Specific decision rights: “The tasks of the franchisor regarding the value chain activities at the local outlets are specified in detail in the contract”; and “the tasks of the franchisees regarding the value chain activities at the local outlets are specified in detail in the contract” (Cronbach’s alpha is .871). (b) Residual decision rights: “The decisions of the franchisor regarding the value chain activities at the local outlets are specified in detail in the contract”; and “the decisions of the franchisees regarding the value chain activities at the local outlets are specified in detail in the contract” (Cronbach’s alpha is .909). Since completeness is operationalized by subjective indicators, we test the impact of the transaction cost and relational governance variables on sDR and rDR separately. Transaction-specific investments Based on Heide and John (1990) and Stump and Heide (1996), the franchisor’s transaction-specific investments (INV_FOR) are operationalized by the following scale: The general managers were asked to rate the transaction-specific investments with a three-item scale: “To what extent does the franchisor bear the initial training costs of the franchisee/the technical support at the beginning of the contract period/the set-up costs of the outlet?”. Cronbach’s alpha for this scale is .632. The franchisee’s 22 transaction-specific investments (INV_FEE) are measured by franchisees’ initial investments at the beginning of the contract relationship (Dnes 1993; Windsperger 2004). Environmental uncertainty Environmental uncertainty (ENV) results in high ex-post transaction costs under highly specified contracts. Consistent with previous studies we operationalize environmental uncertainty with a three-item scale (e.g., John and Barton A. Weitz 1988; Celly and Frazier 1996). The franchisors were asked to provide their perception regarding the fluctuation in the outlet level sales, unpredictability of the market, and volatility of local economic situation. The reliability of this scale was assessed by Cronbach’s alpha (.742). Franchisor brand name If a franchisor’s brand name (BRAND) is of high value, the franchisor will face a higher free-riding risk. Franchisors were asked to indicate (on a four-item seven point scale) how important their brand name is in terms of recognition and strength compared to their competitors, and competitive advantage (e.g., Barthélemy 2008). Cronbach’s alpha is .811. Trust We differentiate between knowledge-based trust and general trust (KTRUST, GTRUST). Table 2 presents the results of the factor analysis. Insert Table 2 23 Knowledge-based Trust (KTRUST): Derived from Yamagishi and Yamagishi (1994) and Dyer and Chu (2000), KTRUST is measured using a four-item seven-point Likert-type scale. The franchisors were asked to rate the level of trust based on their interaction experience with the business partners (franchisees). Cronbach’s alpha for this variable is .876. General Trust (GTRUST): Based on Yamagishi and Yamagishi (1994) and Lazzarini, Miller and Zenger (2008), we measure this variable with a three-item sevenpoint Likert-type scale. The franchisors were asked questions about their general attitude and opinion towards trusting others. The items refer to ‘most people trust others, most people are trustworthy and most people behave cooperatively if they are trusted’. Cronbach’s alpha for GTRUST is .806. Control Variables Size (SIZE): We control for the firm size (e.g., Lyons 1996; Banerjee and Duflo 2000; Susarla, Subramanyam and Karhade 2010). The SIZE of the firm refers to the total number of outlets representing economies of scale through standardization. The larger the total number of outlets, the larger are economies of scale through standardization due to lower average contractual set-up costs, and hence the higher the tendency towards using more specified contractual provisions (Lyons 1996). Therefore, we use the number of total outlets as indicator for economies of contract standardization. Age (AGE): Age is a proxy for inter-organizational experience and learning. Prior relationships may allow for the design of more complete contracts because the franchisor develops contract design capabilities (Argyres, Bercovitz and Mayer 2007; Solis-Rodriguez and Gonzalez-Diaz 2012). 24 Contract duration (DUR): Since a long-term contract reduces the franchisor’s flexibility to adjust the contractual relations in the ex-post period, the franchisor is likely to specify more contingencies in the franchise contract to cover more possibilities due to the long-term perspective of the relation (Chen and Bharadwaj 2009). Sector (SEC): This is a dichotomous variable: 0 refers to product franchising and 1 to services franchising. Since services franchising firms are characterized by more intangible and hence less codifiable know-how compared to product franchising firms, we expect a lower degree of contractual completeness for services firms. 4.3 Results Table 3 presents the descriptive data for the sample in Germany. Insert Table 3 We test our research model (see Figure 1) by conducting a seemingly unrelated regression (SUR) analysis with contractual completeness operationalized by specific and residual decision rights (sDR, rDR) as dependent variables. We examine the impact of the transaction cost and relational governance variables on sDR and rDR separately. The explanatory variables refer to transaction-specific investments of the franchisor and franchisees (INV_FOR, INV_FEE), environmental uncertainty (ENV), franchisor brand name (BRAND), knowledge-based and general trust (KTRUST, GTRUST), SIZE, AGE, contract duration (DUR) and sector (SEC). Table 4 presents the correlations of the variables used in the regression analysis. In addition, the variance inflation factors are well below the rule-of-thumb cut-off of 10. In sum, we do not find any collinearity indication. 25 Insert Table 4 Table 5 reports the results of the seemingly unrelated regressions (SUR) (Zellner 1962) for sDR and rDR. We used SUR as it can be expected that equation residuals are correlated. The Breusch-Pagan tests confirmed this assumption for all three sets of equations with p=0.000. We proceed in three steps: In model 1a and 1b we test the impact of the control variables (SIZE, AGE, DUR and SEC) on sDR and rDR, in model 2a and 2b we test the transaction cost hypotheses (H1a, H1b, H2, H3) and in model 3a and 3b the relational governance hypotheses (H4, H5). Insert Table 5 Control variables: Based on the data from the German franchise sector, we find that contract duration (DUR) has a positive and significant impact on both specific rights and residual decision rights provisions (sDR, rDR). This may indicate that as the length of franchise contract increases, so does its flexibility and specification by using both more rDR and sDR provisions. In addition, we find that the coefficient of SEC is negative and significant in model 1a and 1b indicating that the franchisor will use less formal contract planning in the service sector compared to the product franchising sector. The coefficients of the control variables (SIZE and AGE) are not significant. Transaction cost hypotheses: We find that franchisees’ transaction-specific investments (INV_FEE) have a negative and significant influence on the use of sDR as well as rDR indicating that higher INV_FEE increase the bonding effect and reduce the franchisor’s necessity to use more specified contract provisions as safeguarding mechanism. In addition, the impact of franchisors’ transaction-specific investments 26 (INV_FOR) on rDR is positive and significant but their impact on sDR is not significant. This may indicate that the franchisor who is strongly dependent on the network partners, due to high transaction-specific investments, will rather formulate more residual decision rights in the contract in order to protect his/her system-specific knowhow and brand name against opportunism risk and to increase contractual flexibility during the contract period. Furthermore, we find that the impact of franchisor brand name (BRAND) on sDR is positive and significant. This implies that a strong brand name may be associated with high free-riding hazards leading to more complete contracts by formulating more specific decision rights provisions. On the other hand, the coefficient of environmental uncertainty (ENV) is not significant. This non-significant result is consistent with recent studies on contract design (e.g., Chen and Bharadwaj 2009; Benaroch, Lichtenstein and Wyss 2012). Relational governance hypotheses: We add knowledge-based and general trust (KTRUST, GTRUST) as relational governance variables in our regression model (model 3a, 3b). We find that the impact of general trust (GTRUST) on sDR is negative, as expected, and highly significant. This is consistent with the view that high-trust franchisors perceive a lower relational risk and expect fewer agency problems in the ex-post period. Therefore, they will not set up highly specified contracts based on sDR to control opportunism. On the other hand, the results show that knowledge-based trust (KTRUST) does not significantly influence contractual completeness. Overall, we can conclude that R Squared significantly increased from 0.266 to 0.324 when adding knowledge-based and general trust (KTRUST, GTRUST) to the transaction cost model (see Table 5), which indicates that trust is an important determinant of contractual completeness in franchising. 27 5 Discussion and Implications 5.1 Discussion The aim of the paper is to explain the franchisor’s choice of contractual completeness by developing and testing hypotheses derived from the transaction cost theory and the relational governance view. Starting from the recent literature, which shows that contractual completeness is a very heterogeneous concept without sufficient theoretical foundation, we develop a new concept of contractual completeness defined by the ratio between specific and residual decision rights stipulated in contracts. The results of the empirical study on incompleteness of contracts in the German franchise sector provide some support of our hypotheses. First, according to the transaction cost theory the use of specific rights (sDR) provisions varies negatively with franchisees’ transaction-specific investments and environmental uncertainty, and positively with the brand name. The data confirm the negative relationship between the use of specific decision rights provisions and franchisees’ transaction-specific investments. The bonding effect of franchisees’ transaction-specific investments enables the franchisor to reduce formal control by formulating less complete contracts. The negative relationship between franchisees’ transaction-specific investments and completeness contradicts with the result of Solis-Rodriguez and Gonzalez-Diaz (2012). This deviation is due to the fact that Solis-Rodriguez and Gonzalez-Diaz (2012) do not take into account the different effects of franchisees’ and franchisor’s transactionspecific investments on completeness under bilateral and unilateral dependence. Furthermore, the data support the positive impact of franchisor brand name on the use of more specific decision rights provisions. Contrary to results in the contract literature (e.g., Crocker and Reynolds 1993; Saussier 2000), the impact of environmental 28 uncertainty on contractual completeness is not significant. This might be due to the ambiguous effect of uncertainty on formal governance in the transaction cost literature (e.g., Walker and Weber 1984; Blumberg 2001; Poppo and Zenger 2002). On the one hand, environmental uncertainty requires more adaptability (Klein 1989) and hence less complete contracts, and on the other hand, the franchisor may increase control (Noordewier, John and Nevin 1990) by formulating more specific rights when the degree of uncertainty increases. In addition, residual decision rights (rDR) vary negatively with the franchisees’ transaction-specific investments, which is compatible with the self-enforcing range of contract view. High franchisees’ transaction-specific investments increase the selfenforcing range of contracts and hence reduce the franchisor’s general requirement for formal contract planning by using both specific and residual decision rights provisions. On the other hand, residual decision rights vary positively with the franchisor’s transaction-specific investments. Residual decision rights provisions enable the franchisor to react more flexibly if ex-post adaptation problems arise. Hence compared to specific decision rights provisions, residual decisions rights provisions are more efficient to protect against opportunism risk under high franchisor’s specific investments. This may explain their non-significant impact on specific decision rights (sDR) (see Table 5). Second, based on the relational governance view, we investigate the relationship between trust and contractual completeness. According to Yamagishi and Yamagishi (1994), we differentiate between knowledge-based and general trust. Our data support the view that franchisors’ general trust in their franchise partners results in the perception of lower relational risk and therefore requires less specific decision rights provisions in franchise contracts. However, the impact of knowledge-based trust on 29 contractual completeness is not significant in franchise relationships. One explanation could be that the knowledge acquisition effect of repeated interactions with an exchange partner is less relevant in franchising because the franchisor designs more standardized franchise contracts, which are not closely adjusted to the interaction history of the different franchise partners. 5.2 Implications How does this study extend the results in the literature? The major contribution of this study is the development of a new theoretical concept of contractual completeness and its application to incompleteness of contracts in franchising by combining transaction cost economics and the relational governance perspectives. First, the franchise contract consists of two types of contract provisions: specific decision rights which specify in detail what the franchisor and franchisee has to do under certain circumstances during the contract period, and residual decision rights as contract provisions which specify the franchisor’s and franchisees’ rights to make certain decisions during the contract period. Contractual completeness is defined by the relationship between specific and residual decision rights stipulated in contracts. A franchise contract is more complete if the franchisor’s and franchisees’ value chain activities at the local outlets are more regulated by specific rights and less by residual rights. By defining contract provisions according to specific versus residual decision rights features, we provide a precise criterion to distinguish between contractual completeness and contractual complexity. Complexity does not explicitly differentiate between specific and residual rights provisions in the contract. Second, we extend the transaction cost view of contractual completeness in franchising by testing new hypotheses regarding the impact of transaction-specific 30 investments and environmental uncertainty on incompleteness of franchise contracts. Specifically, compared to Solis-Rodriguez and Gonzalez-Diaz (2012), we argue that the effect of franchisor’s and franchisees’ transaction-specific investments on the degree of contractual completeness is influenced by the dependence of the network partners. Under bilateral dependence franchisor’s and franchisees’ transactioninvestments have a negative impact and under unilateral dependence they have a positive impact on contractual completeness. Third, this is one of the first studies that investigate the impact of different dimensions of trust on formal contracts (Lazzarini, Miller and Zenger 2008; Cao and Lumineau 2015). Previous research has not investigated the role of trust as determinant of contractual completeness in franchising. We complement the transaction cost view by examining the impact of knowledgebased trust and general trust on the franchisor’s choice of contractual completeness. Our results show that general trust is an important determinant of incompleteness of franchise contracts. Therefore, Overall, the paper adds to the existing work on interfirm networks that combines transaction cost and relational governance perspectives. Consistent with the interorganizational governance literature (e.g., Zaheer and Venkatraman 1995), the extension of the transaction cost reasoning by the relational governance view significantly increases the explanatory power of the research model. The results of this study have some implications for the franchisor’s choice of contractual completeness: For instance, our results suggest that the franchise contract should contain relatively more specific decision rights provisions under a strong brand name, low transaction-specific investments of the franchisees compared to the franchisor and a low level of franchisor’s general trust: More specific decision rights provisions will protect the franchisor against the free-riding and hold-up risks when the 31 brand name value is high and the franchise agreements are not self-enforcing due to relatively low franchisees’ transaction-specific investments. In addition, more specific decision rights provisions will ensure a higher level of control by the franchisor when his/her level of general trust is low. 5.3 Limitations This study has important limitations: First, the major limitation of our study results from the operationalization of contractual completeness. The measurement of contractual completeness is only a first step to operationalize contractual completeness. We test the impact of the transaction cost and relational governance variables on contractual completeness by using subjective indicators for specific and residual decision rights. However, the generalizability of our results would require the development of more valid indicators for specific and residual decision rights. Future studies have to use objective measures based on provisions in franchise contracts. Second, we measure all constructs from the franchisor’s point of view. For instance, we use the franchisor’s perception to measure environmental uncertainty. This issue should be addressed in future studies by collecting data from the franchisees. Third, while our transaction cost and relational governance variables are important determinants of contractual completeness, other variables not included in the study may affect contractual completeness in franchising. In addition to the transaction cost and relational governance explanations, variables derived from organizational capability and bargaining power theory may influence incompleteness of franchise contracts. According to the organizational capability theory (e.g., Mayer and Argyres 2004; Argyres and Mayer 2007; Solis-Rodriguez and Gonzalez-Diaz 2012), franchisors develop contract design capabilities through interorganizational learning which enables 32 them to formulate more complete contracts. In addition, based on the bargaining power perspective (e.g., Ben-Shahar and White 2006; Choi and Triantis 2012), we expect that a strong bargaining power of the franchisor may influence the degree of contractual completeness. For instance, Ozmel et al. (2013) show that the bargaining power of alliance partners affect both the contractual complexity and the allocation of residual rights in alliance contracts. Finally, we made the distinction between specific and residual decision rights. However, franchise contracts are characterized by two forms of incompleteness: One form of incompleteness is covered by the residual decision rights. They do not specify a course of action regarding many contingencies, but only the identity of the party who has authority to decide when one of these contingencies arises. The other type of incompleteness refers to the standardization of system-specific know how by using the business format. It implies a certain “rule-governed behaviour” (Heiner 1983, p. 568; Heiner 1986) and entails a certain rigidity because it standardizes behavior across outlets regardless of the local circumstances. This raises the question regarding the appropriate limits of uniformity (Kaufmann and Eroglu 1999). Battigalli and Maggi (2002) label these two forms of incompleteness as discretion and rigidity. Future work has to address the circumstances when these forms of incompleteness arise. 6 Conclusion This study provides a transaction cost and relational governance explanation of contractual completeness in franchising. We develop a new concept of contractual completeness defined by the relationship between specific and residual decision rights. Specific and residual decision rights provide a precise criterion to differentiate between completeness and complexity of contracts. In addition, we extend the transaction cost 33 view of contractual completeness in franchising developed by Solis-Rodriguez and Gonzalez-Diaz (2012) by differentiating between unilateral and bilateral transactionspecific investments and adding environmental uncertainty as determinant of the degree of contractual completeness in franchising. Furthermore, we develop a relational governance view of contractual completeness by examining the impact of knowledgebased and general trust on contractual completeness. 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Industrial Marketing Management, doi: 10.1016/j.indmarman.2012.12.002. 52 APPENDIX: MEASURES OF VARIABLES Index of Contractual Completeness (COMPLETENESS): The general managers were asked to rate the degree of contractual completeness with the following indicators: (a) Specific decision rights (sDR): “The tasks of the franchisor regarding the value chain activities at the local outlets are specified in detail in the contract”; “the tasks of the franchisees regarding the value chain activities at the local outlets are specified in detail in the contract.” Two items, measured on a 7 point Likert-type scale (1 strongly disagree – 7 strongly agree), Cronbach alpha = 0.871. (b) Residual decision rights (rDR): “The decisions of the franchisor regarding the value chain activities at the local outlets are specified in detail in the contract”; “the decisions of the franchisees regarding the value chain activities at the local outlets are specified in detail in the contract.” Two items, measured on a 7 point Likert-type scale (1 strongly disagree – 7 strongly agree), Cronbach alpha = 0.909. Environmental Uncertainty (ENV): Three items, measured on a 7 point Likert-type scale (1 strongly disagree – 7 strongly agree), Cronbach alpha = 0.742 1. The sales at the outlet level are very fluctuating. 2. It is very difficult to predict the market development at the outlet level. 3. The economic environment in the local market changes frequently. Franchisee Transaction-specific Investments (INV_FEE): Initial investments required to start a new franchised outlet. Franchisor Transaction-specific Investments (INV_FOR): Three items, measured on a 7 point Likert-type scale: To which extent the franchisor has toto bear the following expenses? (1 not at all – 7 to a very great extent), Cronbach alpha = .632 1. Franchisee training at the beginning of the contract period 2. Technical support at the beginning of the contract period 3. Set-up of the outlet organization Franchisor Brand Name (BRAND): Four items, measured on a 7 point Likert-type scale (1 strongly disagree – 7 strongly agree), Cronbach alpha = 0.811 1. Our brand is very strong compared to our competitors. 2. Our franchise system enjoys higher brand recognition compared to our competitors. 3. Our franchise system enjoys a good reputation for quality. 4. Our brand name is very important for us for achieving competitive advantage. Trust: Knowledge-based Trust (KTRUST): Four items, measured on a 7 point Likert-type scale (1 strongly disagree – 7 strongly agree), Cronbach alpha = .876 1. The cooperation is based on partnership basis. 2. The exchange of information between us and the partners goes beyond the agreed scope. 3. There is great trust between us and the partners. 4. There is an atmosphere of openness and honesty between us and the partners. General Trust (GTRUST): Three items, measured on a 7 point Likert-type scale (1 strongly disagree – 7 strongly agree), Cronbach alpha = .806 1. The majority of people trust others. 2. Most people are trustworthy. 3. Most people behave cooperatively if they are trusted. Sector (SEC): 0 = Product franchising firms; 1 = Services firms Size (SIZE): Number of outlets in the franchise system (franchised + company owned) Age (AGE): Number of years since opening up the first franchised outlet in Germany Contract Duration (DUR): Length of the contract in years Figure 1. Research Model Franchisor’s Knowledgebased Trust Franchisor’s General Trust Franchisees’ Specific Investments Specific In H5 ab H6 a H1b H2b H1a H2a Franchisor’s Specific Investments H3 Environmental Uncertainty H4 Franchisor Brand Name Control Variables AGE SIZE SECTOR DURATION Contractual COMPLETENESS Table 1. Estimate of Non-response Bias Means, (SD), and Counts1 Population Respondents 10.102 11.190 (8.122) (8.391) N = 449 N = 121 112.718 155.949 (431.444) (328.376) N = 337 N = 118 1.002 0.930 (1.497) (1.342) N = 326 N=127 4.473 5.442 (6.282) (7.452) N = 446 N = 117 Age of Franchise System (Years) System Size (total outlets) Advertising Fee (% of Sales) Royalties (% of Sales) t-value -1.298 p-value 0.195 0.992 0.322 -0.478 0.633 1.408 0.16 The measures of Advertising Fee and Royalties were first tested by a MANOVA to ensure independence of these variables. Table 2. Rotated Factor Matrix Factor Item 1 .776 2 .080 The exchange of information between us and the partners goes beyond the agreed scope .642 .093 The majority of people trust other -.009 .703 Most people are trustworthy .034 .939 Most people behave cooperatively if they are trusted .173 .659 There is great trust between ourselves and the partners .899 .045 There is an atmosphere of openness and honesty between us and the partners .922 .041 The cooperation is based on partnership basis Table 3. Descriptive Statistics N Minimum Maximum Mean Std. Deviation rDR 100 1.00 7.00 5.1200 1.40547 sDR 98 2.00 7.00 5.1378 1.36936 ENV 127 1.00 7.00 3.7323 1.35956 INV_FOR 137 1.00 7.00 4.3723 1.25249 INV_FEE 123 0.00 100000.00 12668.5691 14701.97921 BRAND 137 1.33 7.00 5.6448 1.11306 KTRUST 136 1.00 7.00 5.7960 1.03914 GTRUST 136 1.00 7.00 4.5368 1.31979 SIZE 118 1.00 2520.00 155.9492 328.37593 AGE 121 1.00 34.00 11.1901 8.39078 DUR 119 1.00 20.00 6.8235 3.28104 SEC 127 0.00 1.00 0.6378 .48254 Table 4. Pearson Correlations rDR sDR. ENV INV_FOR INV_FEE BRAND KTRUST GTRUST SIZE rDR 1 sDR .596** 1 ENV .052 -.047 1 INV_FOR .259** .177 ,009 1 INV_FEE -.061 -.073 -,121 ,177 * 1 BRAND .098 .261** -,109 ,117 ,135 1 KTRUST .111 .074 -,288** ,042 ,037 ,297** 1 GTRUST -.110 -.199 ,160 ,035 ,039 ,053 ,171* 1 SIZE .067 .057 ,040 -,124 -,130 -,181* ,053 ,041 1 AGE .062 .196 ,053 -,052 -,091 ,128 ,051 -,078 ,453** DUR .170 .304** -,365** ,158 ,412** ,273** ,084 -,090 -,041 SEC -.149 -.278** -,028 -,085 ,293** -,140 -,085 ,070 -,119 AGE DUR SEC AGE 1 DUR .242** 1 SEC -,141 ,015 ** p < .01, * p < .05 1 Table 5: Seemingly Unrelated Regressions (SUR) of the determinants of Specific Decision Rights (sDR) and Residual Decision Rights (rDR) Model 1a Model 1b Model 2a Model 2b Model 3a Model 3b sDR rDR sDR rDR sDR rDR ENV -0.043 0.043 -0.016 0.099 (0.107) (0.107) (0.113) (0.116) INV_FOR 0.164 0.365 *** 0.141 0.376 *** (0.100) (0.101) (0.097) (0.100) INV_FEE -0.253 ** -0.234 ** -0.230 ** -0.231 ** (0.118) (0.119) (0.114) (0.117) BRAND 0.213 * 0.084 0.257 ** 0.044 (0.109) (0.109) (0.110) (0.113) KTRUST -0.072 0.138 (0.105) (0.108) GTRUST -0.237 ** -0.022 (0.098) (0.101) SIZE 0.016 0.073 0.129 0.174 0.167 0.145 (0.112) (0.116) (0.113) (0.113) (0.111) (0.114) AGE 0.048 -0.062 -0.046 -0.159 -0.084 -0.162 (0.114) (0.118) (0.112) (0.112) (0.109) (0.112) DUR 0.305 *** 0.238 ** 0.357 *** 0.328 ** 0.323 ** 0.327 ** (0.105) (0.109) (0.130) (0.130) (0.125) (0.129) SEC -0.215 ** -0.193 * -0.115 -0.091 -0.105 -0.094 (0.102) (0.106) (0.102) (0.102) (0.098) (0.101) R² 0.155 0.092 0.266 0.265 p-value 0.004 0.074 0.000 0.000 Observations 84 84 83 83 *** p < 0.01; ** p < 0.05; * p < 0.1 Standard errors in parentheses. Variables are standardized. 0.324 0.000 83 0.279 0.000 83