ENTREPRENEURSHIP

Entrepreneurship

Entrepreneurship

Franchising is common among retail and service businesses where production and consumption occur simultaneously (Caves and Murphy 1976). Simultaneous production and consumption forces firms to locate near customers, leading to a chain of dispersed outlets. Operating geographically dispersed outlets requires the services of many outlet managers who can be either employees or franchisees. Employee-managers work in company-owned outlets and are typically compensated through salary and bonus. By contrast, franchisees pay an up-front franchise fee and ongoing royalties in exchange for the right to build and manage outlets, and, most importantly, to keep all profits. Franchisors typically offer training services, furnish ongoing marketing, and conduct periodic quality inspections.

Agency Theory

Agency theory applies to any joint effort in which one party (the principal) delegates authority to a second (the agent-Jensen and Meckling 1976). In franchising, the agency relationship is between the firm (as principal) and its outlet managers (as agents). Agency theory assumes that agents' goals diverge from the principal's goals and that agents opportunistically act to pursue their goals. Thus, the franchisor must expend resources, called agency costs, to ensure that agents act in the principal's best interest (Jensen and Meckling 1976).

Thus, by establishing a minimum level of industry-specific human capital, and by reducing the probability of accepting new franchisees who overestimate their abilities, higher quality and greater standardization should benefit existing franchisees. Accordingly, we expect:

H1: Franchisee failure is negatively related to requiring industry experience.

Although franchising significantly reduces the moral hazard of not being able to (costlessly) observe outlet managers, some franchisors take an additional step by insisting that potential franchisees be active owner-managers and not passive investors. Passive franchisees need to hire employee-managers to monitor day-to-day activities, which merely shifts agency costs from the franchisor to the passive franchisee. Because of their proximity to outlets, passive franchisees might monitor managers more closely than franchisors, but passive franchisees' employee-managers will still withhold some effort because they do not possess powerful ownership incentives (Williamson 1991). In contrast, agency theory predicts that active owner-managers put forth optimum effort (Jensen and Meckling 1976). With more franchisee-owner effort invested, the probability of failure should fall. Thus, insisting on active ownership, while restricting franchisees' behavior, should have the benefit of reducing failure. Stated formally,

H2: Franchisee failure is negatively related to requiring active ownership.

Not all policies devised by franchisors have positive benefits for franchisees. However, as principals in an agency relationship, franchisors must furnish agents with enough compensation to forgo other opportunities. For franchisors, this means offering business opportunities with sufficient promise to attract new franchisees, and with sufficient actual payoff to compensate existing franchisees for their risk-adjusted contributions of labor and capital. Failure to do so will result in exit among existing franchisees and an ability to recruit new franchisees.

As the royalty rate increases, so too does the franchisor's incentive to actively monitor franchisees and make investments to improve the chain (Rubin 1978). However, while franchisors' incentive to monitor increases with the royalty rate, franchisees are weakened because high royalty rates make it more ...