Enforcing System Standards When Franchisees Have Long-Term Contracts

A franchisor's ability to enforce system standards and sustain the positive image of the brand is critical to the long-term success of a franchising system. To some degree, a franchisor's threat of termination or non-renewal contributes to that enforcement effect. But what can a franchisor do when a contract has a long duration and/or a franchisee has a strong legal presumption of renewal?

Two professors at the University of Munster (Munster, Germany) found significant modifications in a franchise's governance structure, as defined by its contract with franchisees, when a franchisor's capacity to threaten termination or non-renewal is significantly limited. The findings of Profs. Oliver Cochet and Thomas Ehrmann were presented in a paper at the 19th Annual Conference of the Inter-national Society of Franchising last year, “The Effectiveness of Con-tractual Self-Enforcement and Implications for the Governance Structure of Franchising Firms.”

By reviewing German franchise contracts, using data from the German Franchising Association and the Yearbook Franchise and Cooperation 2005, a comprehensive database of franchises operating in Germany, the professors found that franchisors typically make two key adjustments when their termination rights are constrained. First, they increase the share of company-owned outlets, and second, they use the franchising contract to centralize decision-making authority in their hands. The first adjustment gives franchisors greater knowledge about how their outlets are operating in the real world, and the second adjustment gives franchisors the ability to control franchisees based on that knowledge.

A contract defines the “decision rights” that a franchisor is offering to a franchisee, which the authors define as “provid[ing] its holder with the right to independently decide on the fulfillment of a specific task.”

Academic research has found that many franchisors (and franchisees) find long-term contracts to be attractive because they offer more time for all parties to recover set-up and training costs and enjoy some certainty in the marketplace. But long-term contracts also increase “moral hazards,” the authors note, in the form of incentives for a franchisee to become a “free rider” in the system. A franchisee that can avoid making some of its contributions to the system while still receiving the benefits of association with a popular franchise brand can raise its profits. Yet free riders, such as franchisees under-investing in advertising, not meeting quality standards, or poorly training employees, can seriously damage the brand and the entire franchise system.

Thus, the franchisor balances granting greater decision rights to franchisees (ie, decentralization) with the potential for franchisees to take advantage of greater freedom by acting outside of the system or not meeting its obligations. “A franchisor's marginal benefit of allocating decision rights to franchisees increases in the extent to which incentive devices control franchisee moral hazard,” they wrote.

Facing this choice, franchisors try a carrot-and-stick approach. Standards are enforced through a combination of measures: allowing franchisees to capture “economic rent” from their operations; actively monitoring franchisee compliance; threatening termination for non-compliance with the contract; and more. Ultimately, it's the termination threat that is often most persuasive, wrote Profs. Cochet and Ehrmann. “The effectiveness of the self-enforcement mechanism in assuring franchisee performance rests on a franchisor's ability to terminate franchisees upon detection of opportunistic behavior,” they wrote.

However, if a franchisee has a long contract and/or protection from non-renewal, termination might be an ineffective threat. In Germany, the problem is potentially acute. Germany's franchising laws are quite favorable to franchisees because franchisors must show “good cause” to terminate a contract, akin to a franchise-relationship clause in some U.S. states, said the authors. Moreover, most franchise contracts in Germany are not fixed-length, as is typical in the United States, but instead are considered permanently renewable. According to the authors, a franchise contract is considered renewed under the same terms unless one party gives proper notice to cancel it.

To counteract those aspects of Germany's franchise law, franchisors have learned to increase centralization and to restrict the decision rights of franchisees, the authors found in their study. Looking at 159 franchisors in a wide variety of businesses, the professors found a strong correlation between the length of a franchise contract and the degree of control that the franchisor retained. “Long-term contracts tend to specify more dimensions of the [franchising] transaction than short-term contracts,” such as purchasing, accounting, and public relations/marketing, the professors found.

The professors also surveyed franchisors, and asked them to rate on a scale of 1-5:

a) How intense is your support of franchisees concerning their entrepreneurial decisions?

b) How important is uniformity among your franchisees?

c) How strongly do you standardize/organize business operating

procedures?

Again, they found that franchisors with longer initial franchisee contracts indicated more effort to enforce greater uniformity on their franchisees.

But how do franchisors obtain enough information about franchisee operations in order to write contracts that meet their needs? The authors found that franchisors with longer contracts tend to have a larger share of company-owned outlets, and they apparently use the knowledge gained from ownership of those outlets to set standards for their franchisees.

Franchisors in Germany, facing termination restrictions, see other benefits of company-owned units, the authors added. “We suggest that contract duration and renewal options increase the relative importance of franchisor effort and therefore the importance of company-ownership in at least two ways. First, long-term contracts may be more difficult to terminate even for good cause, and contracts incorporating renewal options make non-renewal more difficult,” the authors wrote. “Enforcing quality through the threat of contract termination requires more franchisor resources being devoted to litigation and working with poorly performing franchisees.

“Second, we suspect that franchisors offering long-term contracts and renewal options exert additional effort on contract design, namely by specifying detailed franchisee obligations. Restricting franchisee decision-making rights by contract is costly, however. More precisely, the process of specifying the rules of the game by devising and writing more complete contracts, generates information and negotiation costs.”

As the cost of managing franchisees rises, the relative cost of owning outlets declines. Thus, franchisors decide to own more outlets. “Long-term contracts and those including a renewal option render quality enforcement within franchised outlets more costly, such that the cost disadvantage of employee versus franchise operation declines, and franchisors choose to own more of the chain's units on average,” the authors wrote. “Moreover, by owning more of the chain's units, franchisors can more effectively exert indirect managerial control over the remaining franchisees.”

To read abstracts or purchase papers from the 19th Annual International Conference on Franchising, go to www.huizenga.nova.edu/business/internationalSocietyFranchising.cfm.

To contact Prof. Olivier Cochet call +49-251-833 833 5 or e-mail: [email protected], and to contact Prof. Thomas Ehrmann, call +49-251-833 833 5 or e-mail: [email protected].

A franchisor's ability to enforce system standards and sustain the positive image of the brand is critical to the long-term success of a franchising system. To some degree, a franchisor's threat of termination or non-renewal contributes to that enforcement effect. But what can a franchisor do when a contract has a long duration and/or a franchisee has a strong legal presumption of renewal?

Two professors at the University of Munster (Munster, Germany) found significant modifications in a franchise's governance structure, as defined by its contract with franchisees, when a franchisor's capacity to threaten termination or non-renewal is significantly limited. The findings of Profs. Oliver Cochet and Thomas Ehrmann were presented in a paper at the 19th Annual Conference of the Inter-national Society of Franchising last year, “The Effectiveness of Con-tractual Self-Enforcement and Implications for the Governance Structure of Franchising Firms.”

By reviewing German franchise contracts, using data from the German Franchising Association and the Yearbook Franchise and Cooperation 2005, a comprehensive database of franchises operating in Germany, the professors found that franchisors typically make two key adjustments when their termination rights are constrained. First, they increase the share of company-owned outlets, and second, they use the franchising contract to centralize decision-making authority in their hands. The first adjustment gives franchisors greater knowledge about how their outlets are operating in the real world, and the second adjustment gives franchisors the ability to control franchisees based on that knowledge.

A contract defines the “decision rights” that a franchisor is offering to a franchisee, which the authors define as “provid[ing] its holder with the right to independently decide on the fulfillment of a specific task.”

Academic research has found that many franchisors (and franchisees) find long-term contracts to be attractive because they offer more time for all parties to recover set-up and training costs and enjoy some certainty in the marketplace. But long-term contracts also increase “moral hazards,” the authors note, in the form of incentives for a franchisee to become a “free rider” in the system. A franchisee that can avoid making some of its contributions to the system while still receiving the benefits of association with a popular franchise brand can raise its profits. Yet free riders, such as franchisees under-investing in advertising, not meeting quality standards, or poorly training employees, can seriously damage the brand and the entire franchise system.

Thus, the franchisor balances granting greater decision rights to franchisees (ie, decentralization) with the potential for franchisees to take advantage of greater freedom by acting outside of the system or not meeting its obligations. “A franchisor's marginal benefit of allocating decision rights to franchisees increases in the extent to which incentive devices control franchisee moral hazard,” they wrote.

Facing this choice, franchisors try a carrot-and-stick approach. Standards are enforced through a combination of measures: allowing franchisees to capture “economic rent” from their operations; actively monitoring franchisee compliance; threatening termination for non-compliance with the contract; and more. Ultimately, it's the termination threat that is often most persuasive, wrote Profs. Cochet and Ehrmann. “The effectiveness of the self-enforcement mechanism in assuring franchisee performance rests on a franchisor's ability to terminate franchisees upon detection of opportunistic behavior,” they wrote.

However, if a franchisee has a long contract and/or protection from non-renewal, termination might be an ineffective threat. In Germany, the problem is potentially acute. Germany's franchising laws are quite favorable to franchisees because franchisors must show “good cause” to terminate a contract, akin to a franchise-relationship clause in some U.S. states, said the authors. Moreover, most franchise contracts in Germany are not fixed-length, as is typical in the United States, but instead are considered permanently renewable. According to the authors, a franchise contract is considered renewed under the same terms unless one party gives proper notice to cancel it.

To counteract those aspects of Germany's franchise law, franchisors have learned to increase centralization and to restrict the decision rights of franchisees, the authors found in their study. Looking at 159 franchisors in a wide variety of businesses, the professors found a strong correlation between the length of a franchise contract and the degree of control that the franchisor retained. “Long-term contracts tend to specify more dimensions of the [franchising] transaction than short-term contracts,” such as purchasing, accounting, and public relations/marketing, the professors found.

The professors also surveyed franchisors, and asked them to rate on a scale of 1-5:

a) How intense is your support of franchisees concerning their entrepreneurial decisions?

b) How important is uniformity among your franchisees?

c) How strongly do you standardize/organize business operating

procedures?

Again, they found that franchisors with longer initial franchisee contracts indicated more effort to enforce greater uniformity on their franchisees.

But how do franchisors obtain enough information about franchisee operations in order to write contracts that meet their needs? The authors found that franchisors with longer contracts tend to have a larger share of company-owned outlets, and they apparently use the knowledge gained from ownership of those outlets to set standards for their franchisees.

Franchisors in Germany, facing termination restrictions, see other benefits of company-owned units, the authors added. “We suggest that contract duration and renewal options increase the relative importance of franchisor effort and therefore the importance of company-ownership in at least two ways. First, long-term contracts may be more difficult to terminate even for good cause, and contracts incorporating renewal options make non-renewal more difficult,” the authors wrote. “Enforcing quality through the threat of contract termination requires more franchisor resources being devoted to litigation and working with poorly performing franchisees.

“Second, we suspect that franchisors offering long-term contracts and renewal options exert additional effort on contract design, namely by specifying detailed franchisee obligations. Restricting franchisee decision-making rights by contract is costly, however. More precisely, the process of specifying the rules of the game by devising and writing more complete contracts, generates information and negotiation costs.”

As the cost of managing franchisees rises, the relative cost of owning outlets declines. Thus, franchisors decide to own more outlets. “Long-term contracts and those including a renewal option render quality enforcement within franchised outlets more costly, such that the cost disadvantage of employee versus franchise operation declines, and franchisors choose to own more of the chain's units on average,” the authors wrote. “Moreover, by owning more of the chain's units, franchisors can more effectively exert indirect managerial control over the remaining franchisees.”

To read abstracts or purchase papers from the 19th Annual International Conference on Franchising, go to www.huizenga.nova.edu/business/internationalSocietyFranchising.cfm.

To contact Prof. Olivier Cochet call +49-251-833 833 5 or e-mail: [email protected], and to contact Prof. Thomas Ehrmann, call +49-251-833 833 5 or e-mail: [email protected].