Franchising
Steven C. Michael
Franchising, where independent businesses operate under a shared trademark using a common production process, is an organizational form used primarily by service businesses. Franchising is big business in the economy at large, carrying 10 percent of US retail trade and ser vices. Franchising is also commonly used as a method of international entrepreneurship; a recent survey identified over 1 million franchisees worldwide.
Historically, franchising was introduced in the United States in the early twentieth century by manufacturers in order to secure local distribution of their product. Franchise chains formed at that time still dominate automobile and gasoline retailing and soft drink and beer distribution. This type of franchising is called product franchising. A second type, business format franchising, arose in the 1950s by entrepreneurs in services industries and is the subject of this article. Franchising is an important method for entrepreneurs who develop new concepts and products in services to assemble resources efficiently, to grow the firm rapidly, and to manage it effectively.
How Franchising Works
The mechanics of business format franchising are as follows. A franchise is a legal contract between the owner of a production process and a trademark (the franchisor, such as McDon ald’s) and a local business person (franchisee) to sell products or services under the franchisor’s trademark, employing a production process developed by the franchisor. When a franchise contract is signed, the franchisee pays a lump sum, a franchise fee. After signing the contract, the franchisor gives the franchisee services needed to open the unit, including training and blueprints for the production process, and in some cases support for site selection or construction management. The franchisee typically makes all necessary investments in land, building, and equipment to open the particular site.
After opening, the franchisor provides peri odic inspection of the franchise (to ensure operating standards are being followed), access to trademarks, and marketing services (such as advertising and new product development). In return for these services, the franchisee pays a royalty on sales (typically ranging between 1–10 percent) and a royalty for marketing expenses (from 0–6 percent), commonly called the advertising fee. Generally, franchisees do not sell products of the franchisor (although important exceptions exist); the franchisor is compensated for the trademark and its management. The franchise chain is composed of units franchised to local operators and units owned by the franchisor. Both types operate the same production process and sell under the same trademark, but 132 franchising most franchise chains are primarily composed of franchised units.
As an organizational form, franchising has a large and visible presence in consumer industries such as restaurants, lodging, auto repair, real estate, hair styling, and specialty retailing, where it has captured typically 30–40 percent of sales. Business services where franchising is prominent include temporary employment, commercial cleaning, printing and copying, tax preparation, and accounting services. Recent areas of growth include home healthcare, business signage, and child development and education. Moreover, franchising’s share of sales ranges from 71 percent of the printing and copy ing market to 0.5 percent of the accounting market. But the wide range of shares indicates the importance of industry specific factors in the choice of organizational form. Product differentiation in these service and trading businesses is large, grounded in the physical dispersion and localized monopolies of units and in the heterogeneity of customers’ tastes.
Why Franchising?
Strategically, franchising is an organizational form chosen by entrepreneurs in order to compete in certain industries. Services entrepreneurs choose franchising in order to solve the problem of agency or the problem of resource scarcity. The problem of agency occurs when one person works for another; the agent some times pursues her own interest at the expense of the principal. For example, employees (agents) typically do not work as hard as their employer (principal) would like. When operating a chain of dispersed service outlets, each outlet typically requires intensive on site supervision. Franchising makes the local supervisor the owner of the local business, granting to the supervisor franchisee the profits after all expenses have been paid. Requiring site managers to invest their own capital and giving them profits after costs induces the franchisee manager to put forth more effort in supervision than would a corporate employee manager. Through franchising, greater operational efficiency is obtained, and the agency problem is mitigated.
The problem of resource scarcity notes that service entrepreneurs face constraints to growth. The entrepreneur requires financial capital for rollout of the successful business concept across the nation. (Lacking physical assets or sophisticated technology, service firms face particular difficulties in financing.) The entrepreneur also requires information regarding desirable locations for the business, as well as information regarding sources of labor supply. Finally, the entrepreneur requires site managers to implement the proven business concept at dispersed locations. Franchising gives access to all three of these resources rapidly through the use of franchisees, who provide their own capital, their own knowledge of geographic locations and labor markets, and their own managerial labor to the chain. The two theories, agency and resource scarcity, are complementary, particularly if re source scarcity is taken to explain a short run decision while agency explains the persistence of franchising.
Consequences of Using Franchising
By using franchisees’ capital (rather than bankers’), by using franchisees’ geographic knowledge (rather than consultants’), and by encouraging franchisees to self select for management (rather than engaging in a hiring pro cess), franchising is widely regarded to facilitate rapid growth by entrepreneurs. Services typic ally lack intellectual property protection, so rapid growth is often the only way to secure first mover advantage. In particular, services such as retailing and restaurants typically must be delivered at a particular place, so preemption of valuable real estate may be possible. Also, the first entrepreneur in service and retail trade may shape customer preferences for the hamburger, the motel, or the copy shop in directions that benefit the first mover (e.g., two all beef patties must have a particular ‘‘special sauce’’ in order to be desirable). A premium is then created on rapid expansion of geographic sites. More sites allow the preemption of more real estate, and more sites also allow for a broader base of customers to experience the product in order to shape their preferences.
The gains of faster growth and first mover advantage come at a cost, however. Franchise chains are created by legal contracts, not employment relationships. As a result, franchisees are much more independent than employees, and therefore the franchisor has less control franchising 133 than a fully owned chain. Each franchisee is free to set his own pricing, for example, making chain wide promotion difficult.
In addition to problems of coordination, the sharing of the trademark across independent entities creates the risk of free riding. The power of the franchise chain is that it shares a trademark across multiple units, allowing customers to link consumption experiences in time and space. That trademark requires investment in intangible but costly items such as advertising and quality control, for which costs are specific to one franchisee but benefits are shared across franchisees. For example, a billboard erected by one franchisee may induce a customer to stop at a unit of the chain owned by another franchisee. The potential for free riding is created due to this shared trademark.
To claim that free riding can occur is not the same as claiming that free riding does occur. Franchisors are aware of the risk of free riding and take a number of managerial actions to reduce or mitigate the problem. Despite these efforts, research has shown that free riding does occur; franchise chains have lower quality and less advertising than owned chains (chains that do not employ franchising at all). The failure to control quality is at least in part due to the difficulties of termination. Termination of the franchise relationship is the primary sanction available to the franchisor, but it is a blunt instrument that can only be used with the supervision of the court.
The individuals who purchase franchises (franchisees) are entrepreneurs of a different sort. While not innovators, they do bear risk and they do bring a novel product bearing a trademark to a particular location or customer group. In general, failure rates for franchisees are similar or a little lower than failure rates for independent entrepreneurs in services. Returns, however, are generally higher because of the participation in the franchise chain. Therefore, buying a franchise is often a good choice for some entrepreneurs.
Conclusion
Franchising is best viewed as a resource assembly method that enables the entrepreneur in service industries to assemble necessary re sources to quickly exploit opportunity. The entrepreneur develops an innovation in retail trade or services, and turns to franchising to develop resources quickly in order to gather persons, sites, and money needed for expansion. Rapid expansion is necessary in order to secure desirable real estate and desirable mind space against potential imitators. Franchising also pro vides an ongoing supply of motivated managers for dispersed operations. In a world where re sources are scarce, whether managerial, informational, or financial, franchising as a method of rapid expansion becomes a crucial strategic decision.
For a guide to the business details of franchising, Bond and Bond (annual) issue a list of franchises and an overview for potential franchisees. The most integrative academic article addressing agency and competitive effects is Caves and Murphy (1976). For a discussion of the two reasons for franchising, see Combs and Ketchen (1999). For a discussion of the potential for rapid growth, see Shane (1996) and Michael (2003). For a discussion of the problems of free riding, see Michael (2000).
Bibliography
Bond, R. E. and Bond, C. E. (annual). The Source Book of Franchising Opportunities. Homewood, IL: Dow Jones-Irwin.
Caves, R. E. and Murphy, W. F. (1976). Franchising: Firms, markets, and intangible assets. Southern Eco nomic Journal, 42: 572 86.
Combs, J. G. and Ketchen, D. J. (1999). Can capital scarcity help agency theory explain franchising? A test of the capital scarcity hypothesis. Academy of Management Journal, 42: 196 207.
Michael, S. C. (2000). The effect of organizational form on quality: The case of franchising. Journal of Economic Behavior and Organization, 43: 295 318.
Michael, S. C. (2003). First mover advantage through franchising. Journal of Business Venturing, 18: 61 80.
Shane, S. (1996). Hybrid organizational arrangements and their implications for firm growth and survival: A study of new franchisors. Academy of Management Journal, 39: 216 34.