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THEORETICAL FOUNDATION FOR FRANCHISING

A growing literature points to three major potential advantages to the franchising model of growth: a greater administrative efficiency, a more efficient risk sharing and management, and resource de-constraining. Each is addressed successively.

Administrative Efficiency

On administrative efficiency, much research follows Fama and Jensen's (1983a, 1983b) agency theory arguments as applied to franchising (Brickley and Dark, 1987; Martin, 1988; Carney and Gedajlovic, 1991; LaFontaine, 1992). Concept innovators (potential franchisors) grow by hiring managers to operate company-owned outlets. The decoupling of ownership and management at the outlet level creates the potential for agency problems, for example through shirking. This agency problem is compounded by the imperfect linkage between the business outcomes of management action and the subsequent compensation of company outlet managers (Carney and Gedajlovic, 1991; Kruegger, 1991; Castrogiovanni, Bennett and Combs, 1995): since company-owned outlet managers do not directly reap the rewards or suffer the consequences of their actions, the feedback mechanism that could reduce shirking is in effect "rusty" and subject to costly delays. To ensure performance, the concept innovator must monitor outlet managers more directly, in effect "managing the managers". The financial impact of direct monitoring can severely restrict both speed and extent of concept growth (McDougall, Shane and Oviatt, 1994). Furthermore, burdens of administrative efficiency requirements, as prescribed by agency theory, are greater in rapid growth (including international expansion) environments (Fladmoe-Lindquist, 1996). If a company is growing rapidly, resources are required not only for development of outlets, but also for the additional levels of management and the improvement of knowledge and infrastructure (Huszaugh, Huszaugh and McIntyre, 1992). The franchising literature indicates that the requisite knowledge is obtained over time through hands-on experience. Logically, the time required to gain that experience may truncate the rate of growth of the concept. Hence a franchisor may be motivated to raise money from the public in an effort to increase the rate of skills acquisition and facilitate expansion. Concurrently, franchising brings the on-site entrepreneurial capacity of the franchisee to an outlet for local implementation, raising the level of talent and intensity in the trademark execution.

Risk Management

The rapid development of risk theory and information economics over the last few years has provided the researchers with a better understanding of contract theory and its underlying risk-sharing components. A number of arguments have been presented regarding risk in franchise contracting. First of all, franchisors are said to more efficiently manage those outlets which are geographically closer to headquarters (Martin, 1988). Proximity reduces the costs of assuring that the outlet line managers are performing in a manner consistent with policies and procedures. Corporate capital is therefore applied to the development of outlets within a geographic territory that the company self defines as within efficient administrative distance, while the operations which are more remote would tend to be franchised, using franchisee capital.

In effect, the outlet financing decision is a function of supervision costs and aims at reducing franchisor risk.

Holmstrom and Milgrom (1991, 1994) provide a conceptual framework to analyze the relationship between the measurability of tasks and the optimal mix of incentives and monitoring activities. In essence, tasks that are less amenable to measurement, i.e. because of fuzzy metrics, will tend to dampen the incentives component and put the burden of control on the pure monitoring component. Translated into a franchising Vs corporate development argument, the model implies that franchising may be an optimal control mechanism when performance measurement is relatively easy and the consequent incentive system is operating efficiently. When metrics for performance are debatable and ambiguous to measure or analyze, direct monitoring by corporate headquarters may be the most efficient control mechanism available.

Ruben (1978; 1990) highlights the fact that a franchisee is likely to have invested a major portion of his/her net worth in a single outlet. As such, he/she is not taking full advantage of the diversification benefits that could accrue to holding a diversified portfolio of outlets in different franchise systems. Consequently, the level of risk exposure by most franchisees is actually quite high, requiring higher returns on the investments to justify them. The risk sharing benefits of franchising, initially conceived at the franchisor level, are then negated at the franchisee level, eliminating the excess rents.

Resource Constraints

Resource constraint theory would indicate that both capital conservation and concept growth are aided by franchising (Oxenfeldt and Kelly, 1969). Franchising provides the necessary capital to finance the expansion of the trademark through increased locations, marketing weight, and overall economies of scale. Clearly, franchisors perceive growth as an important reason to franchise (Dant, 1994). LaFontaine and Kaufman (1994) argue that franchisees provide cash to the franchisor in the form of franchise fees and royalties and also provide important fixed investment for infrastructure, including land and building. Fladmoe-Lindquist (1996) state that the fees from franchisees preclude the need for the franchisor to raise money. In their 1993 study, Martin and Justis found that the most important reason for adopting franchised distribution is to acquire and conserve capital. This phenomenon is exacerbated by the clear need to establish the distribution network as rapidly as possible (McGuire and Staelin, 1971). It is important to note that some researchers argue that franchising is not the most appropriate solution to the capital resource problem. Caves and Murphy (1976) contend that selling shares in the entire chain is a more efficient answer than franchising. Also, inherent in Rubin's (1978; 1990) argument, detailed above, is the implication that the franchisor could reduce the cost of capital by selling ownership shares to outlet managers.

Summary

The theoretical argument continues unabated. There is an apparent "eitherCor" component to much of the literature which implies an administrative, resource constraint or risk management motivation for the franchise inter-organizational form. Carney and Gedajlovic (1991) attempted to reconcile the validity of resource constraint and administrative efficiency theories in a study of Canadian franchisors. They found support for contribution from both perspectives. However, none of the current research addresses the phenomenon of the concept innovator who simultaneously franchises and raises public money. These 'public franchisors' would appear to address both the positive inducements and negative concerns raised by the three theoretical arguments for franchising. As argued above, administrative efficiency is created by garnering local management talent through entrepreneurial incentives for the franchisee. Thus, monitoring costs are reduced and the burden of inefficiency (shirking) is most heavily born by the franchisee, thus reducing risk. This occurs not only because of on-site entrepreneurial capacity but also because the franchisor's need to rapidly develop infrastructure for the acquisition and support of franchisees is addressed by marshaling the necessary financial resources through public offerings of shares. This can be sustained and multiplied through the acquisition of franchise fees and royalties. The enhanced capital acquisition clearly provides growth rate advantages, allowing the astute franchisor to develop company-owned outlets in geographical locations within a comfortable distance from supervisory management and, simultaneously, have franchisees apply their human and financial capital in more remote (and therefore inherently riskier) locations. Theoretically, coupling a franchise inter-organizational form with franchisor capital should provide risk amelioration versus the non-franchised competitor. Thus, the public franchisor should be able to grow efficiently on both an administrative and capitalization basis. This paper seeks to test the empirical implications of such a model.

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