Chapman Law Review
Fall 2009
Article
REPUTATION LIFE CYCLE: THE CASE OF FRANCHISING
Uri Benoliel [tippy title=”*” header=”off”]Assistant Professor, Academic Center of Law & Business. J.S.D., University of California, Berkeley, 2006; LL.M, Columbia University, 2005; LL.B., Hebrew University of Jerusalem, 2003. This Article greatly benefited from comments and criticisms by Gary Castrogiovanni, Richard Epstein, Tamar Frankel, Warren Grimes, Steven Michael, Renana Peres, Yuval Procaccia, James White, and conference participants at the 2009 Israeli Law and Economics annual meeting. This article was presented at the 2009 annual conference of the Canadian Law and Economics Association (October 2009).[/tippy]
Copyright (c) 2009 Chapman Law Review; Uri Benoliel
Law-and-economics conventional analysis contends that franchise termination laws, prohibiting opportunistic termination by the franchisor, are superfluous. Well-rooted in traditional law-and-economics opposition to such legislation is the belief that the reputation mechanism serves as a sufficient control against opportunistic termination by franchisors. This article questions the idea that reputation concerns can be a substitute for regulation of franchise relationships.
The article argues that the reputation mechanism suffers from an inherent deficiency, which disqualifies it from serving as a substitute for franchise termination legislation. In short, the reputation mechanism often has a limited life cycle consisting of three stages: creation, erosion and collapse. At the early stages of the franchisor organizational life cycle, the reputation mechanism may have some deterring effects on the franchisor. At these stages, the incentive of the franchisor is normally to attract new franchisees and thus the franchisor attaches greater importance to being perceived as fair in the eyes of potential franchisees. As the franchisor’s financial resources increase, the effectiveness of the reputation mechanism will be eroded. Particularly, the franchisor’s incentive to attract new franchisees will decrease. Similarly, its incentive to maintain its present franchisees will decline. Instead, the franchisor, having greater financial resources, will gradually shift towards self-ownership of the units. Following the continuing decrease in the franchisor’s financial constraints and the decrease in its incentive to maintain and attract new franchisees, the reputation mechanism may collapse. This may particularly occur when the reputation-related costs decrease to a minimum level, at which point they will be lower than the franchisor’s benefits from opportunistic termination of the franchise contract.
Introduction
Legal economists have long debated whether the reputation mechanism can serve as a substitute for regulating the behavior of legal entities bound to a contractual relationship. [tippy title=”1″ header=”off”]See Gillian K. Hadfield, Problematic Relations: Franchising and the Law of Incomplete Contracts, 42 Stan. L. Rev. 927, 978 n.232 (1990).[/tippy] If the importance of maintaining a good reputation in the market can effectively regulate or deter opportunistic behavior by the parties, legal regulation of the contractual relationship is a social waste. Conversely, if the market-based reputation mechanism cannot deter opportunism, regulation of the relationship is more justifiable. Traditional law-and-economics analysis, which has found its way into current legislative practices in the United States, tends to suggest that the reputation mechanism can indeed function as an effective substitute for costly regulation of contractual relationships. [tippy title=”2″ header=”off”]See, e.g., Lewis A. Kornhauser, Reliance, Reputation, and Breach of Contract, 26 J.L. & ECON. 691, 703 (1983) (presenting a model in which “reputation will substitute perfectly for a damage rule”); Douglas G. Baird, Robert H. Gertner & Randal C. Picker, Game Theory and the Law 57, 159-87 (1994) (suggesting that the reputation mechanism “can bring about long-term cooperation even if there is no enforceable contract”). But see Steven Shavell, Foundations of Economic Analysis of Law, 323-24 (2004) (arguing that the reputation mechanism is an imperfect substitute for courts).[/tippy] One commercial relationship in particular–the franchise relationship–is well-positioned, say legal economists, to be governed by reputation rather than by regulation.
The franchise relationship involves two major legal entities: the franchisor provides its trademark or trade name and a business system, while the franchisee generally pays the franchisor an ongoing royalty and an initial fee. [tippy title=”3″ header=”off”]The contract underlying the relationship between the two parties is the “franchise contract.” International Franchise Association, Frequently Asked Questions About Franchising, http://www.franchise.org/industrysecondary.aspx?id=10008 (last visited Nov. 1, 2009). See generally Hadfield, supra note 1, at 931-32.[/tippy] To date, the legal ties of franchise relationships are regulated by a minority of fifteen states in the United States. These states enacted termination laws requiring “good cause” for the termination of a franchise contract by a franchisor, [tippy title=”4″ header=”off”]The fifteen “good cause” states are Arkansas, California, Connecticut, Delaware, Hawaii, Illinois, Indiana, Iowa, Michigan, Minnesota, Nebraska, New Jersey, Virginia, Washington, and Wisconsin. See Ark. Code Ann. §4-72-204 (2001); Cal. Bus. & Prof. Code §20020 (Deering 2007); Conn. Gen. Stat. Ann. §42-133f (West 2007); Del. Code Ann. tit. 6, §2552(a) (2005); Haw. Rev. Stat. Ann. §482E-6(2)(H) (LexisNexis 2009); 815 Il.l. Comp. Stat. Ann. 705/19 (West 2008); Ind. Code Ann. §23-2-2.7-1(1)(7) (West 2005); Iowa Code Ann. §523H.7(1) (West 2007); Mich. Comp. Laws Ann. §445.1527(27)(c) (West 2002); Minn. Stat. Ann. §80C.14(3)(b) (West 2009); Neb. Rev. Stat. Ann. §87-404 (LexisNexis 2007); N.J. Stat. Ann. §56:10-5 (West 2001); Va. Code Ann. §13.1-564 (2006); Wash. Rev. Code Ann. §19.100.180(2)(j) (West 1999); Wis. Stat. Ann. §135.03 (West 2009).[/tippy] generally defined as the franchisee’s failure to obey the franchise contract. [tippy title=”5″ header=”off”]See Ark. Code Ann. §4-72-202(7)(A) (2001); Cal. Bus. & Prof. Code §20020 (Deering 2007); Conn. Gen. Stat. Ann. §42-133f(a) (West 2007); Haw. Rev. Stat. Ann. §482E-6(2)(H) (LexisNexis 2009); 815 Ill. Comp. Stat. Ann. 705/19(b) (West 2008); Ind. Code Ann. §23-2-2.7-1(1)(7) (West 2005); Iowa Code Ann. §523H.7(1) (West 2007); Mich. Comp. Laws Ann. §445.1527(27)(c) (West 2002); Minn. Stat. Ann. §80C.14(3)(3)(b) (West 2009); Neb. Rev. Stat. Ann. §87-402(8) (LexisNexis 2007); N.J. Stat. Ann. §56:10-5 (West 2001); Wash. Rev. Code Ann. §19.100.180(2)(j) (West 1999).[/tippy] Under these laws, a franchisor who concludes the franchise contract without a show of good cause must pay the franchisee damages. [tippy title=”6″ header=”off”]Recoverable damages may include the following: (1) a fraction of the franchisee’s tangible assets used with respect to the terminated franchise, including sales outlets and facilities, offices, warehouses, trucks, furnishings, equipment, and accessories; (2) loss of goodwill; and (3) loss of profits. See generally Ark. Code Ann. §4-72-208(b) (2001); Conn. Gen. Stat. Ann. §42-133g(a) (West 2007); Del. Code Ann. tit. 6, §2553(c) (2005); 815 Ill. Comp. Stat. Ann. 705/26 (West 2008); Iowa Code Ann. §523H.13 (West 2007); Minn. Stat. Ann. §80C.17(1), (3) (West 2009); Neb. Rev. Stat. ann. §87-409 (LexisNexis 2007); N.J. Stat. Ann. §56:10-10 (West 2001); Va. Code Ann. §13.1-571(a) (2006); Wis. Stat. Ann. §135.06 (West 2009).[/tippy] These franchise termination laws aim to protect franchisees against opportunistic treatment by franchisors, who inherently enjoy greater bargaining power. [tippy title=”7″ header=”off”]Va. Code Ann. §13.1-558 (2006); Geib v. Amoco Oil Co., 29 F.3d 1050, 1056 (6th Cir. 1994); Wright-Moore Corp. v. Ricoh Corp., 908 F.2d 128, 135 (7th Cir. 1990); Kubis & Perszyk Assocs. v. Sun Microsystems, Inc., 680 A.2d 618, 622 (N.J. 1996); Corp v. Atlantic Richfield Co., 860 P.2d 1015, 1018 (Wash. 1993); Robert W. Emerson, Franchise Contract Clauses and the Franchisor’s Duty of Care Toward Its Franchisees, 72 N.C. L. Rev. 905, 926 (1994); Robert W. Emerson, Franchising and the Collective Rights of Franchisees, 43 Vand. L. Rev. 1503, 1511 (1990).[/tippy] They are designed to protect franchisees from franchisors, who may terminate the franchise contract and opportunistically appropriate the profitable outlet developed by the franchisee. [tippy title=”8″ header=”off”]Corp v. Atlantic Richfield, 860 P.2d at 1018; Robert W. Emerson, Franchise Terminations: Legal Rights and Practical Effects When Franchisees Claim the Franchisor Discriminates, 35 Am. Bus. L.J. 559, 564-65 (1998); Robert W. Emerson, Franchise Selection and Retention: Discrimination Claims and Affirmative Action Programs, 40 Ariz. L. Rev. 511, 519 (1998); Jean Wegman Burns, Vertical Restraints, Efficiency, and the Real World, 62 Fordham L. Rev. 597, 620-21 (1993).[/tippy] More specifically, an opportunistic franchisor may terminate the contract of an efficient franchisee, who fully complies with the franchise contract, in order to sell the latter’s profitable unit to a new franchisee for higher franchise fees. [tippy title=”9″ header=”off”]Roger D. Blair & Francine Lafontaine, The Economics of Franchising 271 (2005).[/tippy] Alternatively, the franchisor can terminate the contract and manage the successful unit himself. [tippy title=”10″ header=”off”]Id.[/tippy]
Conventional law-and-economics analysis proposes that franchise termination laws, prohibiting opportunistic termination by the franchisor, are superfluous. [tippy title=”11″ header=”off”]See Michael J. Lockerby, Franchise Termination Restrictions: A Guide for Practitioners and Policy Makers, 30 Antitrust Bull. 791, 858-60, 866-71 (1985).[/tippy] Deeply rooted in traditional law-and-economics opposition to such laws is the belief that the reputation mechanism can serve as a sufficient control against opportunistic termination by franchisors. Since the incentive of franchisors is to maintain and attract franchisees, their motivation is to uphold a reputation of fairness. Accordingly, out of concern for their reputation, franchisors are not likely to opportunistically terminate the franchise contract. [tippy title=”12″ header=”off”]See infra Part II.A.[/tippy]
This “conventional law-and-economics opposition to franchise termination laws has been significantly influential in the development of franchise law in general, as witnessed by state and federal policy making.” [tippy title=”13″ header=”off”]Uri Benoliel, The Expectation of Continuity Effect and Franchise Termination Laws: A Behavioral Perspective, 46 Am. Bus. L.J. 139, 141 (2009).[/tippy] Most states to date have refused to regulate general franchise termination laws prohibiting opportunistic termination of the franchise contract by the franchisor. [tippy title=”14″ header=”off”]Since 1992, about thirty states have refused to regulate general franchise termination laws. See James A. Brickley, Royalty Rates and Upfront Fees in Share Contracts: Evidence from Franchising, 18 J.L. Econ. & Org. 511, 518 (2002).[/tippy] At the federal level, such statutes have also been rejected. [tippy title=”15″ header=”off”]For example, in 1998 and 1999 the federal government failed to pass two bills that would have made it unlawful for a franchisor to terminate a franchise contract without good cause. See H.R. 4841, 105th Cong. (2nd Sess. 1998); H.R. 3308, 106th Cong. (1st Sess. 1999).[/tippy] Yet legislators may be surprised to discover that the theoretical basis for this law-and-economics opposition to franchise termination laws is not quite as solid as one would hope.
This article, therefore, calls into question the idea that reputation can be a substitute for franchise termination laws. The article argues that the reputation mechanism suffers from an inherent deficiency, which disqualifies it from serving as a substitute for franchise termination laws.
In short, the argument is as follows: The reputation mechanism often has a limited life cycle consisting of three stages: creation, erosion and collapse. At the earliest stage of the franchisor’s organizational life cycle, the reputation mechanism is created. Normally, in this initial phase, the franchisor’s incentive is to maintain its previous franchisees and attract new ones. The franchisor wishes to expand the market of its products as rapidly as possible, but is financially limited and cannot expand on its own. Given the initial need of the franchisor to attract and maintain franchisees, the franchisor will be compelled to act in a manner which appears fair to present and prospective franchisees. Opportunistic termination of the franchise contract is therefore less likely to occur, as legal economists suggest, at the early stages of the franchisor’s organizational life cycle.
However, following the creation of the reputation mechanism, its effectiveness is likely to be eroded. Particularly, as the franchisor’s financial condition improves, the effectiveness of the reputation mechanism will steadily deteriorate. As the franchisor’s financial resources increase, the franchisor will gradually shift away from attracting and maintaining franchisees towards operating, on its own, the present and prospective outlets in its chain. This shift mainly derives from the fact that the franchisor normally gains more profits from a franchisor-owned unit than from a franchisee-owned unit. As a result of this shift, the franchisor will be less concerned about being perceived as fair by present and prospective franchisees, which leads to the conclusion that termination without good cause is more likely to occur at this stage.
Ultimately, the reputation mechanism may collapse. Following the gradual increase in the franchisor’s financial resources and the decrease in its incentive to maintain and attract new franchisees, the reputation mechanism will malfunction. The reputation-related costs will reach a minimum level, which will be lower than the franchisor’s benefits from the opportunistic termination of the franchise contract. When the franchisor accumulates enough financial resources to operate the whole franchise chain on its own, this outcome is to be expected. At this final stage–and herein lies the crux of the argument–the franchisor’s reputation costs incurred from being perceived as unfair by present and prospective franchisees are likely to be lower than the benefits from opportunistic termination. Opportunistic termination therefore is likely to occur.
Part I of this article will provide theoretical context by briefly reviewing the debate over the effectiveness of reputation as a substitute for franchise termination laws. First, the arguments in favor of the reputation mechanism, which underlie the traditional law-and-economics disregard for franchise termination laws, will be introduced. Second, I shall review the scant manifestations of skepticism as to the effectiveness of reputation in preventing opportunistic termination by franchisors. Part II will demonstrate the intrinsic deficiency of the reputation mechanism in preventing opportunism by the franchisor, namely the reputation life-cycle. The three major stages of the reputation life cycle will be presented–creation, erosion and collapse– with an eye toward uncovering the Achilles heel of the reputation mechanism. While this article focuses predominantly on the (in)effectiveness of reputation in preventing opportunism in franchise relationships, I will conclude by suggesting broader implications of my analysis for the legal administration of other long-term commercial relationships.
I. The Debate over Reputation
A. Law-and-Economics Conventional Analysis
Legal economists oppose franchise laws that require franchisors to demonstrate good cause for termination of a franchise contract. [tippy title=”16″ header=”off”]See generally James A. Brickley et al., The Economic Effects of Franchise Termination Laws, 34 J.L. & Econ. 101, 103-09, 130 (1991); Benjamin Klein, The Economics of Franchise Contracts, 2 J. Corp. Fin. 9, 30 (1995); Lockerby, supra note 11, at 858-71. Cf. Richard A. Epstein, Unconscionability: A Critical Reappraisal, 18 J.L. & Econ. 293, 314-15 (1975).[/tippy] Essential to legal economists’ resistance to franchise termination laws is the argument that the market-based reputation mechanism can function as a substitute for regulation. [tippy title=”17″ header=”off”]Another important argument that underlies legal economists’ resistance to franchise termination laws is that a statutory “good cause” requirement will increase franchisor termination costs and therefore tempt the franchisee to cheat or at least to free ride. See Brickley et al., supra note 16, at 104; Epstein, supra note 16, at 314; Matthew Ellman, Specificity Revisited: The Role of Cross-Investments, 22 J.L. Econ. & Org. 234, 250 n.36 (2006); Richard L. Smith II, Franchise Regulation: An Economic Analysis of State Restrictions on Automobile Distribution, 25 J.L. & Econ. 125, 136 (1982). For a critical analysis of this argument, see generally Benoliel, supra note 13 (arguing that a statutory good cause requirement will enhance joint action, expression of trust, and fair treatment of both contractual parties).[/tippy] More specifically, legal economists argue that the reputation mechanism can prevent contract termination without good cause, since such termination will impose reputation-related costs on the franchisor. [tippy title=”18″ header=”off”]Lockerby, supra note 11, at 860.[/tippy] As Charles Goetz and Robert Scott argue, franchisors will “incur substantial ‘goodwill’ losses if they attempt to exploit a discretionary termination authority.” [tippy title=”19″ header=”off”]Charles J. Goetz & Robert E. Scott, Principles of Relational Contracts, 67 Va. L. Rev. 1089, 1148 (1981). See also James A. Brickely, Sanjog Misra & R. Lawrence Van Horn, Contract Duration: Evidence from Franchising, 49 J. L. & Econ. 173, 178 (2006); William L. Killion, One Person’s Sense of Justice Is Another’s Sense of Injustice, 24 Franchise L.J. 3, 6 (2004); Alan J. Meese, Antitrust Balancing in a (Near) Coasean World: The Case of Franchise Tying Contracts, 95 Mich. L. Rev. 111, 131 n.96 (1996); Daniel Clough, Law and Economics of Vertical Restraints in Australia, 25 Melb U. L. Rev. 551, 580 (2001).[/tippy]
Legal economists furthermore specify the reputation-related costs which will prevent termination without good cause. [tippy title=”20″ header=”off”]Epstein, supra note 16, at 314-15; Benjamin Klein & Lester F. Saft, The Law and Economics of Franchise Tying Contracts, 28 J. L. & Econ. 345, 356 (1985).[/tippy] First, a franchisor who terminates the contract without good cause will encounter difficulties in retaining its other franchisees. The franchisor, as Richard Epstein explains, “has incentives to act in a manner which . . . appears to be fair if he wishes to retain his other franchisees.” [tippy title=”21″ header=”off”]Epstein, supra note 16, at 315. See also Thomas M. Pitegoff, Franchise Relationship Laws: A Minefield for Franchisors, 45 Bus. Law. 289, 310 (1989); Smith, supra note 17, at 130; Timothy J. Muris, Opportunistic Behavior and the Law of Contracts, 65 Minn. L. Rev. 521, 577 (1981); Boyd Allan Byers, Making a Case for Federal Regulation of Franchise Terminations–A Return-of-Equity Approach, 19 J. Corp. L. 607, 651 (1994); Clough, supra note 19, at 580.[/tippy] Second, the franchisor will find it difficult to sell additional franchise units to new franchisees. As Benjamin Klein & Lester Saft explain, “[t]he franchisor is not likely to terminate franchisees merely to confiscate their sunk investments opportunistically because franchisors must be concerned about their reputations when attempting to sell additional franchise locations.” [tippy title=”22″ header=”off”]Benjamin Klein & Lester F. Saft, The Law and Economics of Franchise Tying Contracts, 28 J.L. & Econ. 345, 356 (1985); Roger D. Blair & Francine Lafontaine, Understanding the Economics of Franchising and the Laws That Regulate It, 26 Franchise L.J. 55, 64 (2006) (“There may be lurking concern that franchisors may abuse their ability to terminate franchise contracts in some opportunistic fashion. Although there is some possibility of such opportunism, there is scant empirical support for it. From an economic perspective, this is not surprising because most franchisors want to expand, and it is hard to attract new franchisees while abusing incumbent franchisees.”); See also Epstein, supra note 16, at 315; Lockerby, supra note 11, at 859-60; Pitegoff, supra note 21, at 310; Smith, supra note 17, at 130; Robert W. Emerson, Franchise Terminations, supra note 8, at 586; Alan J. Meese, Regulation of Franchisor Opportunism and Production of the Institutional Framework: Federal Monopoly or Competition Between the States?, 23 Harv. J.L. & Pub. Pol’y 61, 68 (1999); Jonathan Klick et al., Incomplete Contracts and Opportunism in Franchising Arrangements: The Role of Termination Clauses 16-17 (Am. L. & Econ. Ass’n Ann. Meetings, Working Paper No. 61, 2006), available at http://www.law.georgetown.edu/olin/papers/klick_paper.pdf; Jonathan Klick et al., The Effect of Contract Regulation: The Case of Franchising 33 (Geo. Mason L. & Econ. Res. Paper No. 07-03, 2006), available at http://ssrn.com/abstract=951464; Henry N. Butler & Barry D. Baysinger, Vertical Restraints of Trade As Contractual Integration: A Synthesis of Relational Contracting Theory, Transaction-Cost Economics, and Organization Theory, 32 Emory L.J. 1009, 1092 (1983); Byers, supra note 21, at 651; Clough, supra note 19, at 580; Muris, supra note 21, at 577; Killion, supra note 19, at 6.[/tippy]
Law-and-economics scholars, therefore, uniformly base their analysis upon the implicit assumption that franchisors have a static incentive: to retain their franchisees and to attract new ones. This assumption, however, is dubious, as will be demonstrated in this article.
B. Skepticism about Reputation Effectiveness
A handful of legal scholars manifest skepticism about the effectiveness of the reputation mechanism in controlling opportunistic termination by franchisors. David Charny posed one of the earlier challenges to the effectiveness of the reputation mechanism, in his innovative article of the early 1990s. [tippy title=”23″ header=”off”]David Charny, Nonlegal Sanctions in Commercial Relationships, 104 Harv. L. Rev. 373 (1990).[/tippy] Charny argues that the reputation mechanism will not function if the franchisor ceases to use franchisees altogether. [tippy title=”24″ header=”off”]Id. at 434.[/tippy] He suggests that this may occur once the franchisor “has established a market niche” or when the acquirer in a takeover puts in place a new management team that decides to terminate existing franchises. [tippy title=”25″ header=”off”]Id. at 435.[/tippy]
Skepticism about the potential for reputation to control opportunistic termination by franchisors was also manifested in a seminal article on franchise contracts by Gilliland Hadfield. [tippy title=”26″ header=”off”]Hadfield, supra note 1.[/tippy] First, Hadfield, similar to Charny, argues that the reputation mechanism will not function if the franchisor stops selling franchisees. [tippy title=”27″ header=”off”]Id. at 978 n.232.[/tippy] She furthermore suggests that this may happen if the franchisor reaches a limit on the number of the franchise units it is able to sell. [tippy title=”28″ header=”off”]Id.[/tippy] This limitation may often exist, she maintains, as franchisors provide their franchisees with territorial exclusivity. [tippy title=”29″ header=”off”]Id.[/tippy] Hadfield’s second argument highlights the problematic fact that the reputation mechanism depends upon inferences, drawn by potential franchisees, about the franchisor’s past behavior. [tippy title=”30″ header=”off”]Id.[/tippy] She claims, “the interdependence, the uncertainty, and the length of the relationship, as well as the inexperience of the franchisee all make the identification of franchisor opportunism very difficult.” [tippy title=”31″ header=”off”]Id.[/tippy]
Over the next few years, other scholars joined in the dispute over the effectiveness of the reputation mechanism in the context of franchising. Warren Grimes, for instance, [tippy title=”32″ header=”off”]Warren S. Grimes, When Do Franchisors Have Market Power? Antitrust Remedies for Franchisor Opportunism, 65 Antitrust L.J. 105 (1996).[/tippy] argues that a franchisor is likely to be less constrained by reputation concerns in several circumstances. First, a franchisor is likely to be less constrained by reputation concerns if a myth of high profitability surrounds franchising or certain types of franchising. [tippy title=”33″ header=”off”]Id. at 130-31.[/tippy] Second, the reputation mechanism will be less effective if the franchisor can counter reputation damage by lowering the franchise fee. [tippy title=”34″ header=”off”]Id. at 131-33.[/tippy] Third, the reputation mechanism is less likely to operate as expected if the franchisor can make less-informed franchisees the target of opportunism. [tippy title=”35″ header=”off”]Id. at 133-34.[/tippy] Fourth, the reputation mechanism’s effectiveness is dubious if the franchisor has a short-term perspective. [tippy title=”36″ header=”off”]Id. at 134-35.[/tippy] Finally, the reputation mechanism will be less effective if the franchisor misapprehends the extent of reputation damage. [tippy title=”37″ header=”off”]Id. at 135.[/tippy]
While I agree with many of the scholarly objections leveled at the reputation mechanism in the past, the next part of this article contends that the reputation mechanism also suffers from an inherent deficiency: its limited life cycle. The three major stages of the reputation life cycle will be presented in chronological order: creation, erosion and collapse. A detailed analysis of the life cycle will reveal that the reputation mechanism is often, by its very nature, doomed to failure.
II. Reputation Life Cycle
A. Stage One: Creation
At the early stages of the franchisor organizational life cycle, the reputation mechanism may have some deterring effects on the franchisor; the franchisor may be particularly discouraged from terminating a franchise contract without good cause. At these early stages, the incentive of the franchisor is normally to attract new franchisees (or other types of intermediaries, such as dealers and distributors) and thus the franchisor attaches greater importance on being perceived as fair in the eyes of potential franchisees. [tippy title=”38″ header=”off”]See supra note 22 and accompanying text.[/tippy] The initial incentive to attract new franchisees derives from three cumulative factors, which will be explained in greater detail below. First, franchisors ordinarily wish to rapidly expand the market for their products by opening many pioneering outlets in various locations. [tippy title=”39″ header=”off”]Alfred R. Oxenfeldt & Anthony O. Kelly, Will Successful Franchise Systems Ultimately Become Wholly-Owned Chains?, 44 J. Retailing 69, 74 (1968-69). For a detailed discussion on this first factor see infra notes 42-59.[/tippy] Second, a young franchisor normally lacks the significant financial resources necessary to promptly expand the market on its own. [tippy title=”40″ header=”off”]Rajiv P. Dant et al., Ownership Redirection in Franchised Channels, 11 J. Pub. Pol’y. & Mktg. 33, 34 (1992). For a detailed discussion on this second factor see infra notes 60-72.[/tippy] Third, new franchisees, attracted by the young franchisor, can effectively support the franchisor in overcoming its initial financial constraints. [tippy title=”41″ header=”off”]Scott A. Shane, Hybrid Organizational Arrangements and Their Implications for Firm Growth and Survival: A Study of New Franchisors, 39 Acad. Mgmt. J. 216, 220 (1996) (describing the types of costs saved by the franchisor). For a detailed discussion on this third factor see infra notes 73-105.[/tippy]
Franchisors generally hope to quickly expand the market for their products by opening many pioneering outlets in various locations. [tippy title=”42″ header=”off”]Oxenfeldt & Kelly, supra note 39, at 74.[/tippy] Swift expansion generates several benefits for franchisors. First, a franchisor, entering the market early can snag superior geographic locations before the market becomes saturated by competitors. [tippy title=”43″ header=”off”]Victoria Bordonaba Juste et al., Franchise Firm Entry Time Influence on Long-term Survival, 37 Int’l J. Retail & Distrib. Mgmt. 106, 109 (2009).[/tippy] A franchisor who quickly develops its franchise system, on valuable real estate, may preempt its competitors; [tippy title=”44″ header=”off”]Oxenfeldt & Kelly, supra note 39, at 74; Steven C. Michael, First Mover Advantage Through Franchising, 18 J. Bus. Venturing 61, 65 (2003). See generally Marvin B. Lieberman & David B. Montgomery, First-Mover Advantages, 9 Strat. Mgmt. J. 41, 44 (1988).[/tippy] followers will face difficulties in gaining possession of the same valuable real estate, already held by the fast franchisor. [tippy title=”45″ header=”off”]Michael, supra note 44, at 65. See generally Birger Wernerfelt, A Resource-based View of the Firm, 5 Strat. Mgmt. J. 171, 173 (1984).[/tippy] McDonald’s, for example, effectively preempted precious real estate from its competitors, through favorable leases. [tippy title=”46″ header=”off”]John F. Love, McDonald’s: Behind The Arches 164-65 (1986).[/tippy] Through its early expansion in the relatively novel sector of fast food, McDonald’s benefited from a first-move advantage. [tippy title=”47″ header=”off”]Michael, supra note 44, at 65.[/tippy] In addition, a franchisor who quickly develops its franchise system, may be able to lease or acquire assets in the early stages of the market at prices below those that will prevail in later stages, after the market has evolved. [tippy title=”48″ header=”off”]Lieberman& Montgomery, supra note 44, at 44; Michael, supra note 44, at 65.[/tippy]
Rapid expansion not only gives franchisors an edge over competitors, but also allows the franchisor to shape the market. [tippy title=”49″ header=”off”]Gregory S. Carpenter & Kent Nakamoto, Consumer Preference Formation and Pioneering Advantage, 26 J. Mark. Res. 285, 286 (1989).[/tippy] A franchisor that promptly expands the market for its products may influence customer preferences. [tippy title=”50″ header=”off”]Michael, supra note 44, at 66.[/tippy] In the early stages of many markets, consumers may not have a strong and precise opinion about their preferred value of the new product ingredients. [tippy title=”51″ header=”off”]Carpenter & Nakamoto, supra note 49, at 286; Lieberman & Montgomery, supra note 44, at 46.[/tippy] They may also not have a strong inclination about their preferred combination of the product features. [tippy title=”52″ header=”off”]Carpenter & Nakamoto, supra note 49, at 286.[/tippy] For example, when Coca Cola first penetrated the market, not many customers had a predetermined preference for how carbonated or sweet a cola should be. [tippy title=”53″ header=”off”]Id.[/tippy] A successful early franchisor is likely to have a seminal influence on the customers’ preferences regarding the value of the product features. [tippy title=”54″ header=”off”]Id.; Lieberman & Montgomery, supra note 44, at 46.[/tippy] A franchisor may also influence customer preferences as to the combination of the product features. [tippy title=”55″ header=”off”]Carpenter & Nakamoto, supra note 49, at 286.[/tippy] Coca Cola, for example, may have critically impacted the development of customers’ preferences for colas. [tippy title=”56″ header=”off”]Id.; Lieberman & Montgomery, supra note 44, at 46.[/tippy] The influence on customers’ preferences may ultimately shift customers to favor the pioneer franchisor over later competitors, [tippy title=”57″ header=”off”]For empirical support, see Carpenter & Nakamoto, supra note 49, at 286, 294; Frank H. Alpert & Michael A. Kamins, An Empirical Investigation of Consumer Memory, Attitude, and Perceptions toward Pioneer and Follower Brands, 59 J. Mktg. 34, 36-37, 41 (1995).[/tippy] leading to a market share benefit. Rapid expansion, therefore, is quite beneficial for franchisors. Empirical studies confirm that swift expansion is advantageous. Examining 137 U.S. franchisors in the restaurant industry, Steven Michael found that a rapid expansion strategy of franchisors leads to superior outlet share and ultimately to higher profitability. [tippy title=”58″ header=”off”]Michael, supra note 44, at 66-67, 69-71, 74. See also Regis Coeurderoy & Rodolphe Durand, Leveraging the Advantage of Early Entry: Proprietary Technologies Versus Cost Leadership, 57 J. Bus. Res. 583, 584, 587, 589 (2004).[/tippy] Similarly, data covering 188 Spanish franchise chains for an eight-year period show that an early entry strategy of franchisors leads to lower failure risk. [tippy title=”59″ header=”off”]Juste et al., supra note 43, at 109, 112, 115.[/tippy]
Nonetheless, despite the advantages, maneuvering an early entrance into the franchise market is difficult. A young franchisor, wishing to rapidly expand the market for its products on its own, normally lacks the significant financial resources needed to fulfill its desire. [tippy title=”60″ header=”off”]Rajiv P. Dant et al., Ownership Redirection in Franchised Channels, 11 J. Pub. Pol’y & Mktg. 33, 34 (1992); Richard E. Caves & William F. Murphy II, Franchising: Firms, Markets, and Intangible Assets, 42 S. Econ. J. 572, 581 (1976); Francine Lafontaine & Patrick J. Kaufmann, The Evolution of Ownership Patterns in Franchise Systems, 70 J. Retailing 97, 99 (1994).[/tippy] Opening new outlets is often too costly for a financially immature franchisor. [tippy title=”61″ header=”off”]Lafontaine & Kaufmann, supra note 60, at 99.[/tippy] Three significant costs must normally be incurred by the young franchisor: information costs, start-up costs, and management costs. [tippy title=”62″ header=”off”]Rajiv P. Dant & Audhesh K. Paswan, The Effect of Financial Resource Availability and System Size on Ownership Redirection in Franchised Channels of Distribution, 10 Asia Pac. J. Mktg & Logistics 85, 86 (1998).[/tippy]
To begin with, financial resources are required to gather information regarding the local market in which the franchisor may potentially expand. [tippy title=”63″ header=”off”]Lafontaine & Kaufmann, supra note 60, at 99.[/tippy] When a young franchisor system expands beyond its original geographic location, it generally lacks information regarding other local markets. [tippy title=”64″ header=”off”]Thomas Bürkle & Thorsten Posselt, Franchising as a Plural System: A Risk-Based Explanation, 84 J. Retailing 39, 41 (2008).[/tippy] Therefore, the franchisor needs to invest capital in searching for and identifying suitable locations. [tippy title=”65″ header=”off”]James G. Combs et al., A Strategic Groups Approach to the Franchising-Performance Relationship, 19 J. Bus. Venturing 877, 880 (2004).[/tippy] It should ideally also evaluate the local market conditions of each potential location. [tippy title=”66″ header=”off”]Id.[/tippy] More specifically, the franchisor will have to invest resources in learning about local marketing strategies, input suppliers, and customer preferences, at each potential location. [tippy title=”67″ header=”off”]Alanson P. Minkler, Why Firms Franchise: A Search Cost Theory, 148 J. Inst. Theoretical Econ. 240, 242 (1992).[/tippy] These information-gathering costs are likely to augment with increases in the unfamiliarity, diversity, and uncertainty of local markets. [tippy title=”68″ header=”off”]Id. at 242-43.[/tippy]
The franchisor, wishing to expand on its own, will furthermore incur considerable start-up costs in establishing each outlet. The total start-up costs of each outlet can range from $20,000, at a minimum, to over $1,000,000, depending on the franchise chosen. [tippy title=”69″ header=”off”]International Franchise Association, Frequently Asked Questions About Franchising, http://www.franchise.org/industrysecondary.aspx?id=10008 (last visited Nov. 12, 2009).[/tippy] Costs may involve renting or building an outlet, stocking it with inventory and equipment, and advertising it. [tippy title=”70″ header=”off”]Justin G. Longenecker et al., Small Business Management: Launching and Growing Entrepreneurial Ventures 99-101 (14th ed. 2007).[/tippy] Finally, a franchisor, ready and willing to promptly expand on its own, will incur significant management costs. These costs include the necessary capital needed to select skilled managers to operate each outlet (selection costs). [tippy title=”71″ header=”off”]See Shane, supra note 41, at 219; Seth W. Norton, An Empirical Look at Franchising as an Organizational Form, 61 J. Bus. 197, 204 (1988); Combs et al., supra note 65, at 880.[/tippy] They also include expenditures for monitoring the managers’ performance (monitoring costs). [tippy title=”72″ header=”off”]See Shane, supra note 41, at 219-20; Seth W. Norton, Franchising, Brand Name Capital, and the Entrepreneurial Capacity Problem, 9 Strat. Mgmt. J. 105, 106 (1988); James A. Brickley & Fredrick H. Dark, The Choice of Organizational Form: The Case of Franchising, 18 J. Fin. Econ. 401, 403 (1987).[/tippy]
Since expanding rapidly is usually too costly for a young franchisor, its initial incentive will be to attract new franchisees. [tippy title=”73″ header=”off”]Rajiv P. Dant et al., supra note 60, at 34; Brent L. Baker & Rajiv P. Dant, Stable Plural Forms in Franchise Systems: An Examination of the Evolution of Ownership Redirection Research, in Strategy and Governance of Networks: Cooperatives, Franchising, and Strategic Alliances 87, 92 (George Hendrikse et al. eds. 2008); Shelby D. Hunt, The Trend Toward Company-Operated Units in Franchise Chains, 49 J. Retailing 3, 4 (1973); Oxenfeldt & Kelly, supra note 39, at 71; Caves & Murphy, supra note 60, at 581.[/tippy] New franchisees will normally be able to effectively assist the financially immature franchisor in overcoming its initial economic constraints. To begin with, franchisees often incur the information costs needed to find suitable locations for expansion in locations which are unfamiliar to the franchisor. [tippy title=”74″ header=”off”]Combs et al., supra note 65, at 880. Sometimes, franchisors select the location, but then they collect fees from franchisees for this service. Hadfield, supra note 1, at 936.[/tippy] Notably, franchisees are likely to have valuable information regarding potential local markets, which the youthful franchisor lacks. [tippy title=”75″ header=”off”]Bürkle & Posselt, supra note 64, at 41; Minkler, supra note 67, at 243; Anna Watson et al., Retail Franchising: An Intellectual Capital Perspective, 12 J. Retailing Consumer Services 25, 28 (2005).[/tippy] This is mainly because they usually reside in the community in which the new unit is planned to be established. [tippy title=”76″ header=”off”]Bürkle & Posselt, supra note 64, at 41; Combs et al., supra note 65, at 880; Lafontaine & Kaufmann, supra note 60, at 99.[/tippy]
In addition, franchisees will commonly incur the start-up costs involved in establishing new outlets, including equipment, inventory building, and real estate costs. [tippy title=”77″ header=”off”]Lafontaine & Kaufmann, supra note 60, at 99.[/tippy] Franchisees furthermore reduce the management costs needed to operate an outlet. [tippy title=”78″ header=”off”]Combs et al., supra note 65, at 880.[/tippy] First, they reduce the selection costs needed to recruit qualified managers. [tippy title=”79″ header=”off”]Shane, supra note 41, at 220.[/tippy] Franchisees typically agree to invest heavily in the outlet and to receive a residual claim on the outlet’s uncertain profits. [tippy title=”80″ header=”off”]Id. at 220; Norton, supra note 71, at 205; Combs et al., supra note 65, at 880.[/tippy] By doing so, franchisees signal their management capabilities, compared to salaried managers, who are willing to take the job. [tippy title=”81″ header=”off”]Shane, supra note 41, at 220.[/tippy] Second, franchisees reduce the monitoring costs needed to scrutinize the performance of managers. [tippy title=”82″ header=”off”]Id. at 219-21.[/tippy] Since franchisees invest significant resources in the outlet and have a residual claim on the outlet’s profit, they are less likely than salaried managers, to put forth a suboptimal effort level. [tippy title=”83″ header=”off”]Brickley & Dark, supra note 72, at 404-05; Shane, supra note 41, at 221; Combs et al., supra note 65, at 880; Watson et al., supra note 75, at 28.[/tippy]
Franchisees support the franchisor in overcoming its initial financial constraints, not only by incurring and reducing significant costs, but also by directly providing the franchisor significant capital. [tippy title=”84″ header=”off”]Hadfield, supra note 1, at 935.[/tippy] First, if the franchise involves the sale of products by the franchisor to the franchisee, the sale price will usually comprise a mark-up over cost representing the franchisor’s return. [tippy title=”85″ header=”off”]Id.[/tippy] In addition, each franchisee ordinarily pays the franchisor an initial lump-sum fee, called a franchise fee [tippy title=”86″ header=”off”]James G. Combs & David J. Ketchen, Jr., Can Capital Scarcity Help Agency Theory Explain Franchising? Revisiting the Capital Scarcity Hypothesis, 42 Acad. Mgmt. J. 196, 199 (1999); Lafontaine & Kaufmann, supra note 60, at 99; Hadfield, supra note 1, at 935.[/tippy] — generally ranging between $10,000 and $30,000. [tippy title=”87″ header=”off”]International Franchise Association, Frequently Asked Questions About Franchising, http://www.franchise.org/industrysecondary.aspx?id=10008 (last visited Nov. 12, 2009). For statistics on the variation in franchise fees, see generally Blair & Lafontaine, supra note 9, at 56-61.[/tippy] Moreover, each franchisee provides a constant and on-going stream of capital to the franchisor, via royalty rates. [tippy title=”88″ header=”off”]Hadfield, supra note 1, at 935; Watson, supra note 75, at 25.[/tippy] Normally, royalty rates are calculated as a percentage of sales revenues. [tippy title=”89″ header=”off”]Blair & Lafontaine, supra note 9, at 62.[/tippy] The average royalty rate paid in 2001 was 5.2%, which in real terms translates to about $500 per month. [tippy title=”90″ header=”off”]Id. at 67, 69.[/tippy] Many franchisees also pay the franchisor advertising fees, [tippy title=”91″ header=”off”]Id. at 69.[/tippy] to support franchisors in advertising their product or service regionally or nationally. [tippy title=”92″ header=”off”]Id.[/tippy] These fees are most often a steady percentage, usually one to two percent, [tippy title=”93″ header=”off”]Longenecker et al., supra note 70, at 100.[/tippy] of the franchisee’s monthly sales revenue. [tippy title=”94″ header=”off”]Blair & Lafontaine, supra note 9, at 69.[/tippy] Finally, franchisees occasionally pay fees to franchisors for bookkeeping and management consultation services. [tippy title=”95″ header=”off”]Hadfield, supra note 1, at 936. Notably, franchisors sometimes also obtain a commission from approved suppliers of their new franchisees. Id.[/tippy]
Given the significant capital that franchisees provide to the youthful franchisor, and their ability to support him in overcoming its financial constraints, [tippy title=”96″ header=”off”]But see P. H. Rubin, The Theory of the Firm and the Structure of the Franchise Contract, 21 J. L. & Econ. 223, 225-26 (1978) (suggesting that passive investors, such as stockholders, are a superior source of capital than franchisees). However, for explanations of why franchisees are in fact a superior source of capital than passive investors, see, for example, Robert E. Martin & Robert T. Justis, Franchising, Liquidity Constraints and Entry, 25 Applied Econ. 1269, 1271-72 (1993); Lafontaine & Kaufmann, supra note 60, at 99; Francine Lafontaine, Agency Theory and Franchising: Some Empirical Results, 23 Rand J. Econ. 263, 267 (1992).[/tippy] one would posit that the initial incentive of the franchisor will be to attract franchisees. This theoretical contention is, in fact, empirically supported. Francine Lafontaine conducted a survey of, among other things, franchisors’ motivation for using franchisees. [tippy title=”97″ header=”off”]Francine Lafontaine, How and Why do Franchisors Do What They Do: A Survey Report, in Franchising: Passport for Growth & World of Opportunity, Proceedings of the Sixth Conference of the Society of Franchising (Patrick Kaufmann ed. 1992).[/tippy] The survey was based on the answers given by 130 franchisors, all members of the International Franchise Association, and involved in a variety of businesses. [tippy title=”98″ header=”off”]Id. at 2, 4.[/tippy] The majority of the respondents began franchising only recently. [tippy title=”99″ header=”off”]Id. at 3.[/tippy] Franchisors participating in the survey explained that they became involved in franchising mainly because it allowed them to expand rapidly, especially because franchisees provide capital to franchisors. [tippy title=”100″ header=”off”]Id. at 11.[/tippy] In another survey, conducted by Rajiv Dant, of 79 founders and representatives of franchisors, similar results were found. [tippy title=”101″ header=”off”]Rajiv P. Dant, Motivation for Franchising: Rhetoric Versus Reality, 14 Int’l Small Bus. J. 10 (1995).[/tippy] Respondents were primarily drawn from the following franchising sectors: fast food and restaurants, gifts and home decorations, hospitality, convenience stores, and services. [tippy title=”102″ header=”off”]Id. at 15.[/tippy] The majority of respondents classified their business in the introduction or growth stages of its life cycle, [tippy title=”103″ header=”off”]Id.[/tippy] indicating the relative youthfulness of the franchisors. [tippy title=”104″ header=”off”]Id. at 16.[/tippy] According to the survey, the most cited motivations for attracting franchisees were “market entry and growth” and “capital access and profits.” [tippy title=”105″ header=”off”]Id. at 23. For further empirical support to the hypothesis that the initial incentive of franchisors is to attract new franchisees due to financial constraints, see Lorelle Frazer, Why Franchisors Discontinue Franchising but Continue Operating, 19 Int’l Small Bus. J. 29, 32 (2001); David A. Kirby & Anna Watson, Overcoming the Financial Constraints on Small Firm Growth: The Case of Franchising, 6 J. of Private Equity 61, 63 (2003); Anne Marie Doherty, The Internationalization of Retailing: Factors Influencing the Choice of Franchising as a Market Entry Strategy, 18 Int’l J. Serv. Indus. Mgmt. 184, 194 (2007); Scott Weaven & Carmel Herington, Factors Influencing Governance Choice and Human Resource Management Within Services Franchising Networks, J. Mgmt. & Org. 126, 132 (2007). For indirect empirical support, see Lafontaine & Kaufmann, supra note 60, at 110 (“the fact that franchisors [examined in the study] that were subsidiaries of larger corporations owned more of their own units, point toward the idea that access to resources might constrain some firms to operate less units than they would like.”).[/tippy]
B. Stage Two: Erosion
As the franchisor’s financial resources increase, the effectiveness of the reputation mechanism will erode. Particularly, the franchisor’s incentive to attract new franchisees will decrease. [tippy title=”106″ header=”off”]Oxenfeldt & Kelly, supra note 39, at 75.[/tippy] Similarly, its incentive to maintain its present franchisees will decline. [tippy title=”107″ header=”off”]Id.[/tippy] Instead, the franchisor, having greater financial resources, will gradually shift towards owning the units himself. [tippy title=”108″ header=”off”]Id.; Rajiv P. Dant et al., What We Know About Ownership Redirection in Franchising: A Meta-Analysis, 72 J. Retailing 429, 434 (1996); Caves & Murphy, supra note 60, at 581; Gary J. Castrogiovanni et al., Shifting Imperatives: An Integrative View of Resource Scarcity and Agency Reasons for Franchising, 30 Entrepreneurship Theory & Prac. 23, 25 (2006); Baker & Dant, supra note 73, at 92.[/tippy] The franchisor will specifically want to progressively open new outlets under franchisor-ownership, which would have been opened as a franchisee-owned outlet, when the franchisor lacked financial resources. In addition, the franchisor’s motivation will be to gradually transform the existing franchisee-owned outlets in his chain into franchisor-owned outlets.
The shift in the franchisor’s incentive stems from the fact that the profits that a franchisor can make, by owning a unit, are normally greater than the profits it can amass through a franchisee-owned unit. [tippy title=”109″ header=”off”]Baker & Dant, supra note 73, at 92.[/tippy] True, establishing and maintaining a franchisor-owned unit is costly for the franchisor since it involves information, start-up, and management costs. In addition, a franchisee-owned unit provides the franchisor capital through a lump-sum fee, franchise fees, and other fees. [tippy title=”110″ header=”off”]See supra Part II.A.[/tippy] However, in the long-run, a franchisor-owned unit is more profitable for the franchisor than a franchisee-owned unit. [tippy title=”111″ header=”off”]Hunt, supra note 73, at 6-7; Hadfield, supra note 1, at 936-37; Paul Tracey & Owen Jarvis, Toward a Theory of Social Venture Franchising, 31 Entrepreneurship Theory & Prac. 667, 669 (2007); James G. Combs et al., Franchising: A Review and Avenues to Greater Theoretical Diversity, 30 J. Mgmt. 907, 909-10 (2004).[/tippy] With its company-owned and operated units, the franchisor continually keeps all of the profits of the unit, whereas with franchised units its chief source of profit is a lump-sum fee and ongoing fees computed as a small percentage of the gross revenue. [tippy title=”112″ header=”off”]Baker & Dant, supra note 73, at 92; James G. Combs & Gary J. Castrogiovanni, Franchisor Strategy: A Proposed Model and Empirical Test of Franchise Versus Company Ownership, 32 J. Small Bus. Mgmt. 37, 38-39 (1994).[/tippy]
The superiority of franchisor-owned units over franchisee-owned units in generating franchisor’s profits is empirically supported. For example, Thomas Ehrmann and Georg Spranger examine the financials of seven large public U.S. restaurant retail chains through their annual 10-k filings with the U.S. Securities and Exchange Commission. [tippy title=”113″ header=”off”]Thomas Ehrmann and Georg Spranger, Franchisee Versus Company Ownership–An Empirical Analysis of Franchisor Profit, in Economics and Management of Networks 31, 39-40 (Gérard Cliquet et al., eds. 2007).[/tippy] They examine each franchisor’s gross margin ratios as well as the operating income ratios for franchisor-owned to franchisee-owned units. [tippy title=”114″ header=”off”]Id. at 40.[/tippy] For each franchisor analyzed in the study, the single franchisor-owned unit added far more to both the gross margin and to the total operating income than the single franchisee-owned unit. [tippy title=”115″ header=”off”]Id. at 41.[/tippy] Similarly, Urban Ozanne and Shelby Hunt found that sales in franchisor-owned outlets in the fast food industry are on average significantly higher than those in franchisee-owned outlets. [tippy title=”116″ header=”off”]S. Select Comm. on Small Business, 92d Cong., 1st Sess., Report on the Economic Effects of Franchising 87 (Comm. Print 1971) (written by Urban B. Ozanne & Shelby D. Hunt); Hunt, supra note 73, at 7.[/tippy]
Anecdotal evidence bolsters the contention that franchisor-owned units are superior to franchisee-owned units in generating franchisor profits, as expressed in several classic statements by franchisors. For example, John Jay Hooker famously stated:
As all of you know, the name of the game is not really franchising. The name of the game is company stores. I was looking at some figures not too long ago and saw where a big company in America has 1,600-1,700 units, and only two hundred of those were company-owned, but the two hundred company-owned units were producing sixty percent of the net after taxes. . . the real name of the game is owning the stores yourself. [tippy title=”117″ header=”off”]John Jay Hooker, The Story of Minnie Pearl–A Case History of One New Company’s Trials, Tribulations and Triumphs, in Franchising Today: Report On The Fifth International Management Conference On Franchising 164, 171 (Charles L. Vaughn ed. 1970).[/tippy]
Similarly, Lawrence E. Singer, who was the president of Royal Castle System Inc. has noted: “We make more profit, per unit, than we could possibly make in franchising. This fact has been acknowledged by many of the franchise operators.” [tippy title=”118″ header=”off”]Lawrence E. Singer, To Franchise or Not–How to Decide: Con–Why Company-Owned Units, in Franchising Today: 1966-1967 23, 24 (Charles L. Vaughn & David B. Slater eds. 1967). Likewise, William Ware of PKI Foods, Inc., stated:
More profits can be gained from company-owned stores. A break-even analysis of operations in the $225,000 to $300,000 range shows this fact to be very true. Since our stores average $270,000 per unit per year and some clear between $50,000 and $100,000, it becomes evident that our stores are more profitable than if franchised.
William Ware, To Franchise or Not–How to Decide: Con–Why Company-Owned Units, in Franchising Today: 1966-1967 27, 29 (Charles L. Vaughn & David B. Slater eds. 1967).[/tippy]
Given the superiority of franchisor-owned units over franchisee-owned units, the effectiveness of the reputation mechanism is likely to be eroded when the franchisor’s financial constraints decrease. As the resources needed for establishing and operating units become more attainable by the franchisor, forgoing the higher levels of profit attained through franchisor ownership ceases to be necessary. [tippy title=”119″ header=”off”]Baker & Dant, supra note 73, at 92.[/tippy] Indeed, empirical studies indicate that as the franchisor’s financial resources increase, the reputation mechanism erodes. These studies particularly confirm that as the financial availability of the franchisor increases, its incentive will gradually shift away from attracting new franchisees and maintaining the present ones, towards owning prospective and present outlets. [tippy title=”120″ header=”off”]Notably, other contradicting empirical studies also examine the relationship between the size and age of the franchisor and its ownership patterns. See, for example, Hunt, supra note 73, at 9; Scott Shane, Explaining the Distribution of Franchised and Company-Owned Outlets in Franchise Systems, 24 J. Mgmt. 717, 724-25, 730, 735 (1998); Gary J. Castrogiovanni et al., Resource Scarcity and Agency Theory Predictions Concerning the Continued Use of Franchising in Multi-Outlet Networks, 44 J. Small Bus. Mgmt. 27, 30, 36-37 (2006); Lorelle Frazer, Causes of Disruption to Franchise Operations, 54 J. Bus. Res. 227, 229-30, 232 (2001); Lafontaine & Kaufmann, supra note 60, at 110; Ilan Alon, The Use of Franchising by U.S.-Based Retailers, 39 J. Small Bus. Mgmt. 111, 117 (2001); Combs & Castrogiovanni, supra note 112, at 45.[/tippy] For example, Rajiv Dant and Patrick Kaufmann examine the changes in ownership patterns of franchise systems as the franchisor financially matures. [tippy title=”121″ header=”off”]Rajiv P. Dant & Patrick J. Kaufmann, Structural and Strategic Dynamics in Franchising, 79 J. Retailing 63 (2003).[/tippy] They utilize a national mail survey of the franchised fast food restaurant industry franchisors, and analyze a total of 152 questionnaires filled out by franchisors. [tippy title=”122″ header=”off”]Id. at 67.[/tippy] The questionnaire asks the franchisor respondent to provide details of ownership patterns, unit reacquisition activity, new units sale activity, and franchisor’s resource availability position. [tippy title=”123″ header=”off”]Id.[/tippy] The questionnaires were most frequently completed by presidents, CEOs, or founders of the franchise. [tippy title=”124″ header=”off”]Id. at 68.[/tippy] The typical franchisor commenced its operation in 1966, sold its first franchise in 1974, and had about 200 outlets. [tippy title=”125″ header=”off”]Id.[/tippy] Dant and Kaufmann’s study confirms the validity of the hypothesis that the greater the franchisor’s internal access to financial, informational, and managerial resources, the more likely the strategic tendency toward company ownership of outlets. [tippy title=”126″ header=”off”]Id. at 72. For similar results and dataset, see Patrick J. Kaufmann & Rajiv P. Dant, Multi-Unit Franchising: Growth and Management Issues, 11 J. Bus. Venturing 343, 351, 354 (1996); Rajiv P. Dant & Patrick J. Kaufmann, Robert A. Robicheaux, Changes in the Mix of Company-Owned and Franchised Outlets: Ownership Redirection Revisited, in Proceedings of the International Society of Franchising Conference 4, 13 (1998).[/tippy] The strategic tendency toward company ownership of outlets is measured by two factors. First, the inclination of franchisors to substitute existing franchisee-owned outlets with franchisor-owned outlets (retrospective substitution), was considered. [tippy title=”127″ header=”off”]Dant & Kaufmann, supra note 121, at 67.[/tippy] This inclination is captured mainly by comparing (a) the number of franchisee-owned units reported by the franchisor to have been permanently converted into franchisor-owned units and (b) the number of franchisor-owned units reported by the franchisor to have been permanently converted into franchisee-owned units. [tippy title=”128″ header=”off”]Id.[/tippy] The strategic tendency toward company ownership is furthermore measured by the propensity of franchisors to open new outlets under franchisor-ownership which would have been opened as a franchisee-owned outlet earlier in the franchisor’s history (prospective substitution). [tippy title=”129″ header=”off”]Id. at 67-68.[/tippy] This tendency is calculated by comparing (a) the current year’s pattern of new units opening activity to (b) the pattern of ownership as established by previous year’s composition of franchisor-owned units versus franchisee-owned units. [tippy title=”130″ header=”off”]Id. at 68.[/tippy]
Empirical support for the erosion of the reputation mechanism in several key industries was also established in a study by Rajiv Dant and Audhesh Paswan. Dant and Paswan culled data from successive volumes of Franchising in the Economy to test, among other things, the shifts in ownership patterns of franchise systems as the franchisor financially matures, [tippy title=”131″ header=”off”]Dant & Paswan, supra note 62, at 90.[/tippy] spanning the period of 1977 through 1986. [tippy title=”132″ header=”off”]Id.[/tippy] They find in the rentals (equipment) industry, as well as in the hotels, motels and campground industry, that as the financial resource availability of franchisor increases there will be greater incidence of ownership redirection favoring the franchisor. [tippy title=”133″ header=”off”]Id. at 93, 96, 99.[/tippy] Ownership redirection, in this context, was captured by the inclination of franchisors to substitute existing franchisee-owned outlets with franchisor-owned outlets. This inclination is measured mainly by comparing the number of franchisee-owned units converted to franchisor-owned units with the number of franchisor-owned units converted to franchisee-owned units. [tippy title=”134″ header=”off”]Id. at 93.[/tippy]
Another empirical study, conducted by James Combs and David Ketchen, indicates that as the financial resources of the franchisor increase, the reputation mechanism erodes. [tippy title=”135″ header=”off”]Combs et al., supra note 86, at 199.[/tippy] Combs and Ketchen’s sample is drawn from the restaurant industry during the years 1989 through 1993. [tippy title=”136″ header=”off”]Id.[/tippy] Their study relies mainly on franchisor’s annual reports and Compact Disclosure, a comprehensive database of public firms. [tippy title=”137″ header=”off”]Id. at 199, 201.[/tippy] Examining data from 91 restaurant chains, Combs and Ketchen empirically confirm the hypothesis that the less a franchisor encounters difficulties stemming from a lack of capital, the less the franchisor will rely on expansion through franchising as opposed to franchisor ownership. [tippy title=”138″ header=”off”]Combs et al., supra note 86, at 199, 202. For similar results and dataset, see Vera L. Hoover, David J. Ketchen, Jr. & James G. Combs, Why Restaurant Firms Franchise: An Analysis of Two Possible Explanations, 44 Cornell Hotel and Rest. Admin. Q. 9, 14 (2003); see also James G. Combs & David J. Ketchen, Jr., Explaining Interfirm Cooperation and Performance: Toward a Reconciliation of Predictions from the Resource-Based View and Organizational Economics, 20 Strat. Mgmt. J. 867, 872, 880 (1999).[/tippy]
C. Stage Three: Collapse
Following the continuing decrease in the franchisor’s financial constraints and the decrease in its incentive to maintain and attract new franchisees, the reputation mechanism may collapse. This may particularly occur when the reputation-related costs decrease to a minimum level, at which they will be lower than the franchisor benefits from opportunistic termination of the franchise contract. Such a low level is reached when the franchisor accrues sufficient capital to manage the whole franchise chain on its own. At this stage, the franchisor’s reputation costs from being perceived as unjust by present and prospective franchisees are likely to be lower than the benefits from opportunistic termination. Termination without good cause therefore is likely to occur.
An analysis of case law on dealership and distributorship relationships, which are often governed by franchise termination laws, arguably reveals the collapse of the reputation mechanism that follows a gradual improvement in a franchisor’s financial position. An early illustrative case is Kealey Pharmacy & Home Care Servs. Inc. v. Walgreen Co. [tippy title=”139″ header=”off”]Kealey Pharmacy & Home Care Servs., Inc. v. Walgreen Co., 761 F.2d 345, 347 (7th Cir. 1985).[/tippy] Between 1972 and 1979, Walgreen sold a wide variety of drugs, beauty aids, and household commodities to consumers through a nation-wide system of both Walgreen-owned stores and dealers using the Walgreen brand-name. [tippy title=”140″ header=”off”]Kealey Pharmacy & Home Care Serv., Inc. v. Walgreen Co., 539 F. Supp. 1357, 1360-1361 (W.D. Wis. 1982), aff’d, 761 F.2d 345 (7th Cir. 1985).[/tippy] The dealers independently owned drugstores pursuant to a standard dealership agreement with Walgreen. [tippy title=”141″ header=”off”]Kealey Pharmacy & Home Care Servs., Inc., 761 F.2d, at 347.[/tippy] Throughout the contractual relationship between Walgreen and its dealers, the dealers provided capital to Walgreen in two chief ways. First, the dealers paid for merchandise which they purchased from Walgreen. [tippy title=”142″ header=”off”]Kealey Pharmacy & Home Care Serv., Inc. v. Walgreen Co., 607 F. Supp. 155, 158 (W.D. Wis. 1984), aff’d in part, vacated in part, 761 F.2d 345 (7th Cir. 1985).[/tippy] In addition, the dealers provided capital to Walgreen indirectly by promoting the Walgreen name, image, and reputation in their local communities. [tippy title=”143″ header=”off”]Kealey Pharmacy & Home Care Serv. Inc., 607 F. Supp. at 159. For example, all of the prescription drugs that the dealers sold included the words “Walgreen Agency.” Id.[/tippy] Arguably, Walgreen relied on these dealers to provide the significant financial resouces needed to promote Walgreen products, which Walgreen lacked at that stage. During the contractual relationships of Walgreen with its dealers, Walgreen’s net sales were almost constantly increasing. [tippy title=”144″ header=”off”]These are the annual net sales of Walgreen during 1972 and 1979 (in thousands): $863,334 (1972), $930,898 (1973), $996,616 (1974), $1,079,143 (1975), $1,169,779 (1976), $1,223,249 (1977), $1,192,855 (1978), $1,344,542 (1979). See Walgreen Co., Annual Reports (1972-1979).[/tippy] For example, Walgreen’s net sales in 1972 were $863,334,000; [tippy title=”145″ header=”off”]Walgreen Co., 1972 Annual Report (1972).[/tippy] whereas by 1979, Walgreen’s net sales had jumped to $1,344,542,000. [tippy title=”146″ header=”off”]Walgreen Co., 1979 Annual Report (1979).[/tippy] Figure 1 outlines Walgreen’s increase in net sales between 1972 and 1979.
Figure 1: Walgreen’s Net Sales: 1972-1979 (in thousands) (click on PDF at top of page)
In 1980, following the constant increase in Walgreen’s annual net sales, it arguably reached a stage in its organizational life cycle in which it had enough financial resources at its disposal to operate all the stores on its own. [tippy title=”147″ header=”off”]See generally Walgreen Co., Annual Reports (1972-1979); Kealey Pharmacy & Home Care Servs., Inc. v. Walgreen Co., 761 F.2d 345, 347 (7th Cir. 1985).[/tippy] Indeed, in that year, Walgreen decided to adjust its marketing strategy. In particular, Walgreen made a decision to cease its reliance on dealers. [tippy title=”148″ header=”off”]Kealey Pharmacy & Home Care Servs. 761 F.2d at 350.[/tippy] Instead, Walgreen chose to maintain and increase its own stores in the same geographic areas where the dealers had already helped build up Walgreen’s reputation and image. [tippy title=”149″ header=”off”]Id.[/tippy] At this stage, the reputation mechanism collapsed. Walgreen was no longer interested in relying on the financial resources provided by the dealers, and thus had no reason to fear a blow to its reputation. [tippy title=”150″ header=”off”]See generally Combs et al., supra note 86 (discussing the deterioration of the reputation mechanism that corresponds with an increase in financial resources).[/tippy] Termination without good cause was likely to occur. In fact, Walgreen terminated its dealership agreements absent any showing that the dealers failed to comply with the requirements imposed by Walgreen. [tippy title=”151″ header=”off”]Kealey Pharmacy & Home Care Servs., Inc. 761 F.2d at 350.[/tippy]
Another important case which reveals the collapse of the reputation mechanism following a gradual improvement in the franchisor’s resource availability is Atlantic City Coin & Slot Serv. Co. v. IGT. [tippy title=”152″ header=”off”]Atlantic City Coin & Slot Serv. Co. v. IGT, 14 F. Supp. 2d 644 (D.N.J. 1998).[/tippy] International Game Technology (IGT) designs and manufactures electronic gaming devices. [tippy title=”153″ header=”off”]Id. at 647.[/tippy] During 1983 and 1997 IGT expanded its products in New Jersey, Maryland, and the Caribbeans using an exclusive distributor. [tippy title=”154″ header=”off”]Id. at 647, 649.[/tippy] Throughout the contractual relationship between the IGT and the distributor, the latter provided significant financial assistance to IGT. [tippy title=”155″ header=”off”]Id. at 654.[/tippy] More specifically, the exclusive distributor invested significant financial resources in promoting the IGT name, expanding a sales force, expanding a marketing facility, expanding a storage area for IGT products, and leasing warehousing devoted to storing, testing, and servicing of IGT gaming devices. [tippy title=”156″ header=”off”]Id. at 646, 653-54.[/tippy] Arguably, IGT relied on its exclusive distributor since it could provide the significant resources necessary to promote IGT products–resources which IGT lacked at that early stage. Throughout its contractual relationship with the exclusive distributor, IGT’s annual total revenues were almost constantly increasing. [tippy title=”157″ header=”off”]These are the annual total revenues of IGT during 1983 and 1997 (in thousands): $60,032 (1983), $73,262 (1984), $56,564 (1985), $41,574 (1986), $83,522 (1987), $98,694 (1988), $151,152 (1989), $210,257 (1990), $237,363 (1991), $399,443 (1992), $478,030 (1993), $674,461 (1994), $620,786 (1995), $733,452 (1996), $743,970 (1997). See International Game Technology, Annual Reports (1983-1993); International Game Technology; Forms 10-K (1994-1997).[/tippy] For example, in 1983 IGT total revenues were $60,032,000; [tippy title=”158″ header=”off”]International Game Technology, Annual Report (1983).[/tippy] whereas by 1997, IGT total revenues had jumped to $743,970,000. [tippy title=”159″ header=”off”]International Game Technology, Form 10-K (1997).[/tippy] Figure 2 demonstrates graphically IGT’s increase in total revenues between 1983 and 1997.
Figure 2: IGT Annual Total Revenue: 1983-1997 (in thousands) (click on PDF at top of page)
In 1997, following the constant increase in IGT annual total revenues, it arguably reached a stage in its organizational life cycle in which it had access to enough financial resources to replace its exclusive distributor with an IGT-owned distribution system. Predictably in that year, IGT decided to discontinue its relationship with its exclusive distributor. [tippy title=”160″ header=”off”]Atlantic City Coin & Slot Serv. Co. v. IGT, 14 F. Supp. 2d 644, 658-59 (D.N.J. 1998).[/tippy] Instead, IGT chose to promote and sell its product on its own. [tippy title=”161″ header=”off”]Id. at 659.[/tippy] At this stage the reputation mechanism collapsed because IGT was no longer interested in relying on distributors. [tippy title=”162″ header=”off”]Id. at 646.[/tippy] Termination without good cause was likely to occur. Indeed, IGT terminated its distribution agreement with its exclusive distributor in 1998, without any allegations of wrongdoing to justify the termination. [tippy title=”163″ header=”off”]Id. at 658-59.[/tippy] Rather, IGT praised the exclusive distributor’s performance just prior to terminating the relationship. [tippy title=”164″ header=”off”]Id. at 658.[/tippy] Good cause supporting the contract termination was noticeably absent. [tippy title=”165″ header=”off”]Id.[/tippy]
The collapse of the reputation mechanism is likewise evidenced by the case of Day Distrib. Co. v. Nantucket Allserve, Inc.. [tippy title=”166″ header=”off”]Day Distrib. Co. v. Nantucket Allserve, Inc., 2008 U.S. Dist. LEXIS 57334 (D. Minn. July 25, 2008).[/tippy] Nantucket Allserve, Inc. (Nantucket) produces a line of upscale sodas known as Stewart’s. [tippy title=”167″ header=”off”]Id. at *1.[/tippy] At the early stages of the organizational life cycle of Nantucket, its resource availability was apparently limited. [tippy title=”168″ header=”off”]Robert Halasz, Company History: Nantucket Allserve, Inc., available at http://www.answers.com/topic/nantucket-allserve-inc (last visited Nov. 1, 2009).[/tippy] One of Nantucket’s founders, Mr. Scott, was so financially strapped that he slept in his car during the summer of 1991. [tippy title=”169″ header=”off”]Id.[/tippy] At that early stage, Nantucket sold its products through distributors [tippy title=”170″ header=”off”]Day Distrib. Co., 2008 U.S. Dist. at *2. Two of the distributors began as sub-distributors of Nantucket but later became distributors of Nantucket. Id.[/tippy] who provided financial resources to Nantucket by purchasing high volumes of Nantucket sodas. [tippy title=”171″ header=”off”]Id. at *3.[/tippy] Arguably, Nantucket chose such a marketing strategy due to its financial inability to distribute its products on its own. At this stage in Nantucket’s organizational life cycle, the reputation mechanism was relatively effective. Nantucket had to rely on distributors, and therefore was restrained from acting opportunistically towards its distributors. [tippy title=”172″ header=”off”]Halasz, supra note 168.[/tippy]
Nantucket’s financial situation improved dramatically over the years. Revenues soared from $200,000 in 1991 to about $30 million in 1996. [tippy title=”173″ header=”off”]Id. In 1996, Nantucket was ranked 13th in Inc’s fastest-growing U.S. private company list. Id.[/tippy] In addition, the successful Nantucket group was purchased in 2002 by Cadbury Schweppes Plc, a British beverage giant, [tippy title=”174″ header=”off”]Corpfin Worldwide, Deal No. 171893 (June 19, 2009) (providing a summary of Snapple Beverage Group’s acquisition of Nantucket Allserve Inc.). Notably, Cadbury bought Nantucket through Snapple Beverage Group, a wholly-owned subsidiary of Cadbury. Id.[/tippy] for an undisclosed sum that was estimated at $100 million. [tippy title=”175″ header=”off”]Cadbury Schweppes PLC: Nantucket Nectars Purchase Will Build Snapple Beverages, Wall St. J., Mar. 26, 2002, at B.6.[/tippy]
Following the acquisition of Nantucket by Cadbury, Nantucket presumably reached a stage in its organizational life cycle in which it had enough financial resources to discontinue its reliance on distributors and perform all the distribution functions on its own. In fact, one year following the acquisition of Nantucket by Cadbury, they both began exploring the possibility of discontinuing distributors. [tippy title=”176″ header=”off”]Day Distrib. Co. 2008 U.S. Dist. at *5. Two clarifying notes: Firstly, Cadbury Schweppes Americas Beverages, one of the defendants in the Nantucket case, was a subsidiary division of Cadbury in the United States. Secondly, the court referred to Nantucket Allserve and Cadbury Schweppes Americas Beverages as “Cadbury,” following the practice of the parties. Id. at *1-2.[/tippy] Instead, Nantucket and Cadbury decided to distribute Stewart’s directly rather than to rely on distributors. [tippy title=”177″ header=”off”]Id. at *5.[/tippy] At this stage, the reputation mechanism collapsed and termination without good cause was likely to occur. Unsurprisingly, Nantucket took its distribution operations in-house and terminated the agreements with its distributors. [tippy title=”178″ header=”off”]Id. at *1.[/tippy] Apparently, Nantucket did not terminate the agreement due to the distributors’ failure to comply with their contractual requirements. [tippy title=”179″ header=”off”]It seems unlikely that all distributors concurrently failed to comply with Nantucket and Cadbury’s requirements.[/tippy] Good cause supporting a termination was presumably absent. [tippy title=”180″ header=”off”]For more cases which potentially reveal the collapse of the reputation mechanism in the context of franchise termination laws see C. C. Hauff Hardware, Inc. v. Long Mfg. Co., 148 N.W.2d 425 (Iowa 1967); Volvo Constr. Equip. N. Am., Inc. v. CLM Equip. Co., 386 F.3d 581 (4th Cir. 2004); Sims Wholesale Co. v. Brown-Forman Corp., 468 S.E.2d 905 (Va. 1996); Cooper Distrib. Co. v. Amana Refrigeration, 63 F.3d 262 (3d Cir. 1995).[/tippy]
Conclusion
This article questioned the effectiveness of the reputation mechanism in deterring opportunistic termination by franchisors. It also cast doubt upon the traditional law-and-economics assumption that reputation can be a substitute for franchise termination laws.
While this article focuses on franchise relationships, its conclusions can have broader implications. The assumption that reputation can serve as a substitute for regulation of long-term commercial relationships must be re-examined. As we have demonstrated, the concern for one’s reputation in long-term commercial relations often has a limited life cycle. A firm in the early stages of its organizational life cycle usually lacks internal financial resources needed to achieve its business goals; therefore, it is spurred on to enter into contractual relationships with other firms that can assist it in overcoming its financial constraints. [tippy title=”181″ header=”off”]See supra Part II.A.[/tippy] To illustrate, a financially immature firm, wishing to erect a factory, may have an initial incentive to enter into a partnership or a joint venture agreement with other firms, in order to recruit necessary capital. At this stage the reputation mechanism has some deterring effects, since the young firm is economically dependent upon its contractual partners. However, as the financial availability of the immature firm improves, it becomes less dependent on its contractual partners. The firm’s incentive will shift towards owning and operating the business on its own, which will increase its profits. At this inevitable stage, the effectiveness of reputation in preventing opportunism will decline and the reputation mechanism may ultimately collapse.