Fairness In Franchising
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This is a theme I will be returning to: the necessary incompleteness of the franchise contract and what it means for the corporate governance of a franchise system.
But, first let us set out the problem.
At the heart of the control problem is a divergence in interest between franchisee and franchisor.A franchisee wants to maximize her profits from the operation of the outlet; she does not wish to undertake any efforts or expenditures that will not compensate the undertaking.
On the other hand, once a franchisor establishes a particular franchise, it aspires to sell more franchises and increase royalty revenues.
These objectives make the franchisor less sensitive to the costs of operating an outlet and prompt the franchisor toward maximizing revenues rather than profits. The greater the volume of sales under the trademark, the greater the likelihood that a consumer has had direct or indirect contact with the trademark, increasing its value. The greater the revenues of outlets, the greater are the royalties collected as a percentage of sales.
Franchisor's Problem: Quality Control
"This divergence in interest goes beyond the basic free-riding problem to touch almost every aspect of the operation of the franchise.Franchisees, seeking to exploit their trademark license, want to limit the number of franchises granted: franchisors, having sold the first round of franchises, may want to saturate the market with franchises.
Franchisees want to locate outlets in profitable area: franchisors, seeking to advertise the trademark and create the image of being on every street corner, may want to license additional franchisees in areas that will contribute to this reputation, even if a particular outlet may not be profitable.
Franchisors may wish to have stores operate twenty-four hours per day in order to develop the trademark's reputation for consumer convenience; franchisees, making few sales at night, may wish to save operating costs and close for a number of hours.
From the franchisor's perspective, bringing the franchisee's interests in line with its own is the central difficulty of this method of doing business."
Franchisee's Problem: Opportunism
If controlling franchisee interests were the only problem within the franchising relationship, its solution would be relatively straightforward, albeit costly.
Franchisors could, for example, retain the authority to dictate required behavior for franchisees and hire squadrons of field people to monitor compliance daily. An unrestricted exercise of control by the franchisor will favor the franchisor's interests over the franchisee's and create an equally significant problem for the franchisee: risk of opportunism.The incentive that causes a business with sunk costs to stay in operation despite losses makes franchisees vulnerable to franchisor behavior known as "opportunism."
Because the franchisee will continue to operate even if it is not recovering its sunk investment, the franchisor can make decisions that induce such losses without the franchisee going out of business.
When these decisions benefit the franchisor at the expense of the franchisee, the franchisor opportunistically extracts a portion of the franchisee's sunk costs.
A franchisor can potentially extract this value from the franchise directly in a number of ways: it can raise the price of goods sold to franchisees, increase rent, boost royalties through an increase in the required volume of a franchise, levy fees, or divert advertising funds to general corporate uses.
Extractions can occur indirectly as well.
To increase the price of new franchises, a franchisor could require franchisees to make excessive advertising investments, to participate in promotional programs which are not cost-effective, or to undertake unnecessary renovations."
Conclusion
The difficulty of distinguishing between a legitimate exercise of control and an opportunistic one provides another perspective on why franchise contracts are necessarily incomplete.It is this distinction that must be drawn, in writing, to complete the franchise contract.
Clearly this is an enormous task, one requiring the franchisee and franchisor to anticipate every detail of the long course of their relationship in a highly uncertain environment.
As a result of the enormity of this task, franchise contracts leave many of the problems at the interface between legitimate quality control and opportunism unsolved.
