AN ANALYSIS OF THE CONTRACT PROVISIONS IN BUSINESS-FORMAT FRANCHISE AGREEMENTS

AN ANALYSIS OF THE CONTRACT PROVISIONS
IN BUSINESS-FORMAT FRANCHISE AGREEMENTS
Janet E.L. Bercovitz
The Fuqua School of Business
Duke University
August, 2000
Draft. Please do not quote or cite without permission. All comments gratefully accepted. The author can be
reached via e-mail at janetb@mail.duke.edu

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I.
Introduction
Franchising is a form of hybrid organization that lies between markets and hierarchy.1
While hybrids are often treated as a discrete type, an investigation of the contractual
arrangements between franchisors and franchisees reveals the existence of significant variation in
this organizational form. Indeed, there is substantial diversity across franchise systems with
respect to the terms specifying contract duration, encroachment restrictions, and termination
conditions. Notably, it is these same terms that are at the crux of the ongoing franchise
relationship legislation debates.2 This combination of diversity and controversy raises two
questions. First, what explains the variation we see in franchise agreements? And second, what,
if any, are the public policy implications of these variations?
Though franchising has been treated extensively in the economics literature, the
variations in contracts noted above remain largely unexplained. Traditional agency models have
explored problems with the supply of effort in the franchisor/franchisee dyad when individual
action is hard to observe (Mathewson and Winter, 1985; Lal, 1990; Lafontaine, 1992; Rubin,
1978). This body of literature deals primarily with the payment terms of franchise agreements
(up-front fixed fees and royalty rates) and ignores the wide variety of non-pecuniary contractual
features (e.g., exclusive territory terms, termination conditions, contract duration) that are central
to the public policy debate. A second strand of literature has focused on the prototypical hazard

1 Williamson (1991: 283) defines the hybrid form as being, "located between market and hierarchy with respect to
incentives, adaptability, and bureaucratic cost. As compared with the market, the hybrid sacrifices incentives in
favor of superior coordination among the parts. As compared with the hierarchy, the hybrid sacrifices
cooperativeness in favor of greater incentive intensity." With respect to franchising, this hybrid mode is adopted in
order to realize stronger incentives (as compared to hierarchy) while maintaining systems gains to the common brand
name (possible due to superior coordination than markets).
2 A recent volley in this long-standing battle came with the introduction of the Small Business Franchise Act of 1998
to Congress (HR 4841). Sponsored by Rep. Howard Coble (R-NC) and Rep. John Conyers Jr. (D-Mich.), this bill
seeks to set uniform standards of conduct for franchise contracts.
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associated with franchising: free-riding on the system’s brand-name (Klein, 1980, 1995; Klein
and Murphy, 1988; Williamson, 1985). While the need to structure franchise arrangements so as
to control free-riding is central in these writings, relatively little theoretical work and essentially
no empirical work exploring how the adoption of specific contract terms can alleviate this hazard
has been undertaken to date.3 Furthermore, the influence of a third exchange issue,
maladaptation hazards and the associated issue of specific investment cost recovery, though
prominent in the trade literature on franchising, has received relatively little attention in the
franchising academic literature. Given the centrality of this hazard in the transaction cost
framework (Williamson, 1975, 1985, 1996; Klein, Crawford, and Alchian, 1978) and its proven
explanatory powers regarding the adoption of specific terms in long-term contracts (Crocker and
Masten, 1985; Goldberg and Erickson, 1987; Joskow, 1987, 1988; Masten and Crocker, 1988;
Mulherin, 1986), this appears to be a notable gap in the franchising literature.
This study addresses these issues. First, employing the economizing perspective, this
paper develops a theoretical basis for exploring the existing variation across franchise
arrangements. Second, this study provides one of the first empirical investigations of the
adoption of non-payment related, as well as payment related, contract terms. Results are
encouraging. The data suggest that contract terms are discriminately selected so as to mitigate
free-riding hazards and resolve cost recovery issues.
The paper proceeds as follows. The conceptual framework is laid-out in Section 2. In
Section 3, I distill hypotheses suggested in the existing theoretical literature to test for underlying
regularities in the use or non-use of key contractual clauses in franchise arrangements. Section 4

3 Klein and his co-authors offer some general prescriptions. They argue that franchisees can be dissuaded from
exploiting demand externalities (free-riding) through the adoption of contractual terms that provide the franchisee
with downstream rent premiums that they will lose if suspected of substandard performance (Klein, 1980, 1995;
Klein and Leffler, 1981; Klein and Murphy, 1988).
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describes the data and outlines the methodology that is used to test these hypotheses. Results are
summarized in Section 5. Section 6 concludes.
II.
Conceptual Framework
There are three strands of the economic literature pertinent to the study of contractual
arrangements in general, and franchising agreements, in particular. These are: (1) the traditional
principal-agent or share-contract models; (2) the self-enforcing agreement literature; and (3) the
transaction cost economics perspective. These complementary frameworks draw attention to
three types of hazards that may impinge upon the franchise relationship. These are: (1) free-
riding hazards; (2) maladaptation hazards; and (3) shirking. As previous researchers have shown
(Brickley and Dark, 1987; Lafontaine, 1992; Minkler and Park, 1994; Bercovitz, 2000), the
decision to franchise versus company-own an outlet rests on the level of the first and third of
these hazards. Specifically, an outlet will be franchised when the shirking-related costs of
integrated ownership exceed the free-riding costs of franchising.4 Following the first-order
ownership choice, economizing logic would suggest that the franchising contract terms would
then be selected to provide “second-order” safeguards against the residual hazards and, equally
important, to insure that the agreement is prospectively remunerative. In the following
discussion and empirical test, I presume that the first-order decision to franchise has already been
made and focus on the use of selected contractual terms to fine-tune the relationship.

4 Maladaptation hazards do not appear to play a significant role in the first-order franchising make-or-buy decision.
To confirm assertions to this effect made by Lafontaine and Slade (1998), I ran models that controlled for the level
of asset specificity when investigating organizational choice decisions. In all cases, the coefficient on this variable
was insignificant (Bercovitz, 2000).
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Below, I briefly discuss the exchange issues of interest with a focus on how these issues
may manifest within the franchise relationship.5
A. Identification and Explication of Exchange Issues
1. Free-Riding Hazards
Free-riding hazards arise in situations where the inputs of more than one party
influence the value of the end-product and/or service, but where, due to incomplete
contracting and measurement difficulties, no one party is able to capture the entire benefits
(or costs) of their individual efforts. In the absence of safeguards that prompt the
internalization of such externalities, transacting parties will, at times opportunistically,
choose to supply effort at levels that optimize individual returns at the expense of joint (or
system-wide) returns.
Given customers that patronize multiple outlets, the perceived value to an outlet’s
offering will be based on the customers’ general as well as local experience. As such, the
benefits and/or damages resulting from the actions of any one franchisee will spillover and
influence customers’ perception of both the individual outlet and all other outlets in the
system. Under such conditions, the possibility of free-riding hazards arise. Free-riding is
likely, however, only if there is some ambiguity regarding the performance of individual
franchisees such that it is possible for an individual franchisee to gain by opportunistically
devaluing the system.

5 Though the highlighted issues are treated as equal threats in the following discussion, it’s probable that some are
more consequential than others. This is an empirical matter that needs investigation.
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There are many ways in which the franchisee may free-ride within the franchise
relationship. In business-format franchising, the creation and maintenance of a strong
brand name is believed to be key to overall system success. Brand names convey
information regarding product and service quality, aid in differentiating company offerings
and, thus, provide a means to generate positive (above competitive) returns.
Unfortunately, brand names, a shared specific asset, are also highly vulnerable to franchisee
free-riding. Operating under a common brand name, each individual franchisee has an
opportunity to lower its direct costs by reducing input quality without bearing the full
consequences of such opportunistic actions. Lacking corrective mechanisms, the resultant
costs of consumer dissatisfaction will be shared with the franchisor (lower brand name
value) and other franchisees (lower demand) in the system. As such, incentives for an
individual franchisee to perform at the jointly optimum level are low.6
2. Cost Recovery Issue
a. Specific Investments
Both franchisors and franchisees are called upon to make specific investments in
support of the franchising relationship. Franchisees are generally required to provide up-
front, lump-sum payments to the franchisor and to purchase trademarked equipment and
accoutrements for their outlets. Franchisors, in turn, are generally obligated to supply
franchisees with training and to assist in the openings of franchised outlets. Specific
investments of these kinds create bilateral dependencies that may give rise to maladaptation
hazards (Klein, Crawford, and Alchian, 1978; Williamson, 1985). That is, complex

6 Disputes centered-on franchisee free-riding are numerous. For a discussion of free-riding cases, see Goldberg,
1979.
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franchise arrangements, which are generally incomplete, are susceptible to, and could
possibly be undermined by, opportunistic renegotiations on the part of either transacting
party.
Broadly, maladaptation hazards are a concern only in relation to unanticipated
contingencies.7 An opportunity to expropriate one’s transacting partner generally follows
an unexpected event that somehow significantly changes initial conditions and thus
behooves the parties to renegotiate their original agreement. It is in these renegotiations,
and/or subsequent adaptations, that one party can opportunistically expropriate rents from
the other.
Within the franchising arena, unanticipated events that could lead to opportunistic
renegotiation include such drastic changes as the acquisition of the franchise system by a
new franchisor or the emergence of new legal precedents that strengthen either the
franchisor’s or franchisee’s termination rights. A less extreme catalyst of maladaptation
hazards may be life cycle transitions (Oxenfeldt and Kelley, 1968-69; Klein, 1980; Dant,
Kaufmann, and Paswan, 1992).8 For example, the threat of opportunistic renegotiation by
the franchisor is expected to increase as the franchise system matures. If the franchisor no
longer anticipates the need to attract new franchisees to expand operations, he will be less

7 Bounded rationality is key here. With unbounded rationality, a contingent contract that specifies actions to be
taken given the realization of any potential event could be drafted. In this case, maladaptation hazards would not be
problematic.
8 Leveraging an organizational life cycle view of franchising, Oxenfeldt and Kelly (1968-69) were among the first to
express concerns about ownership redirection – the reaquisition of franchised outlets by the franchisor – arising with
franchise system maturity. Arguing that: “[F]ranchising is advantageous to a successful franchisor mainly during
the infancy of and adolescence of the enterprise. . .” and highlighting that franchisors “might have the power to
annoy a holder of a good franchise into selling it,” these authors provided motives for franchisor opportunism
(Oxenfeldt and Kelly, 1968-69: 69-70) It is these perceived motives that underlie and continue to drive much of the
ongoing public policy debates about fairness in franchising (See House Committee on Small Business, 1990.
“Franchising in the U.S. Economy: Prospects and Problems”).
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constrained by reputational concerns and may choose to act opportunistically (Klein,
1980).9
In practice, such unanticipated contingencies of these types appear to be relatively
rare.10 Thus, the threat of expropriation may not be a central issue in the structuring of
franchising arrangements. However, the required specific investments do bring forth the
related issue of cost recovery. Specifically, before entering a franchise relationship, rational
(even boundedly rational) transacting parties (franchisors and franchisees) need to have
confidence that, over the life of the agreement, they will be able to recoup the costs of their
specific investments. In order to induce participation, therefore, the franchise agreement
needs to be structured so as to be prospectively remunerative to both parties.
b. Ongoing Effort
Substantial levels of ongoing effort on the part of both the franchisor and the outlet
operator (franchisee or employee-manager) are needed to optimize the overall performance (and
thus value) of an individual outlet in a franchise system. As Caves and Murphy (1976: 574)
note, franchising systems are generally characterized by “divergent scale economies” – that is,
some activities are most efficiently supplied at the outlet-level by the manager (franchisee or
employee), while others are best centralized and supplied to the entire system by the franchisor.
For example, a well-cooked meal or a quick oil change are best supplied near the site of

9 In Siegel v. Chicken Delight (448 F. 2d 43; 1971), for example, the court held that the franchisor was acting
opportunistically by increasingly tying product purchases to the franchisee’s right to use the trademark. Specifically,
Chicken Delight required franchisees to purchase cooking equipment, dry-mix food items, and trademarked
packaging exclusively from Chicken Delight at above-competitive prices. Determining that the less restrictive
alternative of specifying the quality of inputs was possible and would suffice to protect the franchisor’s goodwill, the
courts ruled that the tying arrangement was unlawful.
10 In a review of studies on the ownership redirection hypothesis, Dant, Kaufman, and Paswan (1992) find no
conclusive evidence that ownership redirection is common. Further, these authors find that when franchisors do
reacquire units, the motives are often non-opportunistic.
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consumption while national advertising campaigns and/or standard operating procedures can be
more efficiently developed at the corporate level. Give the joint effort required and the difficulty
of monitoring effort supplied by the outlet manager or the franchisor, it is feasible that either
party may, in their self-interest, choose to not to provide their best efforts.11 That is, this
distribution relationship could be susceptible to a two-sided shirking/moral hazard
(Bhattacharyya and Lafontaine, 1995).12
However, as the franchisor chooses to sell the right to operate a particular outlet to a
franchisee in order to mitigate shirking hazards that arise under the low-powered incentives of
integrated distribution, one must question assertions that franchisee shirking remains a significant
problem that needs to be addressed at the margin in the franchise agreement. More salient
perhaps is the practical consideration of structuring the franchise arrangement in a manner that
makes the ongoing provision of effort economically viable for both the franchisee and the
franchisor. That is, efficient franchise arrangements need to preserve high-powered outlet-level
incentives for the franchisee while simultaneously compensating the franchisor for the continued
provision of services – qualifying input vendors, administering advertising activities, monitoring
franchisees, developing new products, updating operating procedures – necessary to maintain
system brand name value.

11 With respect to franchising, Lal (1990: 312) concludes, “if the service level cannot be specified in the contract
and verified with certainty subsequently, the franchisee has incentives to shirk since it does not capture all the
benefits from delivering the higher service level. Similarly, if the brand name effect can not be specified precisely
and verified by the franchisee, the franchisor has less than maximum incentives to invest in the brand name since
some of the benefits are shared with the franchisee. . .”
12 Dual moral hazard situations have been explored with respect to sharecropping (Reid, 1977; Eswaran and Kotwal,
1985) franchising (Mathewson and Winter, 1985, 1994; Lal, 1990; Lafontaine, 1992; Bhattacharyya and Lafontaine,
1995) and product warranty contracts (Cooper and Ross, 1988; Dybvig and Lutz, 1993).
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3. Summary of Exchange Issues
In general, a significant level of specific investments, (franchisee specific investments in
leasehold improvements and trademarked equipment, franchisor specific investments in training
and site selection, and/or joint specific investments in the creation of brand name value) is
needed to create value in a franchise system. However, as noted above, it is just these
investments that give rise to transacting issues. Farsighted actors, recognizing the mutual
benefits of inducing such expenditures, have incentives to adopt contractual terms that mitigate
hazard-related losses and overcome participation constraints. Specifically, to be viable, a
franchise arrangement must (1) protect against free-riding and the degradation of the common
brand name; (2) preserve the high-powered incentives at the outlet-level; and (3) be prospectively
remunerative (cost recovering) for both the franchisee and the franchisor.
B. Governance
Williamson (1985: 33-34) outlines three general types of governance safeguards:
(1) safeguards that align incentives by incorporating penalties and rewards into the
contractual arrangement; (2) safeguards that signal and support continuity intentions; and
(3) safeguards that create mechanisms for adaptive dispute resolution. A fourth type of
safeguards are those that provide and/or enhance monitoring capabilities (Fama and
Jensen, 1983; Jensen and Meckling, 1976; Klein, 1980, 1995).13

13 Information disclosure and third-party verification of such disclosures provides another possible safeguard type. I
do not explicitly consider such disclosure rights in the following discussion of franchise contractual safeguards as, in
1979, legislation was passed requiring franchisors to provide prospective franchisees with detailed disclosure
documents at least 10 days prior to the execution of a franchise agreement. Thus, in the franchising arena, disclosure
safeguards have been moved from the governance realm into the institutional environment realm.
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Document Outline

• Janet E.L. Bercovitz
• Duke University
• August, 2000
• I
• I. Introduction
• II. Conceptual Framework
  • 2. Cost Recovery Issue
• a. Specific Investments
• Governance
  • • Table 1
  • B. Franchisee and Franchisor Ongoing Effort
  • C. Franchisee Free-Riding and Franchisee Specific Investment
  • B. Dependent Variables
• Table 2 Summary of Variables
  • • • • • Hypothesis
  • C. Independent Variables
    • N = 109
    • Table 7
    • Table 8
      • • • • V. Results and Discussion
  • A. Hypothesis 1: Initial Franchise Fee
    • Table 9
    • OLS Regression: Initial Franchise Fees
    • N=80
  • B. Hypothesis 2: Share Parameter
    • N=109
    • Table 11
    • N=57
    • Table 12
    • N=57
    • N=57
• Bibliography

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