LAS PROFESIONES
ACADEMIA DE JURISPRUDENCIA EN EL AÑO DE
This is critical analysis towards establishing the first objective of the thesis and showing that franchising does stimulate economic activity by offering advantages to those involved in it. It is suggested that there are inherent economic advantages of franchising which attract franchisors and franchisees to become involved in it.
2.3.1 The Economic Drivers of Franchising for Franchisors
Businesses, other than sole traders, involve a relationship between a principal and the individuals he hires to provide a service or manufacture/distribute goods – his “agents”. The principal delegates decision-making authority to those agents133. The interests of the principal and its agents do not always coincide, so there is potential for conflict. The agent may not always act in the principal’s best interests134 and under performing agents are not uncommon135. In order to reduce the risk of a poor employee, a non-franchised business will need to institute a costly management system. Franchising, on the other hand, replaces much of the need for such a management system with powerful financial incentives, namely the benefit of the profits created by his/her endeavours and the risk of losing the capital that they have invested in the business136. Because franchising creates a better financial synergy between the two parties, there is less need for monitoring and a greater probability for maximum performance by the franchisee137. There is evidence that increased managerial
133 Klock. C, 2004, Franchising a Good Strategy for a company operating throughout Europe – Case Study
Benetton, University of Abertay Dundee
134Jensen. M. C and Meckling. W. H, 1976, ”Theory of the Firm, Managerial Behavior, Agency Costs, and
Ownership Structure”, Journal of Financial Economics, October, 305-360. Eisenhardt. K, 1989, Agency
Theory: An Assessment and Review, Academy of Management Review, Volume 14, Issue 1, p.57-74. 135 Rubin. P, 1978, “The Theory of the Firm and the Structure of the Franchise Contract”, Journal of Law and Economics 21, p.223-233 – Brickley. J, and Dark. F, 1987, “The Choice of Organizational Form: The
Case of Franchising”, Journal of Financial Economics, Volume 18, p. 401-420.
136Ibid Brickley and Dark
137 Bradash. J. L, 1997, “Using the Plural Form in the Management of Restaurant Chains”, Administrative Science Quarterly, Vol. 42, No. 2, pp. 276-303.
ownership improves performance138. The corollary of the franchisee’s better performance is improved performance by the franchisor, as the franchisor’s performance depends to a large extent on its franchisees’ performance.
The relationship between principal and agent can be described or explained in mathematical models139. Agents are generally assumed to be risk adverse i.e. they prefer a low but secure income whilst principals are risk neutral140. Many commentators have highlighted the advantages of franchising a business using this “Agency Theory”141
Another analysis proposed is that franchising is a solution to the capital, managerial and information constraints faced by expanding businesses142. The so-called “Resource Scarcity Theory”. It is suggested that growing businesses use franchising as a way of accessing capital that would otherwise be unavailable to it in a cost effective way that offers fair reward to the financier (the franchisee). Support for this analysis is provided by the former president of Kentucky Fried Chicken, John Y. Brown, who estimated that it would have cost KFC $450 million to establish its first 2,700 stores, an amount of capital that was not available to KCF in the early stages of its expansion 143. The traditional ways for new businesses to access capital are to either sell equity or raise a loan, although raising a loan, may not be possible in the early stages of a business’s development due to lack of collateral and a proven track record. Therefore, Franchising is often a more cost effective and realistic option 144. Indeed, franchisees may be able to provide capital to the franchisor at a lower cost than passive investors can 145. In addition to capital, franchising also provides an efficient way to obtain
138Bruton. G. D, Keels. J. K and Scifres. E. L, 2002, “Corporate Restructuring and Performance: An
Agency Theory Perspective on the Complete Buyout Cycle”, Journal of Business Research, Vol. 55, Issue 9,
September, 709-724.
139 Op cit, Jensen and Meckling 1976, 305-360.
140 Williamson. O and Masten. S. E, 1999, The Economics of Transaction Costs Cheltenham, Edward Elgar Publishing Ltd
141 E.g. Dourma. S and Schreuder H, 2002, Economic Approach to Organisation, 3rd ed. Edinburgh, Pearson Education – Brousseau. E and Glachant. J-M, 2002, The Economics of Contracts: Theory and Application 1st ed. Cambridge, Cambridge University Press
- Brickley. A, Dark. F and Weisbach. M, 1991, “An Agency Perspective on Franchising of Financial
Management Spring”, Volume 20, Issue 1
142Oxenfeldt. A. R and Kelly. A. O, 1968, “Will Successful Systems Ultimately Become Wholly-Owned
Chains?”, Journal of Retailing, Volume 44, Issue 49, p.69-83
Norton. S, 1988, An Empirical Look at Franchising as an Organizational Form, Journal of Business, Volume 61 Issue 2, p.197-218 – Carney. M and Gedajlovic. E, 1991, “Vertical Integration in Franchise
Systems: Agency Theory and Resources Explanations”, Strategic Management Journal, Volume 12, p. 607-
629 – Shane. S. A, 1996, “Hybrid Organizational Arrangements and Their Implications for Firm Growth
and Survival: A Study of New Franchisors”, Academy of Management Journal, Volume. 39, No. 1, pp.
216-234
143 Tikoo. S, 1996, “Assessing the Franchise Option”, Business Horizons, May-June. p.78-82
144 Dant. R. P and Kaufmann. P. J, 2003, “Structural and Strategic Dynamics in Franchising”, Journal of Retailing, Volume 79, Issue 2, p. 63-75.
145Combs. J. G and Kitchen. D. J, 1999, “Explaining Interfirm Cooperation and Performance: Toward a
Reconciliation of Predictions from the Resource-Based View and Organizational Economics”, Strategic
the managerial expertise needed to grow the business. Because a franchisee puts a significant amount of her/his assets and time into her/his unit, she/he is likely to purchase a franchise only if she/he is confident in her/his managerial abilities 146.
Several commentators stress the fact that franchising facilitates much more rapid growth for companies147, suggesting that franchisors have used franchising to secure a large market share much more rapidly than they otherwise could achieve148. The reason for this is largely the so- called “Penrose Effect”, that is managerial capacities pose a static limit to a firm’s expansion and rapid recruitment of staff raises operating costs. Franchising is a device that circumvents this constraint by externalising the management functions to the franchisee149.
Thus franchising addresses the adverse selection problem of firms hiring managers who may overstate their qualifications to secure employment. On the international front franchising also allows a firm to leverage the local market knowledge of its franchisees as it expands into new geographic areas150. Thus the “Resource Scarcity” school of thought suggests that low cost capital, motivated managerial expertise, and better local market knowledge are three key resources that should reduce a franchisor’s overall risk and have a significant positive impact on a franchisor’s financial performance.
A third hypothesis is “Value Creation” or “Transaction Cost”. Aliouche, and Schlentrich suggest, the real value of franchising to a business is the improvement in business performance due to its choice of growing through franchising instead of growing through its own means151. Their study of the US restaurant sector over the ten year period 1993-2002, suggests that US public restaurant franchisors have created more value than their non- franchising competitors in that they have a higher propensity to create market value and economic value than non-franchisors and generate on average higher added value than non- franchisors152.
Commentators also suggest that other economic factors that cause businesses to franchise their business model are based upon its ability to give smaller, less well capitalised businesses
146Op cit, Shane, S. A, p. 216-234
147 Barrow. C, 1989, Franchising, in: P. Burns and J. Dewhurst, eds, small business and entrepreneurship (Macmillan London) and Thompson. R. S, 1994, “The Franchise Life Cycle and the Penrose Effect”, Journal of Economic Behaviour and Organisation 24, p.207-218. Noath - Holland
148 Hall. P and Dixon. R, 1988, Franchising, Pitman, London 149 Op cit, Thompson, RS
150Minkler. L. P, 1990, An Empirical Analysis of a Firm’s Decision to Franchise, Economic Letters, 34, 77-82.
151 Does franchising create value? An analysis of the financial performance of us public restaurant firms Aliouche, and Schlentrich, Working Paper No. 2005-02 presented at the 19th Annual Conference of the International Society of Franchising, London, England, May 20-22, 2005
152 Also see Pilat. D, 1997, Regulation and Performance in the Distribution Sector: OECD Economics Department Working Papers No 180
access to some of the commercial advantages enjoyed by their larger, better capitalised competitors. These include lower costs through bulk purchasing, economies of scale, new product development and advertising campaigns153. Its ability to combine the chains’ comparative advantages in creating brand recognition and capturing economies of scale with the local entrepreneur’s local knowledge and commercial drive is seen as a key element in franchising’s success and attractiveness to growing business154. This leads to a conclusion that the capacity of franchising to harness the effort of a central entity, the franchisor, and a number or local entrepreneurs, the franchisees explains much of franchising’s prevalence and popularity as a way of organising certain economic activities155.
All three of these analyses are cogent and in practice combine to produce a powerful reason for businesses choosing franchising. A survey of 25 franchisors in the UK, Germany, France and Spain156 supported the theories with the majority of the sample surveyed identifying elements of the Agency theory, Resource Scarcity theory and the Transaction Cost theory together with other economic drivers as the reasons that they franchised their businesses.
2.3.2 The Economic Drivers of Franchising for Franchisees
Whilst some franchisees become substantial multi-unit operators or operate high investment businesses such as hotels, most franchisees are small, family owned and family run businesses157. All franchisees, regardless of their size are attracted to franchising by certain common factors.
Regardless of the scale and type of the franchisee, research suggests that the economic reasons for a franchisee buying a franchise include access to a national brand158, franchisor support159 such as ongoing operational assistance, marketing/advertising and bulk purchasing, use of a proven business format160 (that is continually developed) and independence161. All of which, regardless of the franchisee’s size, increase its chances of success compared to those of an independent start up business.
153 Op cit, Blair and La Fontaine, p.1
154 Caves. R. E and Murphy. W .F, 1976, “Franchising: Firms, Markets and Intangible Assets” Southern Economic Journal, Volume 42, p.572-586
155 Op cit, Blair and La Fontaine, p.2 156 Appendix 3
157 Kaufmann. P and Stanworth. J, 1995, “The Decision to Purchase a Franchise: A Study of Prospective
Franchisees”, Journal of Small Business Management. 22033
158 Stanworth. J, 1977, A study of Franchising in Britain, London, England, University of Westminster 159 Hough. J, 1986, Power and Authority and their Consequences in Franchise Organisations – A Study of the Relationship between Franchisor and Franchisees, unpublished PhD thesis. London, England:
University of Westminster
160 Withane. S, 1991, “Franchising and Franchise Behaviour: An Examination of Opinions, Personal
Characteristics and Motives of Canadian Franchisee Entrepreneurs”, Journal of Small Business
Management Volume 29, Issue 1, p.22-29
161 Knight. R, 1986, “Franchising From the Franchisor and Franchisee Points of View”, Journal of Small Business Management, July 8-15
The BFA states that one reason that franchisees buy a franchise is that 95% of franchises are in profit after 5 years compared to only 45% of other independent small firms. The other reason given is that franchisors are benevolent business partners with 86% of franchisees are satisfied with their franchisor relationship162. The European Franchise Federation163 agrees with this analysis. Mendelsohn also agrees and adds improved product sourcing, advertising and marketing and increased access to funding as the banks tend to regard franchisees as lower risk than independent operators164.
There are clear economic reasons for franchisees investing in a franchise, but it must be borne in mind that “non-institutional” franchisees (i.e. individuals rather than corporations) are also subject to a “large number of situational, personality and economic correlates…. likely to influence their perceptions”165.
The situational, personality and economic correlatives referred to by researchers include a desire to own and operate one’s own business and lack of other attractive options (for example redundancy)166.
There is much support for the belief that the franchisee has the incentive of owning his own business with the additional benefit of continuing assistance from the franchisor167. The franchisee is an independent businessman operating within the framework and structure of the franchise system. This provides the opportunity to the franchisee though hard work and effort to maximize the return from his business and the value of his investment168.
In order to test the persuasiveness of the commercial advantage and proprietorship theories a selection of 30 UK franchisees representing eight different franchises were surveyed169 as part of this thesis. The responses suggest that both theories detailed above are correct as they are cited by all members of the sample as reasons that they bought a franchise.
162 www.british-franchise.org/casestudies.asp
163 www.eff-franchise.com accessed 3 February 2009. A franchisee's principal motive in joining a franchise network is “to improve his chances of success during the initial start-up period, and to ensure his business’s rapid expansion by virtue of the fact that he: buys into a brand-name, has immediate access to a market via the right to utilise the parent company’s trademark or brand name, and benefits from both the transfer of know-how (professional, management and marketing skills) and on-going assistance. In return for which the franchisee pays the franchisor a fee or royalty, or a combination of fees, which often includes an entrance fee and/or a fixed percentage of annual turnover for the period of the contract”.
164 Mendelsohn – ibid
165 Peterson. A and Dant. R, 1990, “Perceived Advantages of the Franchise Option From the Franchise
Perspective: Empirical Insights from a Service Franchise”, Journal of Small Business Management,
Volume 28, Issue 3, p.46-61 166 Op cit, Kaufman and Stanworth 167 Op cit Mendelsohn
168 Mendelsohn – ibid 169 Appendix 5.
2.3.3 Sub-conclusion
There are inherent advantages which attract franchisors and franchisees to franchising. Franchisors are attracted by the access to quality management resource, capital and economic advantages such as access to volume discount and economies of sale. Franchisees are attracted to enhanced chances of commercial success.