Seth W.

Norton
Washington University

An Empirical Look at
Franchising as an
Organizational Form*

I. Introduction Franchise contracts are

idetitified as a hybrid
In a classic article, Coase (1937) posited that eco- form of economic or-
nomic organization follows two general forms— ganizatioti. Motives for
markets and firms. Markets reflect natural ten- the dominance of fran-
dencies to exploit mutually beneficial gains from chise arrangements are
identified by examining
trade. However, when positive transaction costs
the theoretical litera-
exist, firms will (partially) supplant markets. ture on franchising and
Some researchers provide substantive details of related literatures on
the dominance of firm over market organization the theory of the finn,
(Alchian and Demsetz 1972; Williamson 1975). firm growth, manage-
Other researchers, however, point to hybrid rial and employee
selection, and brand
types of organizations that include elements of name capital. Empirical
both firms and markets. Tv^'o examples are share- tests are performed on
cropping (Cheung 1969; Hallegan 1978) and joint the incidence of fran-
ventures (Mariti and Smiley 1983). This article, chise contracts across
following the approach pioneered by Rubin states for three indus-
(1978) and Mathewson and Winter (1985), exam- tries in which franchis-
ing is prominent and
ines franchising, a third hybrid type. The pur- data are readily avail-
pose is to identify specific market parameters able. The results sug-
that encourage the use of franchising as an or- gest that both princi-
ganizational form and to test these empirically pal-agent incentives
for three industries in which franchising is com- and informational in-
centives favor the use
mon but company-owned outlets are also com- of franchise ar-
mon. rangements.

•Financial support from the John M. Olin Foundation Is

gratefully acknowledged. I wish to thank Yoram Barzel, Lee
Benham, George Bittlingmayer. Elisabeth Case, an anony-
mous referee, and Melvin Reder for their helpful comments
on previous drafts. I am responsible for any errors.
{Journal of Business, 1988, vol. 61, no. 2)
© 1988 by The University of Chicago. All rights reserved.
0021-9398/88/6102-0006$01.50
198 Journal of Business

The article is organized as follows. Section II describes franchising

in an institutional context. Section III describes some received expla-
nations for franchising. Section IV discusses conditions that might
make franchising an optimal organizational form. Section V contains
empirical tests and some evidence from the managerial/institutional
literature. Finally, Section VI contains some conclusions and observa-
tions.

II. Characteristics of Franchise Organization

The central feature of franchise organizations is the presence of both
market-like and firm-hke qualities. The market-like qualities arise from
the existence of trade between two entities that operate in capital,
labor, and product markets. The franchisor, the parent company, de-
velops a product or service for sale by the franchisees that market it in

Distribution of Franchised and Company-owned Outlets for Selected

Fast Food and Motei Firms
No. of Outlets
Company Percentage
Firm Franchised Owned Total Franchised
Fast food industry:
Carvel Corp. 700 2 702 99.7
Kannelkom Shoppes, Inc. 275 4 279 98.6
Swenson's Ice Cream Co. 320 19 339 94.4
Dunkin Donuts, Inc. 1,100 70 1,170 94.0
Arby's, Inc. 1,035 155 1,190 87.0
Burger King Corp. 2,767 488 3,255 85.0
KFC Corp. 3,600 800 4,400 81.8
(Kentucky Fried Chicken)
International House
of Pancakes 350 150 500 70.0
Wendy's International 1,606 767 2,373 67.6
Dotnino's Pizza, Inc. 439 245 684 64.2
Hardee's Food System, Inc. 890 563 1,453 61.3
Captain D's 194 208 402 48.3
Whatabtir^er, Inc. 141 159 300 47.0
Long John Silver
Seafood Shoppes 509 738 1,247 40.8
Jack in the Box 5 783 788 .6
Motel and hotel industry:
Rodeway Inns 153 2 155 98.7
Quality Inns, Inc. 400 26 426 93.9
Holiday Inns
International 1,526 231 1,757 86.9
Econo-Travel Motor
Hotel Corp. 129 21 150 86.0
Ramada Inns, Inc. 635 133 768 82.7
Day's Inn of America 193 118 311 62.1
SOURCE.—Internationa] Franchise Ass r of Membership. 1982-83.
 Empirical Look at Franchising I99

a particular tocation. Typicatty, a franchisee pays a tump sum fee for

the right to market the product and atso pays royalties, sueh as a
percentage of sates. In addition, the franchisee may purchase specific
inputs from the franchisor.
The firm-tike qualities arise from the nature of the restricted bilateral
nexus between the two types of entities. The relationship often resem-
bles fult vertical integration. Franchisors typically offer managerial
assistance—for exampte, site selection, training programs, standard
operating procedures, design of physical layout, and advertising to
the franchisee, and the franchisee agrees to run the business according
to the franchisor's stipulations. The franchisor typically exercises sub-
stantial control over the franchisee. Reliance upon clauses that permit
unilateral termination by the franchisor as well as strict performance
criteria make the relationship resemble an employer-employee con-
tract (Rubin 1978), although the control of franchisors over franchisees
has been reduced somewhat by legal decisions in recent years (Klein
1980).
A curious feature concerning franchise organization is the existence
of both franchise and company-owned outlets simultaneously within
the same firm. Table t contains a breakdown of franchised and com-
pany-owned outlets for some prominent firms in the fast food and
motel and hotel industries.
The data in table 1 clearly show the coexistence of both organiza-
tional forms. Moreover, the data reveal substantial variation in the
relative incidence of franchising. Thus, the data underscore the rele-
vance of what determines the selection of franchising versus company-
owned outlets.

ni. Received Explanations for Franchising

Few consistent, empirically tractable propositions exist as to why this
hybrid configuration develops and survives.' Two prominent "expla-
nations" persist.
A. Capital Market Imperfections
A prevalent explanation for franchising affirms that franchising pro-
vides a means for the franchisor to raise capital (Oxenfeldt and Thomp-

1. A significant literature on optimal franchise contracts or payment mechanisms does

exist (e.g., Blair and Kaserman 1982; Matthewson and Winter 1985). The literature on
the more fundamental question, "why franchising?" is scant. Mathewson and Winter
(1985) do provide some sound theoretical analysis of the question, but several of the
market parameters that they discuss, e.g., national television advertising or product
quality, are not readily tested empirically at least at the level of aggregation used in this
article. For a recent paper that examines some of the issues in this article, see Brickly
and Dark (1987). '
200 Journal of Business

soti 1968-69; Ozantie and Hutit 1971; Caves and Murphy 1976). The
argument holds that, facing a capital constraint, the franchisor is able
to raise capital at a lower cost than other arrangements would allow.
Thus, the franchisees are viewed as an inexpensive source of capital.
Caves and Murphy (1976, p. 581) make the point succinctly; "For
financing outlets the capital supplied by franchisees has no ready sub-
stitute."
Despite broad acceptance among researchers, the capital constraint
explanation seems at odds with the theory of finance (Rubin 1978).
Franchisees' investments will be less diversified than the franchisor's
investment because the parent firm will have a portfolio of revenue
streams from the royalty and input fees. Therefore, risk-averse fran-
chisees should demand a risk premium from the franchisor, resulting in
a lower return for the franchisor. Thus, the argument will hold only if
the franchisors are more risk averse than franchisees. Moreover, Ru-
bin (1978) notes that even if gross capital market imperfections exist,
so that franchisors rely exclusively on store managers for capital, a
franchisor would reduce capital costs by issuing shares to a portfolio of
all stores rather than providing the limited ownership schemes associ-
ated with realistic franchise agreements. Consequently, the absence of
such arrangements in the real world weakens the argument. In short,
empirical analysis of the simple capital market imperfections explana-
tions for franchising seems unwarranted, if not impossible.

B. Market Power
Several researchers (Inaba 1980; Blair and Kaserman 1982; Lee 1984)
presume that franchising exists in response to incentives related to
market power in a vertical chain. In the absence of direct control by an
upstream firm with market power, downstream firms may be able to
substitute away from the inputs sold under market power (Vemon and
Graham 1971). The franchisor's contractual control over the franchisee
nullifies this substitution and other types of behavior that might reduce
the value of the franchisor's monopolistic assets.
The franchising pricing mechanisms that are discussed in this litera-
ture are enlightening and appear to have some real-world validity.
However, the market power framework lacks generality (Rubin 1978).
Moreover, the argument does not easily provide refutable empirical
tests because market power is difficult to measure. Indeed, the ambi-
guity of market definition in terms of either geography or close substi-
tutes (or both) means that testing the incidence of franchising across
markets would be difficult. Even accepting the hypothesis, the difficul-
ties in measuring market power and relating it to the incidence of
franchising across markets seem quite severe. Thus, empirical tests of
market power may not be tractable.
Empirical Look at Franchising 201

IV. Franchising and Theories of Economic Organization

A. General Overview
In recent years, scholars have provided both insights into the existence
of alternative organizational forms (Alchian and Demsetz 1972; Wil-
liamson 1975; Jensen and Meekling 1976; Fama and Jensen 1983a,
1983i) and specific analyses of franchise operations (Rubin 1978; Mat-
thewson and Winter 1985). A central feature of this literature is that
competition and other economic forces determine what organizational
form is optimal. In this framework, franchise operations are the result
of forces that restrict residual risk bearing to important decision
makers.
Franchisees are owner-managers that typically bear the residual
risks of a local operation because their wealth is largely determined by
the difference between the stochastic revenue inflows to the local oper-
ation and promised payments to other factors of production.
The risk bearing of the franchisees differs substantially from that of
other organization forms in two respects. First, in many economic
organizations the risk-bearing function is separate from the daily mana-
gerial function. For example, in large publicly owned corporations,
numerous security holders bear residual risk but do not participate at
all in the management of the firm (Fama and Jensen 1983a, 1983A), and
the risk is typically related to the firm's operations as a whole, not just
one or several local operations. In franchising, in contrast, substantial
residual risk for local outlets is borne by franchisees, who are typically
closely involved in daily operations (Vaughn 1979).^ Second, while
some labor contracts make employees (especially managers) residual
claimants by linking their compensation somewhat to the residual in-
come of the firm (or some relevant subunit) via profit sharing, adjust-
ments to their lifetime earnings profile, and so on (Becker and Stigler
1974; Jensen and Meckling 1976; Lazear 1981), franchise contracts
differ in that the franchisee becomes a residual claimant by paying an
explicit franchisee fee—ex ante bonding, and by paying royalty fees.
The explicit payments make franchisees residual claimants to a de-
cidedly greater degree than most employees, and presumably the use
of franchising reflects the limits to bonding in employment contracts
(Eaton and White 1982, 1983).
The extreme restriction of residual risk bearing to local owner-

2. Rosenberg (1969) notes that large multi-unit franchisees do exist. While such opera-
tions are not typical, their presence indicates that some economies of scale in manage-
ment or ownership may exist. Nevertheless, the combinations of local ownership and
local management in franchising differ substantially from the separation of ownership
and management in most large corporations (Fama and Jensen 1983a, 1983/>; Demsetz
and Lehn 1985).
202 Journal of Business

managers that typically characterizes franchising offers a basis to ex-

plain the incidence of franchising in terms of specific economic forces.
Two separate streams of literature appear relevant—principal-agent
incentives and information incentives,
B. Principal-Agent Incentives
Much of the literature on economic organization stresses the fact that
economic agents may supply less than their best effort or choose
policies that lead to lower wealth for principals—those who bear the
wealth consequences of the agent's actions (Ross 1973; Jensen and
Meckhng 1976; Fama 1980; Fama and Jensen 1983a, 1983/J), In many
organizational arrangements, agency costs—the costs of aligning the
incentives of principals and agents, including bonding and monitoring
and the related forgone output attributable to those activities—are
incurred because the value of specialization between principals and
agents exceeds these costs (Fama and Jensen I983fl, 1983fe), However,
if market parameters make the agency costs too expensive relative to
the gains from specialization, the organization must be altered,
Rubin (1978) suggests that one relevant market parameter that makes
conventional firm organization prohibitive is physical dispersion of op-
erations. For example, the costs of monitoring local operations will be
greater the further the operation is from the monitor. At some point the
monitoring costs associated with intrafirm specialization—investors
separate from managers—exceed their benefits. Franchising loses the
efficiency of specialization but also avoids the monitoring costs be-
cause the local manager is now an investor whose wealth is strongly
dependent on the performance of the local unit.' Therefore, if Rubin's
point is correct, franchising should be more common with physically
dispersed operations, as in rural areas,
A second market parameter that may affect agency costs is labor
intensity. Silver and Auster (1969) assert that capital is relatively easy
to monitor. Machines do not shirk. However, humans do shirk, and for
a given level of output, monitoring costs will rise with increasing labor/
output ratios. One means of reducing the higher agency costs associ-
ated with labor intensive operations is to hire a specialist in monitoring,
but the specialist in monitoring has an incentive to shirk as a monitor
unless his wealth is significantly affected by his performance. The typi-
cal restriction of ownership to managers who monitor local operations
intensely is, of course, a standard feature of franchising and suggests

3. The argument and the additional arguments that follow obscure the point that
sittiple ownership of less than 100% of residual income leaves the owner with less than
perfectly aligned incentives with other owners (Jensen and Meckling 1976). For details
on necessary atid sufficient contractual features that make the franchisor's and fran-
chisee's incentives compatible, see Mathewson and Winter (1985).
Empirical Look at Franchising 203

franchise contracts should be more common with increasing labor in-

tensity.
Establishment size may also be a relevant market parameter. Fama
and Jensen (1983a, 1983fc) note that activities with substantial econo-
mies of scale generally entail greater gains from specialization and
separation of investment from management. Thus, large size would
seem to discourage franchising. On the other hand. Silver and Auster
(t969) note that a major limit on (firm) size is entrepreneurial capacity
or the supply of nonshirking monitors.'' If franchising can be viewed as
a contractual mechanism that increases the supply of nonshirking man-
agers, then franchising may be associated with larger-sized operations.
Therefore, the relationship between size and the incidence of franchis-
ing is ambiguous a priori.

C. Information Incentives
Three market parameters that are linked to information should also be
expected to influence the incidence of franchise contracts. The first is
brand name capital (Klein 1980; Klein and Leffler 1981). Essentially,
this concept refers to specific assets acquired by a firm that signal that
its selling prices are justified by their quality level and that provide
informational value to consumers. The link between brand name capi-
tal and franchising rests on two features. First, observed franchise
operations exhibit brand name capital, for example. Holiday Inn's logo
or McDonald's golden arches. The existence of brand name capital
makes the parent company (and other local outlets) vulnerable to qual-
ity debasing by a local outlet. Using local managers who make heavy
site-specific investments and post a large bond in the form of a fran-
chise fee makes quality debasing less likely, because a franchisee has
much more to lose upon termination than a local employee-manager.'
Second, the form of brand name capital is predictable. Competition
among firms compels firms to acquire "assets which provide the great-
est direct service to consumers" (Klein and Leffler 1981, p. 626). Thus,
we might expect the brand name capital motive for franchising to be
greater where consumers' knowledge about a seller's produet quality is
relatively low. Because tourists as a class are relatively ignorant about
local markets (Stigler 1961), travel intensity might be a market parame-
ter associated with franchising.
A second informational market parameter that might affect contrac-

4. Silver and Auster (1969) do not explicitly separate the management and risk-bearing
functions of the classic entrepreneur. However, their discussion obviously focuses on
the management function. Thus, in their framework the terms are interchangeable.
5. Presumably, the limits of bonding in employee contracts (Eaton and White 1982,
1983) tend to render bonding via employee contracts less effective as an incentive-
compatible device in the case of substantial brand name capital.
204 Joiirna] of Business

tual choice is demand variability. Stochastic elements of business con-

ditions create a signal processing problem for investors (Demsetz and
Lehn 1985), The agency costs of monitoring managers rise because
owners cannot cheaply distinguish shirking from low demand. Conse-
quently, the relative gains from diffuse ownership and specialized man-
agers fall. One alternative is franchise ownership (Matthewson and
Winter 1985), Therefore, franchising may be more common with
greater local demand variability,
A third information market parameter deals with the market for man-
agers, A well-established theme in the investment literature (Lucas
1967; Gould 1968; Treadway 1970; Mortensen 1973; Brechling 1975), as
well as the theory of firm growth (Penrose 1959; Wright 1964; Marris
and Wood 1971; Rubin 1973), recognizes that growth is not a free good
because "adjustment costs" make rapid expansion more expensive
than a slower approach to a desired capital stock. Recent research
(Slater 1980; Faith, Higgins, and Tollison 1984) suggests that a signifi-
cant part of an expanding firm's adjustment costs is the value of lost
current production associated with selecting and training of new man-
agers by incumbent managers. Faith et al. (1984, p. 663) summarize the
problem:

The eost of outside hiring is primarily the cost of bringing the

outsider's productivity up to the level ofthe insider. This cost arises
because insiders have been trained in firm procedures and own spe-
eific capital which is valuable to the firm. The greater the rate of
outside hiring, the greater these training costs. In addition, there are
costs of finding the outside manager. It is costly to detect fakers
(low-productivity types) in the supply of outside candidates. It is
assumed that the marginal eost of error (higher training eost to offset
lower productivity) rises the more the firm resorts to the outside
market.

Prescott and Visscher (1980) provide an additional insight on the

cost-of-growth argument. They suggest that when a firm expands rap-
idly the time period for evaluating new employees is shortened. The
result is poorer matehes between employees' skills and job assign-
ments than a slow-growth or no-growth firm. Poorer employee/task
matehes lead in turn to higher production costs
Despite the existence of increased screening and production costs
attributable to rapid expansion, firms have some alternative strategies
that may, at least partially, offset these costs of growth. Recent ad-
vances in labor economics suggest that firms can offer complicated
wage packages or wage plans and tests to compel heterogeneous poten-
tial employees to self-seleet according to their abilities (Guasch and
Weiss 1980, 1981; Coyte 1984), Other scholars maintain that the form
of contract ean serve as a screening device to seleet superior workers
Empirical Look al Eranchising 205

when ability or motivation is difficult to ascertain. For example, share-

cropping is justified as a contractual form to select able workers (Aker-
lof 1976; Hallegan 1978; Allen 1982). The logic is that economic agents
with low skill or motivation levels are less willing to accept a compen-
sation package that makes their wealth largely dependent on residual
income than are agents with higher skill or motivational levels.
Sharecropping and franchising give agents significant residual claims
to localized operations. Moreover, because sharecropping and fran-
chising have a number of similarities as contractual forms (Murrell
1983), it is reasonable to judge that one reason for a firm to choose
franchising as a distribution form would be to facilitate managerial
selection, because competent and motivated agents would accept (pre-
fer) franchisee status.^ Also, an additional advantage to the firm of
hiring new managers via a franchise contract is that even if applicants
are myopic in the sense that they believe their abilities or willingness to
work are greater than they really are, the costs of being myopic can be
largely borne by the franchisees' payment of the franchise fee. In
short, if the costs of managerial selection are higher for rapidly expand-
ing operations, and franchising serves as a means of managerial self-
selection, the incidence of franchising should be positively related to
firm growth.'

V. Empirical Tests
In this section some empirical evidence is presented on the relative
incidence of franchising as an organizational form. The discussion
above suggests several testable hypotheses on the determinants of
franchising.
A. The Data
The 1977 U.S. Census of Retail Trade (U.S. Department of Commerce
Klla) provides relevant data on the distribution of franchised and
nonfranchised establishments in two retail food industries—(1) restau-
rants and lunchrooms and (2) refreshment places. These industries are
both part of the SIC industry "Eating Places" (SIC no. 5812). The data
include dollar sales and establishment data by state for retailers in
these two industries. In addition, the 1977 Census of Service Industries

6. The similarity of contractual forms holds despite the fact that sharecroppers are
more laborers than managers. The idea of self-selection via sharecropping is quite old.
See Spillman (1919) on the agricnitural ladder.
7. Some anecdotal evidence that franchise contracts provide a screening function is
evident in data reported by Mathewson and Winter (1985). They report that acceptance
rates for franchise applicants are 1% for McDonald's and 1.5% for Burger King. While
the authors argue that these facts indicate the presence of queues, the data unambigu-
ously show a screening process if applicants are heterogeneous. For an account on
sorting in the market for franchisees/managers, see ch. 5 of Rosenberg (1969).
 Journal of Business

TABLE 2 DistribuUon of Franehise Operations as a Percentage of Establishments

across States, 1977
Industry Group
Restaurants Refreshment Motels and
and Lunchrooms Places Tourists Courts
Quantiles (/V = 49) (JV = 50) (N = 41)
Maximum .148 .627 .302
95% .140 .478 .296
90% .111 ,457 .262
75% .091 .428 .219
50% .055 .378 .174
25% .040 .261 ,103
10% .028 .183 .077
5% .019 .172 .071
Minimum .006 .113 .049
Range .142 .514 .253
SOURCE.—tJ.S. Department of Commerce. 1977a. 1977fc.

(U.S. Department of Commeree 1977*) provides data on the incidence

of franchise operations for the motel industry (SIC no. 7011).* Suffi-
cient data are available in this census for analysis of the subindustry
group, motels and tourist courts. The percentage distribution of fran-
chised operations across states for all three industry groups is sum-
marized in table 2,
The industry groups exhibit some range in the incidence of franchis-
ing, but franchising is considerably less common in the restaurant and
lunchroom business and most common in the refreshment business.
Presumably, the technologies of the industries differ signifieantly.
Hence, the empirical analysis should be separate, and we might expect
the industries to differ in terms of the importance of explaining the
incidenee of franchising,

B. The Model
The empirical results are derived from estimates of the following re-
gression equation:^
\n(Pf,n - Pfl) X 100 = *o + 6i • RURAL -l- (>2 • ln(LABSLS)
+ b, • ln(SIZE) -I- bt • DVAR -I- b; • ln(TRAVEL) (1)
+ bf, • GROWSLS -h e,,
where
Pfl = the percentage of establishments categorized as
franchise holders by the Census Bureau in the
state for the respective industry in 1977;
8. The motel industry data are given for members and nonmembers in "Franchise or
Co-Ownership Group Carrying Common Name."
9. Summary statistics for the dependent variables are shown by industry in the Appen-
dix.
Empirical Look at Franchising 207

RURAL = the percentage of the population in the state hving

in nonmetropoHtan areas in 1977;
LABSLS = the ratio of employees to sales for the industry and
state in 1977;
SIZE = the mean dollar sales size per estabhshment in the
state and industry in 1977;
DVAR = the estimate of demand variability from detrended
percentage variations in eating and drinking retail
sales in the state;
TRAVEL = the number of household trips in the state divided
by the population in the state in 1977;
GROWSLS = the percentage growth in sales per establishment
from 1972 to 1977 for the industry and state;
e, = the regression error term.

The dependent variable, \a{PfJ\ - PfX reflects the Census Bureau's

taxonomy. Presumably, its distinction between franchised and non-
franchised operations is unique and therefore operationally meaning-
ful. The log-odds transformation is used as a simple statistical matter
because the dependent variable is a percentage (see Neter and Wasser-
man 1974, p. 332). The variable RURAL represents physical dispersion
of the establishments in a state. If franchising is designed to make local
managers residual claimants because physical dispersion creates incen-
tives for managerial shirking, then the proportion of firms that are
franchise operations should be greater as RURAL rises, and fc, should
be positive. The variable LABSLS represents the labor-output ratio. If
higher labor-output ratios encourage franchising, then ^2 should be
positive. The variable SIZE is a proxy for establishment size. Its pre-
dicted sign is ambiguous. DVAR is an estimate of demand variability.
It is the root mean square error from the regression of percentage
changes in eating and drinking retail sales for the state on trend for the
1966-77 period. Higher measures indicate greater uncertainty (Dem-
setz and Lehn 1985). If franchise operations reflect local demand un-
certainty, then bi should be positive. The variable TRAVEL is a crude
proxy of the value of the brand name capital. Because tourists are
typically more ignorant about local markets than residents (Stigler
1961), a measure of tourism should capture some of the value of brand
name capital and hence that rationale for franchising. Accordingly, b-,
should be positive. The variable GROWSLS attempts to capture the
dynamics of firm growth. If franchising is an efficient form of self-
selection in managerial labor markets, and sales growth raises the man-
agerial screening and related production costs, bf, should be positive.
An additional factor that could influence the relative incidence of
208 Journal of Business

franchising is public policy. Specialized state regulation has clearly

affected automobile franchising (Smith 1982; Eckard 1985). Moreover,
a number of states passed legislation governing the sale and administra-
tion of franchise contracts in all industries (Minnesola Law Review
1975; RolUnson 1980). For example, by 1975, laws regulating franchis-
ing existed in 15 states, governing sales disclosure (10 states), franchise
termination (3 states), and "good faith" practices (4 states), and a
number of additional states passed laws between 1975 and 1979 (Rollin-
son 1980; Rudnick and Young 1980).
State regulations could raise the cost of franchise operations and
thus reduce the incidence of franchising or could lead to well-defined
property rights for franchise contracts, reducing the risks of litigation
and thus increasing the incidence of franchising. On the other hand,
sales taxes unambiguously raise the costs of market exchange between
franchisor and franchisees and thus may lead to more company-owned
outlets. Therefore, the restriction of state laws to a limited number of
states and differential state sales tax rates could affect the incidence of
franchising across states. Nevertheless, preliminary analysis suggested
that differential sales tax rates have no impact on the distribution of
franchising, and the presence of state laws or specific provisions of
state laws are not significant determinants of the relative incidence
of franchising in these industries at the state level. Thus, equation (1)
can be estimated without including variables for state sales taxes or
state franchise regulations.'"

C. Results
Equation (1) is estimated by a weighted OLS procedure (Neter and
Wasserman 1974, p. 332). If the supply of nonshirking managers con-
strains establishment size, and franchise contracts increase that supply
when various market parameters are present, then size may also be
endogenous. Regression diagnostics suggest a high probability that it is
endogenous only in the motel and tourist court industry." Accordingly,

10. The preliminary runs included the state sales tax rate—in levels and in deviations
from the mean rate across all states, and dutnmy variables for the presence of a law
governing any aspect of franchising, a disclosure provision, a "good faith" provision, or
a termitiatiotl provision in either 1975 or 1979 (Minnesota Law Review 1975; RoUinson
1980). Most of the coefficients had r-statistics less than |1.0|, and none was significant at
convetitiotial levels.
11. Using several alternative ttiodels, the best {lowest RMSE) establishment-size re-
gression estimates are:
(restaurants and lunchrooms):
ln(SIZE) = .26 - .34 RURAL + .77 ln(PEMP77) - .68 ln(CAPLAB)
(0.27) (-4.97) (6.50) (5.40)
- .02* In (Pf/l - Pf),
(0.46)
fi" = .77;
Empirical Look at Franchising 209

two-Stage least squares (2SLS) are also estimated for this group. More-
over, because the RURAL and GROWSLS variables appear to exhibit
multicoUinearity (r = .52) in the refreshment place industry, the results
of estimates with each variable omitted are also reported for that indus-
try. The results for the three industries are summarized in table 3.
The data in table 3 document three important patterns. First, consid-
erable support exists for the underlying theories. Second, the resuhs
suggest that no single factor accounts for the incidence of franchise
contracts. Both principal-agent and information incentives affect the
choice of contractual form. Third, the results vary by industry group.
Thus, one implication of the data is that theoretical discussions that
emphasize only one raison d'etre for franchising are incomplete.
In terms of specific market parameters, the weakest results are for
demand variability and travel intensity. Both are significant in only one
industry. Demand variability appears important only for refreshment
places, and travel appears important only for motels and tourist courts.
In the demand uncertainty case, the variable may be a poor proxy for
the theory. Alternatively, increasing uncertainty may lead to full verti-
cal integration (WiUiamson 1975) and therefore to less franchising.
Similarly, travel intensity may be a poor proxy for the demand for
brand name capital and thus account for the null results in the food
industries. Nevertheless, the travel intensity results for the motel in-
dustry are robust and suggest that the brand name capital/franchising
nexus may be important in this industry.
Labor intensity and sales growth are positive and significant in two
of the three industries, although the multicoUinearity dampens the con-
tribution of sales growth for refreshment places in the full estimates of
equation (1). Therefore, the data suggest that the higher monitoring
costs associated with more labor intensive operations and the sorting

(refreshment places):
ln(SIZE) = 2.83 -.13 RURAL + .37 ln(PEMP77) - .51 In(CAPLAB)
(1.41)(-1.14) (1.47) (-3.40)
+ .17 GROWSLS - .01*ln(iV/l-i>,),
(1.23) (-0.12)
R'' = .38;
(motels and tourist courts):
ln(SIZE) = 2.43 - 1.88 ln(CAPLAB) - .25 GROWSLS
(3.50) (-7.05) (-1.93)
- 2.11 LABSLS - .17 TRAVEL + 2.85* ln(/V/l-/"/),
(-6.99) (-2.52) (6.44)
R' = .88.
The variable CAPLAB, a capital intensity measure, is the ratio of seats to employees in
the restaurant and lunchroom and refreshment place industries and the ratio of units to
employees in the motel and tourist court industries. The variable PEMP is payroll per
employee. 7"-values are in parentheses; asterisk indicates x 10^
 Journal of Business

I ill

° "
I 111

I
I

i»11-s * ^ l
Empirical Look at Franchising 211

processes in the market for local managers cannot be rejected as strong

determinants of the franchise form in the respective industries. More-
over, the positive results for size in the refreshment place and motel
and tourist court industries are consistent with the hypothesis that
franchising increases the supply of nonshirking managers, although a
more detailed study of the size/franchising link is warranted.
Finally, the estimates for the rural variable are quite robust, having
the predicted sign and statistical significance for all three industry
groups. Thus. Rubin's (1978) original hypothesis and the underlying
principal-agent theory receive strong support in explaining the choice
of the franchise contractual form.

D. The Managerial/Institutional Literature

The statistical evidence provides support for both principal-agent and
information-incentive explanations for franchising. Additionally, ac-
counts in the managerial/institutional literature provide at least anec-
dotal evidence that is consistent with some of these explanations. Al-
though the demand variability, labor intensity, and establishment size
variables are not prominent in this literature, the other variables are
discussed.
First, consider physical dispersion of outlets. In an industry study of
chain restaurants, Wyckoff and Sasser (1978, pp. 139-44) describe the
strategic choice between company-owned outlets or franchise-owned
outlets for Waffle House, Inc., which was planning a national expan-
sion. The firm chose company ownership for the southeast region of
the United States, where its corporate operations were located, and for
the southwestern region, where the firm had some company opera-
tions. The firm selected franchisee-owned operations for the remainder
of the United States, including most of the more distant areas. If physi-
cal dispersion raises monitoring costs and franchising is an organiza-
tional response to physical dispersion, then the franchising should in-
crease with increases in physical dispersion of outlets; the firm's
strategy was consistent with the theory. A similar result is robustly
supported in recent empirical research (Brickly and Dark 1987).
Second, consider the role of brand name capital. While httle discus-
sion of the concept exists in the managerial/institutional literature,
some of the more successful franchise systems are known for the un-
usual strength of their brand names and their advertising and promo-
tional expenditures. For example, the collective McDonald's enter-
prise "spends more than $600 milhon a year promoting the most
advertised brand in the world" (Love 1986, pp. 1-2). Similarly, the
founder of McDonald's franchise operations, Ray Kroc, spent unusu-
ally large sums on promotional fees to get the hamburger chain's name
in newspapers during the early years of the venture (Love 1986, p.
207). Moreover, as early as 1959 the McDonald's franchise contract
 Journal of Business

Sales Growth and Franchising for Wendy's Old-fashioned Hamburgers

Sales($000,OOOs) New Units

Year Company Franchise Total Company Franchise '^Franchise
1971 .682 0 .682 4 0 0
1972 1.807 .208 2.015 7 2 22
1973 4.315 1.949 6.234 17 15 47
1974 12.742 11.491 24.233 44 49 53
1975 31.599 42.863 74.462 83 169 67
SOURCE.—Wyckoff and Sasser (1978. pp. 103-5).

required operators to spend 2.5% of their sales to promote tiieir stores

locally, and the amount was raised to 4% in 1969. Subsequently, suc-
cessful franchisors such as Wendy's Old-fashioned Hamburgers (Wen-
dy's International) required franchisees to spend a minimum percent-
age of sales on local advertising and promotion and to contribute a
fixed amount of sales to national advertising as well (Wyckoff and
Sasser 1978, pp. 107-8).
Third, consider growth and the market for managerial talent. The
link between sales growth and the relative incidence of franchising for
Wendy's Old-fashioned Hamburgers is illustrated in table 4.
The data in table 4 are similar to the regression results above in table
3 because the pattern is consistent with expansion via franchising as a
means to expand rapidly. To obtain a comparison of the sensitivity of
organizational form to firm growth, I regressed the change in units on
the change in total sales (in $OOO,(X)Os). The results were (r-ratios in
parentheses):

A company units = .88 A company sales,

(5.78)
R^ = .918, RMSE = 8.045, D-W = 1.55,
A franchise units = 2.34 A company sales,
(23.79)
(R' = .995, RMSE = 5.25, D-W = 3.11).
The difference in coefficients is statistically significant at the .001 level.
Thus, the sensitivity of franchise units to the firm's sales growth is
more than twice the sensitivity of company units during this early
period in the firm's history. Therefore, these data are consistent with
franchising as a contractual form that economizes on managerial
screening and selection costs.
However, that observation must be tempered by the fact that fran-
chisees do supply capital as well as entrepreneurial services to the
collective enterprise. A more subtle argument than Caves and Mur-
phy's (1976) for the franchisee as a supplier of capital is also consistent
Empirical Look at Franchising 213

with the data.'^ The fact that entrepreneurial skills and capital are
jointly supplied means that the joint supply price of those inputs is less
than the sum of the competitive prices times the quantities of those two
inputs separately. While the data are consistent with a contractual form
that bundles entrepreneurship and capital when monitoring costs are
high (e.g., physically dispersed outlets) or managerial screening costs
are high (high growth), attributing the contractual economies solely to
the entrepreneurial component of the franchisee'sjoint supply could be
misleading.
Nevertheless, the managerial screening argument suggests that capi-
tal and entrepreneurial skills are bundled precisely because it is costly
to find talented, nonshirking local managers as a firm tries to expand
rapidly. Some accounts in the managerial/institutional literature bear
this point out. For example. Love (1986) notes that during the early
years of McDonald's franchise operations, Kroc found about half of his
franchisees from fellow members at a local country club. With a few
exceptions, this group was the least competent of all operators in
McDonald's 30-year history, primarily because they were passive in-
vestors and lacked entrepreneurial skills or motivation. Similariy, Wy-
ckoff and Sasser (1978, p. Ill) cite Wendy's International (Wendy's
Old-fashioned Hamburgers) criteria for franchisee selection:
We are not interested in investor groups who plan to be absentee
owners. The franchisee should have solid net worth and liquidity.
We like to see something like $200,000, but we will accept less if the
situation is right. We want people who will be involved. Doctors and
lawyers who want to invest money do not have the attitude and
desire to do well. We don't make our profits from selling our fran-
chisees goods and services. Our income comes from their sales vol-
ume. So we are interested in franchisees who can build sales. We
will supply them with support to do this, but we must select people
who will dig in and do it. We are interested in signing a whole area
with one experienced and proven individual who has the ability to
build an organization.

In short, the managerial/institutional literature suggests that manage-

rial screening is extremely imporiant, and this may at least partially
account for the bundling of capital and entrepreneurial skills via fran-
chising.

VI. Summary and Conclusion

Recent advances in the economic theory of organization suggest that
residual claims should be restricted to managers only under special

12. I am indebted to Melvin Reder for some helpful comments on this point. A similar
argument distinguishes portfolio investment from foreign direct investment in explaining
the existence of the multinational tirm (Little 1986).
214 Journal of Business

circumstances because capital costs would be higher and the available

pool of competent managers would be smaller under such restricted
contracts. Extending the theory to franchising suggests that this type of
contractual arrangement arises not so much from traditional explana-
tions—simple imperfections in the capital market or product market
power—but from market parameters that make the separation of man-
agement and risk bearing relatively inefficient. For the three industries
examined in this article, the incidence of franchising is positively and
significantly related to principal-agent incentives—physically dis-
persed operations and increasing labor-output ratios and establishment
size—and information incentives—higher travel intensity (the value of
brand name capital) and sales growth (managerial screening). Simi-
larly, some anecdotal evidence from the managerial/institutional litera-
ture is also consistent with the physical dispersion, brand name capital,
and managerial screening explanations.
Two points merit further comment. First, the robustness of the sta-
tistical results is remarkable because it occurs despite a high-level
aggregation. Noise in the data (e.g., establishments operated by local
managers who are residual claimants but not franchisees) simply biases
against finding statistically significant coefficients. Future research us-
ing intrafirm data might yield even more robust results. Second, sev-
eral researchers document a "life cycle" to franchising (Rubin 1978;
Matthewson and Winter 1985). Future empirical testing for this phe-
nomenon might also shed further light on the question why this hybrid
organizational form exists and survives.
Empirical Look at Franchising
 Journal of Business

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