An explanation of international franchisors' preference for multi-unit franchising.
Most international franchisors seem to follow multi-unit franchising. But it is often treated as an anomaly from an agency theory perspective. We argue that multi-unit franchising can be explained by agency theory, if we consider the full range of agency problems. These include: shirking, adverse selection, information flow, inefficient risk bearing, free-riding, and quasi-rent appropriation. Although past agency theoretic examinations have mostly focused on single-unit franchising, our analysis shows that in the international context, multi-unit franchising may be more appropriate considering the significant geographic and cultural distance between franchisors and franchisees.
Franchising has become a very popular means for rapid organizational growth in the U.S over the last four decades. Starting with the fast food industry, franchising has now become pervasive in a variety of industries ranging from auto repair to day care. The rapid diffusion of franchising is also reflected in a surge in the number of academic studies of franchising as well as greater attention in the popular press. A significant number of academic researchers have relied on agency theory to analyze a variety of franchising related issues such as the structure of the franchising agreement, the choice of a specific type of franchising, and financial success of the franchising system (Bates, 1998; Shane, 1996a). The appeal of agency theory stems from the fact that the relationship between the franchisor and the franchisee is essentially an agency relationship. Interestingly enough, most of the theoretical arguments based on agency theory implicitly seem to assume that franchisees are essentially single unit operators (Kaufmann and Dant, 1996: 346). This assumption, however, is surprising given that multi-unit franchising (MUF) seems to be the norm in many industries. For example, using Bureau of the Census data, Bates (1998:114) noted that "among the recently started restaurant franchise units, 84% were units of multi-establishment corporations." Kaufmann and Dant (1996: 346) note several other examples leading to the conclusion: "It is clear that the typical location-based franchising system (of which the fast-food franchises are the prime and modal example) is populated with multi-unit franchisees." Interestingly, the prevalence of multi-unit franchises is even more widespread in the context of international franchising (Alon, 2000; Dant and Nasr, 1998).
Prior research, by and large, has focused mostly on single-unit franchising (SUF) because of the assumption that agency problems can be best resolved by having owner operators. The moment they become multi-unit systems, individual units are managed by employees, thereby reintroducing the agency problem. This led Kaufmann and Dant (1996) to call the prevalence of MUF "a curious anomaly" in search of a clear theoretical explanation. The objective of this paper is to answer the question: Why do international franchisors prefer MUF over SUF? We argue that there is no need to embark on a search for a new theory to explain this preference. Our position is that MUF is not a theoretical anomaly and that agency theory can adequately explain the preference for MUF among international franchisees.
Multi-unit franchising differs from single-unit franchising in one fundamental way. In MUF, the franchisees own, operate, or control more than one outlet (Kaufmann and Dant, 1996). Even within MUF, there are many different types (Alon, 2000). Incremental or sequential MUF occurs when a single-unit franchisee is awarded additional units based upon the performance of existing units. In master franchising, on the other hand, the franchisor grants a franchisee rights to multiple units from the outset (Kaufmann, 1992). Area development agreements are a special type of master franchising which requires the master franchisee to open and operate multiple units within a geographical area according to a pre-specified schedule. Individual outlets, in turn, are run by employee-managers hired by the master franchisee.
Kaufmann and Dant (1996) suggested that though MUF is an anomaly from an agency theoretic perspective, it has merits over SUF as an entry mode from a capital acquisition perspective. However, this suggests that somehow MUF cannot be explained from an agency perspective. This is intriguing, given the enormous success that agency theory has had in explaining a variety of principal-agent relationships in general and the franchisor-franchisee relationship in particular. The domain of agency theory is relationships between a principal and an agent who are engaged in cooperative behavior, but have differing goals and differing attitudes toward risk (Eisenhardt, 1989). A large volume of both conceptual and empirical work has been published in recent years, applying agency theory to diverse settings (see Sharma, 1997, for some examples). How can a theory that has enjoyed such enormous success in analyzing principal-agent relationships in other settings prove so inadequate to explain the overwhelming prevalence of MUF in international franchising?
We argue in this paper that it is possible to explain the prevalence of MUF using agency theory. We focus on international franchising for two reasons. First, international franchising is growing much faster than domestic franchising (Shane, 1996b). Second, international franchising offers a unique setting for the comparative evaluation of the magnitude of agency problems associated with MUF and SUF. In the domestic context, we see some firms following a single unit franchising strategy and others following a multi-unit franchising strategy. In most cases, this can be explained by either factors specific to an industry or a firm. In the international context, on the other hand, the preference appears to be predominantly for multi-unit systems. This suggests that internationalization introduces a set of management considerations that are unique to foreign operations.
The paper is organized as follows. First, we present a review of the agency theory perspective of franchising. Then, we apply the agency perspective to analyze how international multi-unit franchising addresses agency problems. Finally, we discuss the implications for research and practice.
EXPLANATION OF FRANCHISING FROM AN AGENCY THEORY PERSPECTIVE
An agency relationship involves two parties: the principal and the agent. There will always be some divergence between the interests of the principal and the agent. The principal delegates work to an agent because the principal does not have the skills or resources to carry out the task. The principal wants the agent to act in his best interest but the agent's self interest dictates otherwise. This assumption of goal divergence is at the heart of agency theory (Eisenhardt, 1989; Jensen and Meckling, 1976). Agency theory assumes that agents are likely to misrepresent information concerning their skills and behavior and to withhold effort (Jensen and Meckling, 1976). The options available to the principal to mitigate these problems are incentive alignment and monitoring (Shane, 1996a). In incentive alignment, the agent's incentives are set in such a way that in maximizing his own incentive, the agent also maximizes the principal's interests. Franchising seeks to bring about incentive alignment through residual claimancy. Monitoring involves any action aimed at providing principals with information concerning the behavior of agents (Eisenhardt, 1988).
Theoretically, a franchisor has two options: either to open an outlet and hire salaried managers to run it or to enter into a franchise agreement with an owner operator. Agency theory would suggest that there is likely to be greater goal divergence between franchisors and hired managers than between franchisors and franchisees. This is because franchisees have stronger incentives for maximizing the profits of their franchises (Anderson, 1984; Brickley and Dark, 1987; Carney and Gedajlovic, 1991; Caves and Murphy, 1976; Combs and Castrogiovanni, 1994; Norton, 1988a, b). In a franchise relationship, the franchisee is the residual claimant. That is, the franchisee is entitled to all the profits after paying all the business costs as well as the royalties to the franchisor. This means that if the franchisee succeeds in lowering costs and increasing revenues, his profits tend to grow. As Brickley and Dark (1987:404) point out, "the costs and benefits of franchisees' actions that affect the value of their individual units are capitalized onto their own shoulders" (Brickley and Dark, 1987: 404). Because franchisees are residual claimants, not only do they have no reason to shirk but they also have an incentive to put forth higher levels of effort. If, on the other hand, the firm proceeds with the option of opening company-owned outlets, the hired managers are likely to shirk because they are typically promised fixed pay-offs, though some variable payments are possible. In other words, although agency problems exist both in the case of a firm's relationship with a hired manager as well as a franchisee, they are better resolved through incentive alignment in the case of franchising. This is primarily because residual claimancy provides incentives to a franchisee that are not available to the hired manager.
The growth and the size of firms are, in the final analysis, constrained by monitoring problems (Norton, 1988a). That is, as the firm keeps growing additional layers of hierarchy are added whose only function is monitoring lower layers. The problem of monitoring is not solved by delegating monitoring to hired managers because then, the monitors will have to be monitored. Eventually the cost of such monitoring becomes so high that the firm is better off not expanding. Franchising is an institution that helps to "circumvent the entrepreneurial capacity constraint" (1988a: 107). Residual claimancy ensures that franchisees can not afford to shirk because that would reduce their revenue from the local unit. In addition, compared to a hired supervisor, a franchisee stands to lose substantially more wealth if shirking is detected because the franchising contract can be terminated in the event of the breach of the contract. Thus, franchising, by substituting owner-managers (franchisees) for the hired supervisors, effectively reduces monitoring costs by reducing the need to monitor.
Although residual claimancy reduces monitoring costs, it does not completely solve a somewhat different problem, namely, free riding by franchisees (Carney and Gedajlovic, 1991; Combs and Castrogiovanni, 1994). One of the biggest assets of a franchise system is its brand name capital. It is the presence of brand name capital that gives rise to the opportunity for free riding. This can happen in two ways. First, brand name capital leads the customer to believe that each unit in a retail system provides the same levels of quality. Second, it may even potentially reduce the ability of customers to detect differences in the quality of service received from different units of a retail system. This may lead an opportunistic franchisee to free ride on the brand name capital and shade input quality, especially if located in a low repeat purchase location. A franchisor must necessarily incur monitoring costs to detect and prevent free-riding by franchisees so that the brand name capital of the system is not diluted. Such costs are, however, absent in the case of company owned units run by hired managers because they do not have similar economic incentives to shade quality. This, to a great extent, explains the presence of company owned units in a franchising system.
GOAL CONFLICTS IN FRANCHISING
Although residual claimancy and monitoring are theoretically alternative mechanisms to address agency problems, in practice, most firms use a mix of both. Dant and Nasr (1998) have emphasized that a perfect alignment of incentives is unlikely despite residual claimancy because of the differences in the perspectives of the franchisor and the franchisee. These differences lead to basic conflicts between franchisors and (single-unit) franchisees, making monitoring necessary even when incentive alignment is attempted. The conflicts arise from the differences in priority, time perspective, and form of earning. We argue that these problems are less pronounced in a multi-unit franchise relationship than in a single-unit franchise relationship. This is because a multi-unit franchisee has greater system-specific investments relative to a single-unit franchisee (e.g. region specific advertising). Therefore, the perspectives of a multi-unit franchisee concerning brand name and time will be better aligned with the franchisor relative to the alignments between a single-unit franchisee and franchisor concerning the same issues. Because a multi-unit franchisee is likely to face the negative effects of opportunistic practices in one unit on other units in her block, she has greater likelihood of safeguarding brand name capital and maintaining a longer-term profitability perspective than a single-unit franchisee, as summarized in Table 1. Based on these general conclusions about multi-unit franchising, we now move to a more detailed examination of international multi-unit franchising (IMUF).
AN AGENCY THEORY PERSPECTIVE OF INTERNATIONAL MUF
Most studies of franchising, especially those that use an agency perspective, implicitly assume a single-unit franchisee in their arguments. For instance, Shane (1996b: 74) defines franchising as "an organizational form based on a legal agreement between a parent organization (the franchisor) and a local outlet (the franchisee) to sell a product or service using a process ..." Other examples include Brickley and Dark (1987) who provide a detailed discussion of the magnitude of some of the agency problems such as shirking and perquisite-taking by unit managers, inefficient risk-bearing, free-rider problems, and quasi-rent appropriation associated with owning versus franchising, and Shane (1996a) who addresses another important agency problem, namely, adverse selection.
The assumption that franchise systems are populated by operators who own single units does not fit with observed reality, especially in the case of international franchising. This led to a growing chorus of calls for paying greater attention to MUF (e.g., Alon, 2000; Bradach, 1995; Dant and Nasr, 1998; Kaufmann and Kim, 1995). Kaufmann and Dant (1996) compared agency problems in MUF and SUF and concluded that overall, these problems are better addressed by SUF than by MUF. The obvious question, therefore is, what explains the prevalence of MUF? They suggested that "Although from an agency theory perspective, multi-unit franchising may have detrimental effects on growth, from the perspective of capital acquisition, its impact is positive" (1996: 349). In their study, they hypothesized that franchising system growth would be positively correlated with MUF in general, but negatively correlated with master franchising. However, their results did not support the predicted negative relationship between master franchising (which, incidentally, was used by 45% of franchisors in their sample) and growth. This unexpected outcome suggests the need to re-examine the original rationale that led to the conclusion that MUF does not adequately address agency problems. It is possible that in addition to its relative advantage based on capital acquisition, MUF may also have advantages in dealing with agency problems inherent in a franchise relationship. In the case of international franchising, as Shane (1996b) suggests, franchisors' capabilities to reduce franchisee opportunism may be of paramount importance. These capabilities must necessarily include "the ability to provide franchisees with an incentive not to act opportunistically" and "the ability to monitor more closely the actions of franchisees" (1996b: 77).
The basic argument we develop in this paper is that the capital acquisition explanation alone is not adequate to account for the widespread prevalence of MUF and that there are indeed situations where MUF is preferable for both capital acquisition and agency reasons. We believe it is important to develop a theoretically coherent explanation for the preference for MUFs exhibited by international franchisors for a number of reasons. First, agency problems such as monitoring are likely to be a greater challenge in distant, unfamiliar, overseas markets (Dant and Nasr, 1998). The sheer physical distance that separates the service delivery system from corporate headquarters can only compound the problem of incomplete information regarding agent behavior (Fladmoe-Lindquist and Jacque, 1995). Second, in the case of international franchising, physical distance is compounded by cultural, administrative, and legal distances as well (Ghemawat, 2001; Fladmoe-Lindquist and Jacque, 1995: 1239). Third, MUF is even "more ubiquitous" in the international context than in the domestic context (reflecting, for example 100% incidence in the former, Dant and Nasr, 1998: 22).
In the following sections, we develop our core argument that international MUF (IMUF) provides to franchisors greater ability to reduce opportunism than does international SUF (ISUF). Our argument is based on a careful analysis of a larger set of agency theory problems than are usually considered in MUF research. Our position is that, because IMUF has lower magnitude of agency problems, it has a relative advantage over ISUF. We now present our analysis concerning each agency issue. To help our discussion, we have summarized key terms in Table 2.
Because the franchisees are residual claimants, there is general consensus that the incentives of franchisors and franchisees are better aligned than the incentives between the franchisors and hired managers. This has led some to suggest that ISUF would have an advantage over IMUF because, at the unit level, SUF involves supervision by owner-managers whereas MUF involves supervision by hired managers (Kaufmann and Dant, 1996). Our examination of incentive alignment perspective, however, suggests that ISUF is unlikely to have any advantage over IMUF and that, in fact, the opposite may be true.
Analysis of incentive alignment within IMUF systems requires consideration at two separate levels, namely, at the store level and at the country level. At the store level, the alignment is likely to be better in the case of ISUF than for IMUF because ISUF involves residual claimancy whereas IMUF does not. But, any study of large MUF systems requires the consideration of incentive alignment at the next level, namely, the country level. As a franchising system grows, in order to maintain brand name capital, it becomes important to monitor the outlets. In the case of IMUF, such monitoring is done by multi-unit franchisees. But in the case of ISUF, this task is carried out by hired foreign managers. Because franchisors' incentives are better aligned with franchisees than with hired managers (Anderson, 1984), it follows that at the country level, incentive alignment is better in IMUF than in ISUF.
Further, our analysis shows that monitoring costs are likely to be lower in IMUF than in ISUF. This is because the task of monitoring to prevent shirking at the unit level will be delegated, by and large, to foreign multi-unit franchisees in IMUF (Alon, 2000). This delegation can lead to higher monitoring efficiency. Under ISUF, a franchisor may need a much larger, and therefore costly, foreign subsidiary to monitor individual units operated by a large number of single-unit franchisees than that required in IMUF. A small foreign subsidiary may be adequate in IMUF to monitor individual units operated by the managers hired by a multi-unit franchisee. Shirking at the store level can be detected by the multi-unit franchisee more easily than by hired subsidiary managers of the franchisor in ISUF, due to geographical and cultural proximity of the multi-unit franchisee. Thus, the overall likelihood of shirking is lesser and the probability of its detection higher in the case of IMUF than ISUF.
Adverse selection refers to the problem of less qualified individuals misrepresenting their abilities in order to obtain employment (Shane, 1996a). The ability of an organization to grow is limited by the entrepreneurial capacity constraint (Martin, 1988a). Franchising addresses entrepreneurial capacity constraint by recruiting franchisees who are themselves entrepreneurs. But in doing so, the problem of adverse selection rears its ugly head. Although the problem of adverse selection can never be completely solved, we suggest that it would be less in IMUF than in ISUF. Interviews that Bradach (1995: 74) conducted with the executives of five leading fast food restaurant chains showed that finding appropriate candidates for franchising is a key factor in limiting growth: "To get franchises they could "work with," chain operators spent considerable resources on selecting and developing new franchisees." This suggests two advantages of IMUF over ISUF. First, in the case of IMUF the franchisee can increase the amount of information concerning each applicant and process it in more depth than is possible in the case of ISUF where typically there will be a much larger number of applicants.. Increased information in IMUF can reduce the potential for adverse selection. Second, franchisors can economize on recruiting, screening, and training franchisees and devote their limited managerial resources on other tasks by selecting one multi-unit franchisee instead of numerous single unit franchisees (Kaufmann and Kim, 1995). The problem of adverse selection can never be completely eliminated, but its likelihood can be greatly reduced in the case of IMUF by collecting greater amounts of information about the potential franchisee while also simultaneously economizing on selection costs.
Third, unlike in ISUF, the task of recruiting, screening, and training unit level monitors (i.e., managers) is delegated to the franchisee in IMUF. The franchisee has the advantages of both geographical and cultural proximity. That means that the problem of adverse selection of unit level monitors would be less for the local multi-unit franchisee than for the foreign franchisor. The local franchisee can more easily check the credentials, background, and references of a potential employee than the franchisor can from a distance.
Multi-unit franchisees can play a significant role in the development of unit-level monitors given the cultural distance between those monitors and the international franchisor. Since "both the service concept and its management system are an extension of the cultural roots of the principal's home-country" (Fladmoe-Lindquist and Jacque, 1995: 1239), they require some level of adaptation to the local culture, whose norms need to be integrated into employee training procedures. Assuming that the franchisee has been selected carefully, a multi-unit franchisee is likely to possess a significant level of financial resources, considerable managerial experience, and country-specific expertise, especially in terms of local culture and customs. This combination of managerial resources and cultural expertise facilitates the process of local adaptation in IMUF relative to ISUF. The franchisee's embeddedness in the local culture and social milieu provides him with the necessary expertise in evaluating applicant traits such as diligence and honesty. In the case of IMUF, the applicants' knowledge that a local recruiter is involved, who is simultaneously a residual claimant, would discourage him from engaging in opportunistic misrepresentation of abilities. The possibility of adverse selection remains high in the case of ISUF because of the franchisor's lack of knowledge of local conditions and also because of the large number of franchisees involved.
The success of a franchise system critically depends on the smooth flow of information between the franchisor and the franchisee (Dant and Nasr, 1998; Dant, Li, and Wortzel, 1995). Especially in the case of foreign franchisees, the upward flow of information from the franchisee to the franchisor is vital to ensure control. We suggest that in this respect IMUF has a relative advantage over ISUF. When there are a large number of single-unit franchisees, the franchisor will have to create an administrative hierarchy in order to monitor them. In the case of IMUF, only one franchisee needs to be monitored since the monitoring of individual units is primarily the responsibility of the multi-unit franchisee. Organizations have considerable discretion in designing a structure that is most appropriate for their strategy. However, there is a general tendency for organizational hierarchies to grow taller as the number of units to be monitored increases. But, a multi-unit franchisee will have less number of units in her mini-chain than the franchisor would have under ISUF. In addition, a multi-unit franchisee is usually in a location relatively close to outlets under his control and those outlets are typically geographically contiguous (Kalnins and Lafontaine, 2004). Due to contiguity of outlets and geographical as well as cultural proximity of the multi-unit franchisee to the hired unit managers (Fladmoe-Lindquist and Jacque, 1995), IMUF will likely have a greater span of control that would reduce the number of management layers. Thus, other things being equal, ISUF will need a taller hierarchy than IMUF.
A taller hierarchy would result in two disadvantages. First, it would be costly. Second, information flows in tall hierarchies may be slow as well as subject to potential loss and distortion because information has to be channeled through an increasing number of people (Shane, 1996a). Distortion, withholding of information, or slowness of its flow, may fuel suspicion of opportunistic franchisee behavior. Such suspicions may necessitate higher behavioral monitoring on the part of the franchisor, leading to higher monitoring costs. In addition, the lack of information flow would likely blunt the capability of the franchising system to plan and implement counter-moves to local competitors' actions, especially when competition is high (Dant and Nasr, 1998). On the other hand, timely and accurate upward flow of information can greatly help in cementing franchisee-franchisor relationship. Such sharing of information signals cooperative intent. It also helps build mutual trust and commitment to the relationship. Dant and Nasr (1998: 11) further point out that
"... the more sticky knowledge (i.e., knowledge not readily packaged for dissemination) franchisees share with their franchisor partners, the greater the likelihood that they will be perceived as invaluable to the partnership, and the more they will be compensated for their gestures in terms of assistance like customized supportive treatment and/or marketing advice."
One of the most important resources that a foreign franchisee brings to the franchisor-franchisee relationship is the possession of superior knowledge of the local market (Dant, Kaufmann, and Paswan, 1992). Interviews we conducted with some franchisors, such as Decorating Den and Minuteman Press International indicated that many franchisors tap into a much wider set of franchisee inputs. For example, Minuteman Press International stresses local marketing and customer responsiveness. Even in the case of restaurant chains, which usually are characterized by a low degree of strategic discretion, Bradach (1998) noticed variations. Fisherman's Landing and Jack in the Box permitted little strategic local responsiveness, whereas KFC, Pizza Hut, and Hardee's "allowed for greater latitude in varying elements of the uniform format in response to local circumstances" (Bradach, 1998: 25). Franchisees can contribute greatly to the process of knowledge creation within a franchise system by sharing how they solved unique problems in their business (Phan, Butler, & Lee, 1996). Often, what starts out as a small tactic for a local market can lead to a system-wide strategy: "Thus, Pizza Hut's '2 Pizzas for 1 Price' which became the cornerstone of its growth strategy in 1991, was developed by a Florida franchisee responding to a local competitor" (Bradach, 1997: 295).
The sharing and utilization of franchisees' inputs depend, however, on an efficient flow of information, especially in the context of international franchising. There are several reasons to believe that IMUF is less likely to be susceptible to the loss or distortion of information, or retardation of its flow than ISUF. Dant and Nasr (1998) suggest that MUF facilitates more upward information flow than ISUF because IMUF entails better alignment of franchisor-franchisee goals in areas such as maintenance of brand name capital. Because they have less incentives to engage in opportunistic behavior such as shirking and free-riding, and more to lose from it in the event of getting caught, international multi-unit franchisees are more likely to engage in information sharing than single-unit franchisees.
Agency theory assumes that, in addition to being unwilling to fully exert themselves on behalf of principals, agents are also risk averse. Therefore, inefficient risk-bearing is another important source of agency problems. When a franchisee has a large proportion of his wealth and income tied to the performance of a unit, his investment portfolio is undiversified (Brickley and Dark, 1987: 405). Thus, inefficient risk-bearing leads to two related problems: likelihood of under-investment by franchisees and their expectation of higher returns. Our analysis suggests that these problems are likely to be less in IMUF than ISUF.
First, finance theory suggests that an investor owning a less diversified investment portfolio is likely to make sub-optimal investment decisions than one with an efficiently diversified portfolio because the latter would be concerned only with the systematic risk associated with a specific decision, whereas the former would likely be concerned with the total risk. For example, let us take the case of a large local advertising and promotion campaign involving billboards, newspaper ads, two-for-one specials, etc. Now let us apply the agency logic to compare the two types of agents under consideration, namely a multi-unit franchisee and a single-unit franchisee. It can be argued that the investment portfolio of the multi-unit franchisee would be more diversified (e.g., outlets placed in different parts of a city), leading to higher likelihood of making adequate investment in such a campaign. In the international context, this difference is likely to be even more pronounced because a single-unit franchisee is less likely to be able to influence the adaptation of such investments to local conditions than would a multi-unit franchisee. Bradach (1995) provides two reasons for this expectation. First, issues demanding a local response, such as customer tastes, are frequently of a regional nature rather than pertaining to a single unit. Given their ability to spread specific investments over a larger number of units, multi-unit franchisees can amortize the costs of developing local adaptation responses. Thus, the problem of under-investment by franchisees is likely to be far less in IMUF than in ISUF.
Second, compared to more diversified risk-bearing agents in IMUF, a higher perceived risk by less diversified risk-bearing agents in ISUF might lead to their demanding a higher compensation (Brickley and Dark, 1987). Multi-unit franchisees would likely have greater expectations of recovering their investments such as advertising and sales promotion due to economies of scale among all units in their portfolio than single-unit franchisees. Thus, multi-unit franchisees would likely accept less compensation per unit than single-unit franchisees. Again, this difference is particularly relevant in an international context because a multi-unit franchisee may be better able to tailor such investments to his portfolio than the single unit franchisee.
As we mentioned earlier, the presence of brand name capital can potentially encourage free-riding by franchisees (Carney and Gedajlovic, 1991). This is because brand name capital signals quality to customers and potentially reduces their ability to detect differences in the quality of service received from different units of a retail system. Therefore, an individual franchisee can potentially free-ride without losing business because of the spillover benefits from those units whose franchisees do not shade input quality. Our analysis shows that free-riding is likely to be less prevalent in IMUF than in ISUF. Shading quality by one franchisee "amounts to reneging on the franchisor's promise to other franchisees of a specific system-wide quality" (Fladmoe-Lindquist and Jacque, 1995: 1241).
When multiple units in a geographic area are owned by a single franchisee, the detrimental effect of free-riding would largely be borne by the franchisee himself, thus discouraging the likelihood of opportunism (Bercovitz, 2004b). In addition, a multi-unit franchisee has to keep in mind that if the franchisor detects free-riding, it would jeopardize the franchisee's prospects of getting the approval for adding more units. The caution is especially important because the chances that the franchisor would notice free-riding are higher in MUF than in SUF. The multiple locations owned by one franchisee in MUF allow the franchisor more opportunities for evaluating that franchisee's adherence to contractual stipulations (Bradach, 1998). Moreover, the efficiency of such evaluations, on a cost-per-franchisee examined basis, is greater. Thus, the international multi-unit franchisee would likely refrain from attempting to free-ride because his units will bear most of the cost of such free riding, which if detected, would also jeopardize future growth of his franchise. Further, at the individual outlet level, managers hired by the multi-unit franchisee in MUF would also have no incentive to free-ride compared to single-unit franchisees.
Both the principal and the agent have the potential to engage in post-contractual opportunistic behavior in an agency relationship to appropriate quasi-rents. Quasi-rents are said to exist "if the value of the asset is higher in a given use than its value in alternative uses" (Brickley and Dark, 1987: 406). That is, quasi-rents arise when firm-specific assets such as a franchisor's brand name are present. On the one hand, the franchisor can refuse to renew the franchise contract unless higher fees are paid, thereby appropriating quasi-rents. On the other hand, the franchisee can negotiate for a lowering of the same if the contract enforcement costs are higher than benefits. Our analysis shows that the likelihood that either the franchisor or the franchisee will engage in opportunistic behavior aimed at appropriating quasi-rents is lower in IMUF than in ISUF. This is because, in IMUF, the existence of multiple units gives the franchisees better ability to earn an acceptable return on their mini-chain investments such as training of employees and advertising. The franchisee also has the possibility to open additional units increasing his overall profits. Bercovitz (2004b), for example, suggests that allocation of multi-unit expansion opportunities by the franchisor acts as an effective "carrot". A single-unit franchisee, without such incentives, is more likely to engage in post contractual opportunism, especially where legal enforcement is difficult or costly. Interestingly, in IMUF, the franchisor is also unlikely to engage in excessive appropriation of quasi-rents because he is dealing with a franchisee with multiple units, who may have greater resources to retaliate than a relatively small single-unit franchisee.
The foregoing analysis suggests that agency theory can provide a theoretical explanation for the prevalence of multi-unit franchising by systematically comparing IMUF and ISUF in terms of various agency problems. In the following paragraphs, we present the implications of our analysis for future theoretical and empirical research.
First, our analysis treated MUF as a homogeneous category. There are, however, several different types of MUF. These types include sequential multi-unit franchising, master franchising, and sub-franchising (Alon, 2000; Kaufmann and Kim, 1995). Each one of these types requires detailed analysis in terms of their differential solutions to the agency problem. Such an examination would help us in developing a more comprehensive theory of franchising as well as providing practitioners with intelligent choices that best address the most crucial agency problems in a given context. For example, when a franchisor has to decide about opening a new unit in a foreign location where it already has a franchise, sequential multi-unit franchising can address the adverse selection problem better than master franchising (Kaufmann and Dant, 1996). This is because in sequential MUF, the franchisor has greater information about the capabilities and behaviors of a franchisee compared to master franchising. The primary sources of information about an aspiring master franchisee are external and self-presented. External information can be costly and potentially less reliable than that can be obtained through a close working relationship with a franchisee. The information provided by franchise applicants may be even less reliable due to incentives to misrepresent abilities and traits (Shane, 1996a). Thus the franchisor's choice of franchise form may be driven by the characteristics of the country as well the franchisor's strategic objectives. In overseas markets where opportunism is a more manifest aspect of local culture (see Dant and Nasr, 1998, for some examples), franchisors might prefer sequential multi-unit franchising to master franchising. On the other hand, where speed is more critical for competitive reasons, and where local culture is low on opportunism, master franchising may be more suitable. In situations where speed is critical but opportunism is a major issue, franchisors might pursue sub-franchising. This involves a trade-off between sharing the returns with one more layer of agents and mitigating the problem of opportunism by adding those agents that possess crucial knowledge of the local culture.
Second, the preference for one type of franchising over another may also be driven by industry-specific factors. For example, the need to protect brand name capital is likely to be more strongly felt in those industries that provide services that are relatively easily imitable and difficult to protect using legal means such as patents (Fladmoe-Lindquist and Jacque, 1995). Examples of such industries include fast food restaurants, hotel chains, etc. This suggests that the need for monitoring would vary from industry to industry. As a result, the relative advantage of IMUF over ISUF would also vary across industries. Some industries might be more labor intensive rather than knowledge intensive. Fast food restaurant industry would be one such example. In labor-intensive industries, monitoring problems are more critical due to increased incentives to shirk and shade quality. This suggests that based on industry characteristics, different agency problems may become more salient and therefore the solutions to the problem in terms of type of franchising may also vary.
Third, consideration of cultural differences across countries is relevant even in an agency theoretic analysis of IMUF. A basic axiom of agency theory is the assumption that agents would act opportunistically. However, the extent of opportunism may vary significantly across cultures. For example, Dant and Nasr (1998: 15) suggest that in Lebanon, there was evidence of franchisees who sometimes attempted to bribe the market research firms in order to provide franchisors with rosy, inaccurate market information (Nasr, 1995). On the other hand, Churchill Coffee Company USA, a coffee shop chain based in Springfield, Missouri has recently granted a license to a Japanese company, JEL, for opening up to 300 coffee shops. The company feels that trust can be easily taken for granted in business deals in Japan. Often, formal contracts either do not exist or merely outline the agreed terms. Therefore, Churchill feels that there is very little need for monitoring the conduct of a Japanese franchisee.
Finally, our agency theoretic analysis seems to suggest that IMUF may always be preferred over ISUF. Therefore, we may need additional non-agency considerations to explain the existence of international single-unit franchising. We expect that more power over a franchisor will be enjoyed by a multi-unit franchisee than by a single-unit franchisee. Therefore, a multi-unit franchisee would be able to extract significantly higher concessions from a franchisor than would a single-unit franchisee. This suggests that some franchisors may be willing to risk some channel satisfaction by using single-unit franchisees in order to avoid sharing power with multi-unit franchisees, who might demand higher quality of service or sharing of information, both of which may be very costly in an international context.
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Vinay K. Garg, Missouri State University
Abdul A. Rasheed, The University of Texas at Arlington
Table 1: Basic Goal Orientations in Franchising (a) Single-unit Multi-unit Subject Franchisor franchisee franchisee Priority Brand name capital Profitability Both Time perspective Long-term Short-term Long-term Form of earnings Percent of sales Net profits Net profits A fixed initial fee (a) Adapted from Dant and Nasr (1998: 9). Table 2: Key Definitions Term Definition Franchising The granting of exclusive rights by one party (principal, called franchisor) to another party (agent, called franchisee) for the local sale of a service or trademarked product and receiving in return fee and/or royalty and conformance to quality standards, price controls, and other practices (Caves and Murphy, 1976). Single-unit Form of franchising in which the franchisee is franchising restricted to only operate one unit (Kaufmann and (SUF) Kim, 1995). Multi-unit Form of franchising in which the franchisee can franchising operate many units (Kaufmann and Kim, 1995). (MUF) Shirking Agent's tendency to supply less effort than agreed (Jensen and Meckling, 1976). Adverse Problems arising from uncertainty regarding the selection characteristics of an individual (Levinthal, 1988: 156). Inefficient The tendency of franchisees to under-invest in risk-bearing business or expect higher returns on investments than franchisors due to their lack of diversification of investments causing them to engage in risk avoidance (Brickley and Dark, 1987). Free-riding Situations in which individuals fail to participate in collectively profitable activities in the absence of coercion or individually appropriable inducements (Stigler, 1974). Quasi-rent When the full value of a firm-specific asset (e.g., appropriation brand name) cannot be extracted if deployed in an alternative use, both the principal and the agent can resort to opportunism by way of quasi-rent appropriation (Brickley and Dark, 1987).
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|Author:||Garg, Vinay K.; Rasheed, Abdul A.|
|Publication:||International Journal of Entrepreneurship|
|Date:||Jan 1, 2006|
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