Synonyms

Franchising

Definition

Franchise is a successful system of business organization to market goods and services based in a contractual relationship between two legally independents parties, according to which one well-established business, the franchisor, in exchange for the pay of an initial sum, fees or periodic royalties, transfer or license to the other part, the franchisee, the right to use in a given area and during a period of time, their trademark, trade name, or another industrial and intellectual property rights, with the provision of commercial support and technical assistance.

Franchise as a Business Model

From a broad perspective, franchise can be defined as a contractual relationship involving two legally independent entrepreneurs with the goal of market goods or services in a given location during a specified or indefinite period of time. Using a narrow approach, franchise commonly refers to those agreements known as business format franchise. In this sense, the purpose of contract is the transmission by the franchisor of a successful and recognized business system, giving continuous provision of commercial and technical assistance to the franchisee. Subsequently, the franchisor must make available to the franchisee – through appropriate license agreements – all intangible assets that had led the company success (good will), like the brand name or another industrial and intellectual property rights as well as the know-how. The franchisee has obligations of confidentiality and no competition about franchisor’s business methods, even after termination of the relationship. In exchange to join the network, the franchisee assumes the payment of an up-from lump sum or fixed initial fee and ulterior royalties, commissions, or percentages of retail sales. Given that his business opportunity is the distribution of the product or service under franchisor’s techniques and knowledge, the franchisee may make highly specific investments to maintain the value and quality of the brand – thus, franchisors must guarantee a reasonable length of the contract. The contract clauses, standardized, attribute to the franchisor wide powers of monitoring. The franchisor controls the supply, distribution, and the resale of goods or services, although he is obligated to provide equal treatment to all franchisees. He imposes conditions about characteristics of the franchised outlet and staff training because the network has to be homogeneous and uniform. By recommending resale prices and coordinating franchise advertising and promotional activities, the franchisor is involved in the distribution process.

Business format franchise must be differentiated from product distribution franchise, which is basically focused in the reselling of franchisor’s brand products (often soft drinks, automobiles, and gasoline), frequently with the allocation to the franchisee of exclusive agreements about supplies and area (not necessarily present in business format franchise). In this case, the franchisor habitually does not provide to franchisees an entire system of business. The degree of integration is apparently minor than in the business format franchise. However, both types of distribution agreements can be combined in practice. The business format franchise must also be differentiated from selective distribution, which is characterized by the selection of resellers considering criterions directly related with the specialties of luxury markets or complex technology products.

The existing literature refers the origin of modern franchise to the USA, even though etymologically the term comes from the Old French word Franc (free) and its derivation francher or affranchir. The medieval franchise consisted on privileges granted by kings and lords to their vassals to obtain licenses about trade, fishing or forestry rights, exemptions about taxes or customs, although it was also associated to the statutes of the villas francas, released of manor or vassalage. In the sense of concession or privilege, the term franchise still remains in government grants and in the field of sports. Despite this, the franchise, as we know it today, arises in the late nineteenth century as a distribution method used by manufactures to avoid the application of the Sherman Act, which impeded to manufactures the resale to final costumers. The great boom of the franchise occurs after Second World War, with the expansion of the business format franchise (s. Martinek 1992, Martinek, Semler & Flohr 2015).

Nowadays, franchise networks represent almost a third of retailing in the USA. According to the Franchise Business Economic Outlook for 2014, a report prepared by the International Franchise Association (IFA) Educational Foundation, around 3.5 % of the US GDP corresponds to franchise business (a total of $ 472 billions). This method of distribution is especially relevant to small and medium sized firms. In Europe, the statistics of the European Franchise Federation show that franchise is also growing, although the impact of franchise is still minimal comparing to USA or other countries, as Japan, Canada, and Australia. New technologies as the Internet – via e-commerce – may be a likely way of development of franchise.

Franchise contracts have interested both lawyers and economists. Initial economic works showed that franchise was an efficient method for reducing monitoring and agency costs (Caves and Murphy 1976; s. also model of Rubin, 1978). The agency theory explains that franchising is an optimal business decision when the cost of monitoring is high, as in the case of dispersed units located far from the franchisor (Mathewson and Winter 1985; Brickley and Dark 1987; Shane 1996, 1998, among others).

But, in the business relationship incentive and interest conflicts may arise, reducing the efficiency of the franchise contract. A franchise is a long term and relational contract, in which certain conditions are implicit, due to the inability to predict at the outset all contingencies. This fact implies that both franchisors and franchisees must consider common interest, being reciprocally obligated to act in good faith (this being understood as a fair behavior and the prohibition of reciprocal opportunism). But, both franchisors and franchisees have also incentives to take advantage of the loopholes and uncertainties of the written contract in their own benefit. From the agency theory perspective, franchisors must protect the value of their trademarks from the problems of adverse selection (the franchisor cannot ensure that the franchisee is able to reach the purpose of the contract) and moral hazard. Due to vertical and horizontal externalities, the franchisee has a tendency to practices like double marginalization, underinvestment, and internal free riding. The franchisee may also be worried about the franchisor holdup. In the relationship, he acts as a passive investor. Through encroachment (invasion of the area of protection or the franchisee’s territory) or simply by exercising their right to cancel or not renovate at will, franchisors may appropriate profits of efficient franchisees, such as sunk cost and the local goodwill built by their efforts.

The legal approach has considered the vulnerability of franchisees, in general less sophisticated and with a lower bargaining power than franchisors – thus, the franchise contract may be subject both to laws regarding unfair terms and to those prohibiting discrimination (antitrust law and contract law). The imbalance between the parties has justified the global tendency to the regulation of franchise agreements or, in the absence of law, designing mechanisms of court enforcement (based on Common Law). Complementary, different associations have developed Codes of Ethics for franchising.

The first laws about franchise arise in the USA. At the federal level, the Federal Trade Commission (FTC) Rule 1979, amended in 2007, governs presale disclosure obligation and registration. The government also regulates the termination of the relationship in specific areas, as automobile (Federal Automotive Dealer Franchise Act, FADFA 1956) and petroleum sectors (Petroleum Marketing Practices Act, PMPA 1978). From 1971 to 1992, a third part of states enacted relationship laws about franchise and automobile dealers. Franchise relationship laws impose the performance of the contract in good faith, encouraging the stability of the relationship, prohibiting encroachment, and establishing restrictions about termination. The termination or not renovation of the contract is based on various formal requirements (notification, notice, cure period) and on allegation of good cause. This legislation has influenced other legal systems and international law (s. the draft UNIDROIT Model Franchise Disclosure Law). Many countries in Asia, Latin America, and Canada regulate franchise to a greater or lesser extent. In general terms, franchise has been not “encoded” in Europe, but in the last decade the tendency is changing. The Italian law is a good example. France, Belgium and Spain have enacted laws about disclosure obligations of franchisor and registration. The Spanish Draft Commercial Code establishes also parameters about the duration of franchise and distribution agreements (reasonability), the termination of the relationship, and the compensation of the franchisee (articles 543–18 to 543–249).

Over the last decades, starting from agency theory, the economic literature has tried to explain the economics of franchise contracts. A great number of works focus especially in the study of monetary clauses (royalty rate and initial franchise fee). The monetary clauses ensure a continuous flow of rents that benefits both franchisors and franchisees and offer incentives in order to control double-sided moral hazard (starting by Rubin, 1978, s. for a model Bhattacharya and Lafontaine 1995 and later empirical works that support this model, Lafontaine and Shaw 1999). A complementary approach has showed that franchise contracts themselves are designed to solve the problem of postcontractual opportunistic behavior as well as incentive conflicts through mechanisms of self-enforcement (Brickley et al. 1991; Mathewson and Winter 1994; Klein 1995; Dnes 1993, 1996). The disciplinary powers of the franchisor and, if required, the termination of the relationship can constitute a very efficient hostage to assure the optimal performance. The end of the relationship supposes to the franchisee the loss of the ongoing rents and future profits and additionally, the recovery of specific investments can be difficult. The economic literature considers that the risk of opportunistic behavior by the franchisee is higher than the risk of the franchisor holdup. Theory suggests that franchisors would tend to throw out of the network less efficient franchisees (Blair and Lafontaine 2010) and have no incentives to the appropriation of resources – they are interested in maintaining the brand prestige, which could be damaged by litigations derived of termination, thus generating the image of “hard network.” This approach explains the structure of franchise contracts and justifies the asymmetrical allocation of rights in favor of franchisors, with the power of termination at will (s. empirical work of Arruñada et al. 2001, 2005, 2009, about automobile dealing agreements).

Most recent economic works have considered that, in long-term contracts, optimal contract duration can be a mechanism to reduce incentive conflicts and to avoid the problem of underinvestment (Guriev and Kvassov 2005). Given that the literature traditionally has assumed that initial investments are a key factor for the expected length of the franchise agreements (Joskow 1987; Brickley et al. 2006), a theoretical model to determine optimal duration of franchise is developed in García-Herrera and Llorca Vivero 2010 and empirically tested.

The economic analysis of the franchise contract, supported by empirical works, suggests that in general both Franchise termination laws – and even, those that protect franchisees from unfair treatment and discrimination – have no justification, inducing to a reduction in the use of franchise (s. Smith 1982; Beales and Muris 1995; Blass and Carlton 2001, about gasoline retailing; most recently, about automobile industry Arruñada et al. 2009; Lafontaine and Scott Morton 2010; Zanarone 2009; Zanerone 2012, about rigidity to adapt the contract). But the impact of franchise relationship laws is not homogenous because of its differences (Klick et al. 2008). Moreover, given that the opportunistic behavior of franchisors is not entirely compensated by the contractual engineering of the franchise, complementary legal, court, and extralegal enforcement mechanisms can be justified under certain conditions (s. Dnes 2009).

Vertical restraints associated to franchise contracts have been also analyzed from the antitrust law perspective. Some practices like the resale price maintenance or price discrimination, territorial restriction, tied-in sales, or the refusal to supply may breach antitrust laws. The economic analysis has justified vertical restraints associated to franchise contracts because of their efficiencies and benefits (Klein 1995; Rey and Stiglitz 1995; Mathewson and Winter 1994; Lafontaine and Slade 2007 among others). Since the eighties, the European Commission has enacted block exemption regulations (BER) about distribution and dealership agreements, complemented by guidelines, and after the case Pronuptia, also about franchise. These rules, unified nowadays – excluding automobile sector – have been criticized and successively amended (the last modification was in 2010 (Commission Regulation (EU) No. 330/2010 of 20 April 2010 on the Application of Article 101(3) of the Treaty on the Functioning of the European Union to Categories of Vertical Agreements and Concerted Practices [2010] OJ L102/1-7; Commission Regulation (EU) No. 461/2010 of 27 May 2010 on the application of Article 101(3) of the Treaty on the Functioning of the European Union to categories of vertical agreements and concerted practices in the motor vehicle sector [2010] OJ L129/52-5; Commission Notice, Supplementary Guidelines on Vertical Restraints in Agreements for the Sale and Repair of Motor Vehicles and for the Distribution of Spare Parts for Motor Vehicles [2010] OJ C138/16-27.7.), reflecting the changes in distribution, as e-commerce and relaxing policies about passive sales and resale price maintenance).

Summary and Future Directions

Economic analysis has explained the business decision about franchise and the economics of franchise contracts, justifying the asymmetrical allocation of rights and vertical restraints associated. The empirical works have also demonstrated in general the negative effect of franchise relationship laws over the business decision about market goods or services through franchise. However, these generic results require qualifications and more empirical work should be necessary. The current tendency in Europe, as before in USA, is to ensure the stability of the contracts and their equilibrium by mechanism of legal and court enforcement, providing certainty and incentives to entrepreneurs to invest in franchise. In the reduction of litigations derived from under-perfomance, renegotiation or termination of the contract, it should be studied the complementary role of mediation, negotiation or arbitration clauses. EU competition rules for franchising agreements should probably be amended in the future to reflect the changes in distribution caused by the Internet phenomenon.

Cross-References