Territorial Exclusivity in Franchisee Systems1
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 +351 254 615 477. Fax +351 254 613
029. E-mail: apina@estgl.ipv.pt
Luis Vázquez. Departamento de Administración y Economía de la Empresa. Campus
Unamuno, s./n. Salamanca, Spain, E-37005. Tel. +34 923 29 4640. Fax +34 923 29 4715.
E-mail: lvazquez@usal.es
1
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
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
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
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 2008.
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
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
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
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
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 2008. 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
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
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
REFERENCES
Armstrong J. S., & Overton T. S. 1977. Estimating nonresponse bias in mail
surveys. Journal of Marketing Research, 14: 396–402.
Azoulay P., & Shane S. 2001. Entrepreneurs, contracts, and the failure of young
firms. Management Science, 47: 337–358.
Blair, R. D., & Kaserman D. L. 1983. Law and economics of vertical integration
and control. New York: Harcourt Brace Jovanovich.
Bork, R. H. 1978. The antitrust paradox: A policy at war with itself. New York:
Basic Books, Inc.
Brickley, J. A., & Dark, F. H. 1987. The choice of organizational form: The case of
franchising. Journal of Financial Economics, 18: 401–420.
Cady, J. F. 1982. Reasonable rules and rules of reasons: Vertical restrictions on
distributors. Journal of Marketing, 46: 27–37.
Campbell, D. T. 1955. The informant in quantitative research. American Journal
of Sociology, 60: 339–342.
Dutta, S., Heide, J. B., & Bergen, M. 1999. Vertical territorial restrictions and public
policy: Theories and industry evicence. Journal of Marketing, 63: 121–134.
Kalnins, A. 2004. An empirical analysis of territorial encroachment within
franchised and company-owned branded chains. Marketing Science, 23:
476–489.
Lilien, G. L. 1979. Advisor 2: Modeling the marketing mix decision for industrial
products. Management Science, 25: 191–204.
Mathewson, G. F. & Winter, R. A. 1984. An economic theory of vertical restraints.
Rand Journal of Economics, 12: 27–38.
12
Miracle, G. E. 1965. Product characteristics and marketing strategy. Journal of
Marketing, 29: 18–24.
Rubin, P. H. 1978. The theory of the firm and the structure of the franchise
contract. Journal of Law and Economics, 21: 223–233.
Seidler, J. 1974. On using informants: A technique for collecting quantitative data
and controlling measurement error in organizational analysis. American
Sociological Review, 39: 816–831.
Williamson, O. E. 1985. The Economic Institutions of Capitalism. New York:
The Free Press.
Winter, R. A. 1993. Vertical control and price versus nonprice competition.
Quarterly Journal of Economics, 108: 61–76.
13
TABLE 1
Distribution of sample chains by sector
Sector
Number of franchise chains
1
4
2
3
1
14
4
5
6
3
4
3
4
1
3
2
2
3
1
2
5
15
1
8
5
2
6
1
2
1
3
3
121
Adventure
Automobile services
Beauty and personal hygiene
Cafés & ice-cream
Cleaning-interior restoration
Clothing-fashion
Computers
Consulting firms
Cosmetics
Drugstore
Dry-cleaning
Food and bakery
Furniture and decoration
Hairdresser’s
Jewelry and costume jewelry
Leisure
Office-stationer’s
Personalized editions
Photography
Printing and signs
Real estate agencies
Restaurants
Specialized products
Specialized services
Specialized shops
Sports
Teaching
Telephone stores
Textiles
Transport services
Travel
Vending
Total
Note: The sample consists of 121 Portuguese and Spanish business format franchising
networks from 2008. Sectors with three or fewer observations are marked in italics.
.
14
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
0.69
3.84
5.62
38.96
12.89
S.D.
0.44
2.07
Territorial exclusivity
2.53
*
0.218
Initial investment required*Level of
specific investments
Free-rideable services
Chain size
*
Note: Correlation statistically significant at 5% level.
33.47
9.65
*
*
0.274
-0.148
0.005
-0.048
0.064
0.033
-0.012
0.051
0.117
25
TABLE 3
Probit estimates for exclusivity choice (1 = adoption of territorial exclusivity; 0 =
otherwise)
Independent variables
0.86***
0.72***
0.72***
0.59**
-0.69**
-0.83*
0.12
0.22
Sector fixed effects
NO
YES
Observations
121
81
Pseudo R2
0.36
0.42
Initial investment required*Level of specific
investments
Free-rideable services
Chain size
Chain age
Notes: Two-tailed tests.
† p < .10
*
p < .05
**
p < .01
***
p < .001
32
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 1998.
Chain age
Q5
Age of the franchise system in Spain at the
beginning of 1998.
33