Multi-unit franchising strategies: a real options logic

Abstract

Theories of the firm so far applied to explain franchising struggle to enlighten its operational extensions, such as multi-unit franchise strategies. The corporate decision to grow via multiple franchising has not been yet analyzed with a view to accounting for how the flexibility to franchise or not (vis-à-vis the rigidity of investing into new own outlets), as uncertain market circumstances warrant, can drive performance. In this study, we seek to fill the gap by proposing a theoretical framework and empirically investigating about the real options that underlie multi-unit franchise strategies. Three are the key contributions to the franchising literature. First, an options-based classification of multi-unit franchise strategies is advanced in an effort to better explicate franchising and its performance consequences. Second, evidence drawn from the U.S. franchising industry is provided so as to both support classical findings on franchising and highlight the key source of extra value brought in by optionality associated with multi-unit arrangements and their impact on network performance. Third, “theoretical diversity” on franchising (Combs et al. In: J Manage 30:907–931, 2004) is enlarged by responding to the recent call for researchers to deliver complementary insights into what makes franchising work applying for the first time the real options theory to franchising. Implications of our findings for researchers, managers and policy-makers are discussed.

1 Introduction

Franchising is an organizational form based on a contractual arrangement between two legally independent firms in which one party (franchisor) grants the other (franchisee) the right to sell a product or service developed and owned by the former using her business format (e.g., brand name, process) in a given location for a specified period of time in return for a lump sum payment and an annual, sales-based royalty fee (Rubin 1978; Hoffman and Preble 1993; Shane 1996a; Blair and Lafontaine 2011).

Franchising is a proven business strategy worldwide. It has a multiplier effect in terms of enterprise creation, job generation and contribution to GDP growth. Indeed, about 30,000 franchise systems operate globally generating at least 2 million firms (World Franchise Council 2013) and accounting for almost 10–25 % of the GDP of most OECD countries. The U.S. franchising industry,¹ where a new franchise business opens approximately every 5–8 min of each business day, grows twice as fast as the rest of the economy since 2010 (3 % or $ 472 billion of GDP as of 2013, with a 4.5 % growth expected in 2014).² Besides fuelling entrepreneurial opportunities under favorable circumstances, it has also shown resilience throughout the recent recessions (e.g., the downturn of 2008–2009) maintaining job growth and minimizing losses.³

Research work on franchising, spanning various fields (including economics, strategy and marketing) and aspects (e.g., bargaining power, governance) (see for all Yin and Zajac 2004), can be classified into three main streams: (a) resource scarcity (RS); (b) administrative efficiency (AE); (c) risk management (RM). According to their combined interpretation of this phenomenon, the franchisor leverages capital of others, more motivated outlet owners and a portfolio of owned vs. franchised units properly allocated depending on the riskiness of locality.⁴

Growth and expansion go to the very essence of franchising.⁵ Extant research has shown that firms that have created an easily replicable business model typically face two strategic alternatives to rapidly expand their operations and leverage their brand so as to reach new geographical or product markets with the aim of improving or preserving performance and competitive advantage. The first is the opening of new company-owned stores through which managers pre-commit to network expansion today passively exposing their firm to the future outcomes of such decision. The second entails pursuing a multiple (or multi-unit) franchise strategy, wherein the franchisor gives franchisees the right to own several outlets.⁶

Four main theories have been so far applied to help explain franchising: agency theory (AT), transaction cost economics (TCE), property rights (PR), resource-based view (RBV). Franchising typically occurs when: (1) it involves a trade-off between the costs of monitoring outlet managers and the cost of free riding (AT—Rubin 1978; Lafontaine 1992a); (2) parties make investments in specific assets that bond them together and align their interests in anticipation of future profit streams (TCE—Klein 1995); (3) franchisors are exposed to incomplete contracts due to the presence of non-contractible assets offered by franchisees (PR—Windsperger and Dant 2006); (4) centralized and local activities that can be loosely coordinated are combined to enhance value creation (RBV—Combs et al. 2004). Some take a franchisor’s perspective (AT, PR), others a franchisee’s (TCE, RBV). What such theories struggle to enlighten are operational extensions of franchising (e.g., multi-unit, plural form ⁷) and their connectedness to the growth opportunities pursued by the parent company via establishment of a franchise system. Recent attempts exploit agency theory (Perryman and Combs 2012). In this domain, however, the corporate decision to grow via multiple franchising has not been analyzed with a view to accounting for how the flexibility to franchise or not (vis-à-vis the rigidity of investing into new own outlets), as uncertain market circumstances warrant, can drive performance. Indeed, to the best of our knowledge, no prior research has applied the real options logic to franchising.⁸ In this study, we seek to fill the gap by proposing a theoretical framework and empirically investigating about the real options that underlie multi-unit franchise strategies.

Our study makes three key contributions to the franchising literature. First, we combine the real options perspective with an organizational mechanism predominantly used by firms such as franchising advancing an options-based classification of multi-unit franchise strategies in an effort to better explicate franchising and its performance consequences. In this regard, we offer an integrative tool helping managers to identify and evaluate franchise investment opportunities that need to be made under uncertainty based on growth acceleration potential, network control features and type/degree of embedded managerial flexibility. Second, our analysis provides evidence drawn from the U.S. franchising industry that, besides supporting classical findings on franchising, highlights the key source of extra value brought in by optionality associated with multi-unit arrangements and their impact on network performance, which has not received attention in prior empirical research. Finally, we respond to the recent call for researchers to deliver complementary insights into what makes franchising work using alternative theories other than economic-based (e.g., agency theory), strategy-based (e.g., resource-based view) and social-psychological (e.g., relational marketing) approaches (Nijmeijer et al. 2014). To this end, the application of real options theory borrowed from finance in the context of franchising contributes to that “greater theoretical diversity” pointed out by Combs et al. (2004).

This article proceeds as follows. Section 2 provides an overview of multiple franchising techniques. Section 3 develops the real options framework. Section 4 formulates the hypotheses grounded in the classical as well as the real options theory (ROT) of franchising. Section 5 contains the empirical analysis. Section 6 discusses the results and related implications for researchers, managers and policy-makers leading to conclusions drawn in Sect. 7.

2 Multi-unit franchising strategies: an overview and a growth/control-based classification

Franchisors pursuing a multi-unit (or multiple) franchising strategy may resort to five types of contractual arrangements (that may coexist): (1) direct franchising; (2) area development agreement (3) subfranchising; (4) area representation agreement; (5) franchise brokerage.

Under direct franchising, whereby franchisors bear the entire burden of granting franchises (and related support) directly to franchisees, franchisees may acquire additional units within areas contiguous to their original territories by exercising the right of first refusal granted by the franchisor. Based on a prior and periodic assessment of the franchisee, the granting of such a right may serve as an incentive mechanism to reward high-performing parties in exchange of a lower franchise fee per unit, thus allowing for sequential acquisition of franchised units. For example, McDonald’s makes use of this contractual mechanism to control franchisees’ behavior and motivate them to perform (Kaufmann and Lafontaine 1994).

An alternative way for a franchisor to promote multiple-unit owners within its chain is the provision in the contract of the area development agreement according to which the franchisee is granted the right to open a pre-specified number of outlets in an exclusive territory over a prescribed time period. The area developer (e.g., an experienced entrepreneur in the franchisor’s industry) owns and operates directly any new unit established under the agreement, being required to pay an upfront (fixed) development fee for the exclusive right to develop the territory as well as a franchisee fee and a royalty, both reduced, for each unit as it becomes operational (Blair and Lafontaine 2011). Area developers may enter such type of agreement at the beginning of the franchising relationship or subsequently, often as a way to diversify their own businesses into or within franchising.

Three are the main advantages of the area development agreement for franchisors. First, it permits a moderate acceleration of the franchise network growth, thus enabling the franchisor to maintain control over the pace of development due to the fact that the soliciting and selling of franchises is conducted by the franchisor directly with potential area developers. Second, it favors an enhanced coordination of the franchise system’s local development via increasingly engaging sophisticated and inventive multi-unit investors (rather than single-unit owners) that may contribute to the innovativeness of the network with novel ideas and demand for a lower franchisor’s support as their experience increases. Third, it improves the franchisor’s cash flow due to the extra charge of the development fee and the increase in royalty-based revenues arising from accelerated growth.

Area development agreements expire on the date the area developer successfully completes the development schedule, are readily incorporated into the disclosure document used in connection with the individual franchise agreement and are more successfully used as a means of expansion in a domestic setting.

A further mode used by a franchisor to foster the growth of the franchise network is subfranchising, whereby the franchisor grants to an entity (the subfranchisor)⁹ the right to find the franchisees to develop a territory and to contract with them (Lowell 1991; Kaufmann and Kim 1995; Bond 2002).¹⁰ A subfranchisor functions as a franchisor in a specified territory on an exclusive basis by engaging in both pre- and post-sale activities (e.g., provision of training to subfranchisees, calculation of royalties). The subfranchisor has the right to offer and sell franchises, to sublicense the use of the franchisor’s trademark, to collect franchise fees, and to provide certain services to (sub)franchisees. While subfranchising permits the franchisor to pass on to the subfranchisor the responsibility for scouting around new quality franchisees and locations within a certain territory, the franchisor may contractually retain the right of final approval for franchisee and location selection, and optimally exercise it when circumstances warrant (e.g., in the early stages of the relationship when the rate of failure is high). A subfranchisor pays to the franchisor an initial fee (subfranchise fee) for the (subfranchise) right to sell franchises in an exclusive territory and, in return, retains a portion of the initial unit fees and ongoing royalties paid by (sub)franchisees to the franchisor.¹¹

Subfranchising has two main advantages (and associated other-side-of-the-coin drawbacks). First, subfranchising enables the franchisor to accelerate the franchise network’s growth (at the expense of the franchisor’s control over the network). Second, the franchisor’s administrative burden (and related costs) is drastically reduced because of her reliance on a third party (subfranchisor)’s resources to expand the system and provide most services to franchisees (in exchange for reduced upfront fees and royalties shared with the subfranchisor). Such advantages of domestic subfranchising get amplified in an international setting, which promotes its use as a means of foreign expansion.¹²

Other (less employed) methods of multiple franchising include area representation and franchise brokerage that are both variations on subfranchising. Under the first agreement, the franchisor grants to the area representative the right to solicit for prospective franchisees and to provide certain services (typically related to the establishment and the operation of franchised units) to existing (as well as new) franchisees in exchange for sharing fixed fees and royalties paid by the newcomers. The main advantage of such arrangement is that the franchisor retains control over the franchise system by contracting directly with franchisees. Network is thus expanded via utilizing resources of third parties with no need for additional regulatory burden. Given the beneficial disclosure procedure and the fact that a longer distance may lessen control of the franchisor over foreign franchisees, the area representation arrangement is widespread domestically.

The franchise broker is instead granted only the right to solicit for prospective franchisees. Franchise brokerage may advantageously permit the franchisor to increase franchise units, especially on international scale through an effective sales program tailored to meet the host country conditions at a reduced cost, because most brokers employ experienced salespersons with strong entrenchment into the local territories. The risk for the franchisor is the loss of control over the sales process delegated to the workforce of the franchise broker. Moreover, network growth in the long run may be slackened for two reasons. First, the broker, who receives a commission on completed sale with no real incentive to find industrious franchisees, may only accomplish her short-run (franchise sales) rather than long-run (franchisee performance) goals. Second, the commission¹³ paid to the broker may reduce significantly the franchisor’s capability of enhancing its managerial and service-based skills, which in turn drive long-term growth.

The above discussion of the key features of multi-unit franchising strategies can be summarized into a classification matrix, where multiple franchise decisions may fall in different quadrants based on the (long-term) growth acceleration potential (horizontal line) and the degree of control over franchise system granted to franchisors (vertical line) (Fig. 1). Depending on the type of contractual arrangement implemented to expand the network, the franchisor may accelerate or reduce growth (especially in the long run) at the expense or not of the degree of supervision over the entire system. The various combination of dimensions such as growth and network control may also explain the predominant use of area development and representation-based strategies domestically and of franchise brokerage and subfranchising-based strategies internationally. Interestingly, most strategic modes of multiple expansion (franchise brokerage, area representation, subfranchising), where the presence of a third party is leveraged to solicit for new franchisees, create an increasing (both physical and administrative) distance between franchisor and franchisees based on power delegation (see the sequence of arrows in Fig. 1).

Fig. 1

Multi-unit franchising strategy classification matrix

3 A real options logic in multiple franchising

What emerges from the growth/control matrix presented above is that franchisors may flexibly choose among different types of contractual arrangements to pursue a value-creating, multi-unit franchising strategy that better adapts to uncertain economic and market conditions at both local and international level. In so doing, franchisors taking a strategic move towards the expansion of their network by opting for one franchise mode or another establish a relationship with prospective franchisees and, possibly, third parties (subfranchisor, area representative, franchise broker). Such interaction may benefit from the individual (franchisor) or collective (franchisor/franchisee/third party) managerial flexibility to react to market uncertainty by adjusting or changing committed plans as circumstances warrant. Flexibility is valuable and its extra value is measurable by using a real options analysis.

Our contention is that each multi-unit franchising mode embeds different real options. A real options perspective may thus help uncover the franchisor’s implicit strategy associated with the decision to franchise and better exploit embedded operating flexibility. An options-based classification of the most frequently employed multi-unit franchising strategies (and associated contractual arrangements) is proposed as a practical way for recognizing and understanding how much part of a single or multiple unit franchise investment derives from managerial flexibility executable by the franchisor in its relationship with franchisees and other intermediary entities (Fig. 2).

Fig. 2

Real option-based classification of the non-monetary terms of a franchise agreement

When evaluating a franchise investment opportunity, the franchisor must refer to: (a) the exclusiveness of option ownership (proprietary versus shared), that is the firm’s ability to fully appropriate the value of the real option embedded in the franchise decision; (b) the degree of interrelationship among strategic franchise decisions, that is whether the franchise opportunity is independent and valuable by itself or may become a prerequisite for subsequent franchise opportunities (simple versus compound); (c) the timing of the strategic franchise decision, that is whether franchise investments obey an immediate accept/reject criterion or can be deferred (expiring versus deferrable) (Trigeorgis 1996).

In direct franchising, whereby the franchisee retains an exclusive right as to whether and when to invest in the purchase of additional outlets in its own assigned territory, the right of first refusal may be seen as a proprietary option. Other external parties would be unable to replicate such a right (embedded in the franchise agreement), which confers exclusiveness of option ownership to actual franchisees. The same logic applies to area development agreements, where the area developer’s exclusive rights to the territory are proprietary options expiring on the date the development schedule is successfully completed.

In subfranchising the franchisor shares the responsibility to identify and recruit new (sub)franchisees with the subfranchisor. Furthermore, the franchisor shares the use of its trademark with the selected (sub)franchisees via sublicensing. Any other strategic support decision on how to foster and gain from the network’s growth [e.g., the development of advertising or field training for ultimate use by (sub)franchisees] is apportioned between franchisor and subfranchisor. As franchisor and subfranchisor share the right to pursue a network growth strategy by exercising embedded optionality and each of them may be able to appropriate part (or all) of the value of subfranchised operations, then subfranchising can be seen as a shared option. One can look at subfranchising as a set of jointly held investment opportunities of both franchisor and subfranchisor along with (sub)franchisees, which are exercisable by any one of their collective owners.

As to the level of interrelationship among strategic franchise decisions, direct franchising and area development agreement embed options of simple type, whose optimal exercise allows the franchisor to incrementally expand the chain on a domestic scale through investing in the stand-alone opening of new units with no connection to future opportunities. It follows that, using options lens, such multi-unit franchise arrangements can be treated as expansion options.

The subfranchising situation is more complicated. The franchisor may enjoy a gain or suffer a loss in the value of its franchise strategy as a result of its interaction with the subfranchisor. An overvaluation of the subfranchisor’s skills and local market knowledge leading to a poor performance in terms of opened units and/or an unfair allocation of upfront and royalty payments may be turned into a loss-making franchise strategy. Conversely, the selection of a competent subfranchisor may resolve the uncertainty about the new (geographical or niche) market’s reception of the franchisor’s product or service giving rise to an option to enter a new market, whose optimal exercise would allow it to pursue a profit-making franchise strategy.¹⁴

More interestingly, subfranchising enables the franchisor to foster its network growth by leveraging the market knowledge and the marketing efforts of the parties involved within a cooperative stance. The choice of subfranchising becomes a precondition for subsequent growth opportunities that the franchisor may exploit in the new market segment or geographic territory via granting to the subfranchisor the right to grant new franchises to an increasing number of (sub)franchisees. These (sub)franchisees are in turn in charge of pursuing growth opportunities in their local competitive arenas ultimately impacting the performance of the franchise system. In this sense, subfranchising is a real option of shared type, leading—upon exercise by the franchisor—to further discretionary investment opportunities pursued by (sub)franchisees at local level. Subfranchising should be then viewed as a compound option, that is an option to share the rights associated with the establishment and management of franchised operations (e.g., use of trademark, advertising, training) in a new market, whose payoff is another option, which corresponds to the growth option exercisable by the franchisor via (sub)franchisees.¹⁵

In general, the collaboration mode between franchisor and subfranchisor ends up generating an overall gain (or loss) for the entire network thus increasing (or decreasing) the total market pie for all [including (sub)franchisees] depending upon, among others, the interaction of different factors at the various stages of the subfranchising arrangement such as: (1) the relative bargaining power of the parties in the negotiation process; (2) the presence of adverse selection in the franchisor’s selection of subfranchisors; (3) the undertaking of a moral hazard behavior by subfranchisors in their provision of support services to (sub)franchisees.

Moreover, franchise contracts commonly include a renewal clause, which indicates under which conditions (typically predetermined requirements that the franchisee must have met) the agreement (of any type) can be renewed, for how many years such a renewal applies or, whether, alternatively, the contract must be terminated. It follows that franchise arrangements are quite long-term with a high tendency to continue beyond the original term. By means of this clause, for example in the presence of subfranchising, the franchisor maintains a flexible choice as to how long growth opportunities can be pursued by (sub)franchisees at local level. This entails analyzing the relative benefits and costs of keeping the relationship with the subfranchisor [and related (sub)franchisees] open and thus deferring its termination to more or less distant future depending upon its intrinsic growth potential. Low-growth subfranchised operations will be rapidly terminated, while high-growth subfranchised operations will be kept alive via exercise of the option to defer the end of the franchise relationship (embedded in the renewal clause), whose positive amount is deferrability value further accruing to the owner of the franchise network.

Finally, the real options logic may help better understand the role of the passive ownership clause in franchise contracts.¹⁶ If a franchisee owning a franchised outlet hires an external manager to operate such unit (but remains still liable toward the franchisor), passive ownership is applied.

Real options and agency theories may complement each other by elucidating together some key issues in strategy. This is the case of passive ownership in franchise strategies. Passive ownership seems to negate the agency-based explanation of franchising (e.g., Castrogiovanni et al. 1995). The agency problem affecting corporate ownership of outlets, and overcome by the recourse to franchised units, comes back in the relationship between the passive owner and the outlet manager (Shane 1998). Nonetheless, similarly to subfranchising where growth opportunities are jointly held by multiple collective owners (franchisor, subfranchisor, subfranchisees), passive ownership permits a franchisee/investor to engage in a “shared administration” of the outlet via delegation of the management of one or more units to a third party familiar with the territory. Based on real options theory, the cost of monitoring the behavior of external unit managers—which, using agency lens, would be an extra charge that frustrates the relationship—may thus be viewed as the price payable for exercising an option to share tasks and growth opportunities in a promising territory. In so doing, the franchisor accelerates the development of its local, franchised operations by promoting specialization of franchisees with capital availability and outlet managers with market expertise.

4 Theoretical background and hypotheses

The main results on the nature of franchising and its outcomes at network level arising from the interplay of different (but intertwined) disciplines (economics, strategy, marketing) (RS, AE, RM) and associated, distinct theories of the firm (AT, TCE, PR, RBV) are used to develop the first set of our hypotheses (H1–H7). The testing of such set of hypotheses seeks to support prior studies with new empirical evidence from the global franchise market so as to construct a comprehensive framework of testable predictions on the performance consequences of the franchising business model (business format, brand strength, franchisee requirements, franchisor support). A further set of hypotheses (H8–H9) is formulated to shed new light on managerial flexibility embedded in franchise agreements using the lens of real options theory (ROT). Hence, our model strongly draws upon the classical and more recent developments in the theory of franchising, but it also advances the extant understanding of such phenomenon by investigating the real options features of the multi-unit franchise strategy

The ownership structure chosen by the franchisor for its distribution network is considered as a key factor influencing the outcomes of franchising (Nijmeijer et al. 2014). Several studies have been conducted to verify whether the co-existence of company-owned and franchised outlets (plural form) outperforms the presence of only franchised operations (pure franchise). A network of plural form is shown to be more managerially effective because innovation, uniformity and economic efficiency are better nurtured (Bradach 1997; Cliquet 2000; Cliquet and Croizean 2002; Dant and Kaufmann 2003), while the risk of the outlet portfolio is minimized (Fladmoe-Linquist 1996). Innovation is facilitated by franchisees incentivized to act as independent entrepreneurs and disseminated by company-owned units, which also contribute to increasing uniformity being used as both pilot and training sites for old and new franchisees, respectively. Furthermore, plural forms maximize efficiency (Perrigot et al. 2009), franchisor survival (Bordonaba-Juste et al. 2009) and the financial performance of the network (Hsu and Jang 2009; Koh et al. 2009).¹⁷ However, franchisors operating a dual distribution network (owned + franchised) are not immune to risks of conflicts between managers of owned units and franchisees or demotivation across franchised operations due to franchisor interest misalignment in managing such different types of outlets (Cliquet 2000).

Researchers have tried to estimate the optimal proportion between franchised and company-owned units.¹⁸ The optimal size of franchisees within a network is proven to depend upon environment, strategy, business format and age-related factors. Geographical dispersion of units, early market entry (first-mover advantage) with use of franchising and level of business maturity positively affect financial performance of franchisors increasing their franchise proportion (Hsu and Jang 2009; Sorenson and Sorenson 2001; Vazquez 2007; Bordonaba-Juste et al. 2009). To enhance performance and survival, franchisors should diminish franchised operations in the presence of a business format characterized by tacit knowledge (Barthelemy 2008) and boost them to exploit relevant local knowledge (Vazquez 2007) or when business approaches maturity (Kosova and Lafontaine 2010). Revenue generation (and related performance) are improved in concentrated markets if company-owned units outweigh franchised ones (Vroom and Gimeno 2007). Finally, use of complex (vs. simple) strategies by franchised (vs. company-owned) operations amplifies financial performance (Yin and Zajac 2004).

Given the predominance of beneficial effects arising from the entrepreneurial use of a dual network due to the role assigned to franchised units as innovation facilitators and, above all, as risk minimizers (RM-based theory of franchising) (Fladmoe-Linquist 1996), we posit:

H1 . The number of franchised outlets in the distribution network will be positively associated with the franchisor’s economic performance due to risk minimization.

In the face of a rapid growth in international franchising in the 1990s, early research seeks to explain the overseas expansion of franchisors based on external forces, such as the response to: inquiries of potential franchisees (Walker and Etzel 1973; Walker 1989), domestic market saturation or foreign markets with great potential (Aydin and Kacker 1990). To complement this external perspective, Shane (1996b) contends that international franchising expansion is motivated by the possession of a superior capability to reduce franchisee opportunism, which is more likely to occur in international transactions than domestic ones due to greater uncertainty and difficulty in monitoring franchisees in a culturally different and distant, foreign business environment. More specifically, franchisors develop two key capabilities: the ability to provide franchisees with an incentive not to act opportunistically through the use of an ex-ante bonding mechanism inherent in the franchise pricing structure¹⁹ and the ability to monitor more closely the actions of franchisees.

McIntyre and Huszagh (1995) first provide a test of the firm internationalization (FI) model developed by Cavusgil and Nevin (1980) in a franchise setting. By identifying two types of franchisors engaged in international development—that is, those actively involved that systematically explore opportunities for expanding their international franchising activity versus those committed on a long-term basis to franchising in international markets—they find out that higher commitment in international operations yields greater sales volumes. Furthermore, they show that the size of the domestic franchise system has little impact on the degree of its prospective international involvement. Hence, in the light of the results of the extension of research on internationalization of business operations to franchise networks, we posit:

H2 . The higher the degree of internationalization of the franchise network, the higher the franchisor’s economic performance.

Contract design, which crucially affects the outcomes of franchising (Nijmeijer et al. 2014), performs the main task of defining monetary contract terms (e.g., franchise, royalty and advertisement fees). Contrary to the tenets of economic theory according to which a profit-maximizing franchisor should customize the terms of the franchise contract for each specific franchisee in a chain, Lafontaine (1992b) finds that contract uniformity tends to prevail (also in a cross-border context),²⁰ with franchisors applying the same monetary terms to all new franchisees for two key reasons such as fairness and easiness of contract administration/enforcement.²¹

Among monetary terms, franchise fee is a lump sum payment made by a franchisee to the franchisor at the beginning of the contract period to compensate the latter for the cost incurred to set the former up in business²² and is highly variable across franchisees (Bhattacharyya and Lafontaine 1995).²³ Some franchisors adopt a “low-cost” strategy by keeping a relatively low upfront fee to attract franchisees (Blair and Lafontaine 2011). Franchisors also require franchisees to make ongoing payments in the form of sales royalties by often introducing some contractual non-linearity, such as a minimum royalty payment when franchised outlet sales are too low or a declining (or increasing) royalty rate as outlet sales reach certain target levels (Lafontaine 1992b; Bhattacharyya and Lafontaine 1995).²⁴ In addition to charging an initial franchise fee and running royalties, several franchisors also stipulate in their contracts that the franchisee must make contributions to support (national, regional or local) advertising. Advertising fees are most often specified as a constant proportion of the franchisees’ sales revenues, and in some cases, as a fixed periodic amount or as a function of the number of the outlet transactions (Blair and Lafontaine 2011). Both upfront/start-up (e.g., initial investment, franchisee fee) and running payments (e.g., royalties, advertising fees) are due to the franchisor by the franchisee to remunerate the former for the provision of its own intangible resources (e.g., brand) to the latter in exchange for financial, tangible (e.g., outlets with related real estates) and intangible (e.g., human assets) capital investments. The contractual set-up of monetary terms thus facilitates the reciprocal leveraging of scarce resources (RS-based rationale for the diffusion of franchising) (Caves and Murphy 1976).

Although most strategy and economics scholars find no (or even negative) impact of the magnitude of franchise fees on franchisor survival (Lafontaine and Shaw 1998), financial performance (Gillis and Combs 2009) or growth (Castrogiovanni and Justis 2002) and of royalties on franchisor shareholder return (Spinelli et al. 2003), some studies provide opposite evidence. For example, interestingly, survival of franchisors is positively affected by higher levels of upfront/start-up cash investments (Shane 1998). Variable payments (e.g., royalties) may positively affect franchisor growth (Kaufmann and Dant 1996). Franchise networks gradually lowering royalty rates and starting-up with low franchise fees that are raised over time tend to experience a size increase (Shane et al. 2006). Moreover, the level of advertising fees is positively associated with franchisor survival and the level of royalties (along with that of advertising fees) with franchisor growth in mature firms (Kosova and Lafontaine 2010). In line with the latter studies informed by the resource scarcity (RS) view of franchising and the need for designing monetary contract terms to enforce mutual engagement of parties, we expect the following:

H3 . The amount of total payments due by any franchisee to the franchisor according to the contractual terms will be positively associated with the franchisor’s economic performance.

Concerning H3, it must also be highlighted that an important control variable used in prior studies testing the RS perspective of franchising is the age of the franchise chain. What emerges is that overall the passage of time tends to have a neutral or negative effect on franchisor’s financial performance (Sorenson and Sorenson 2001; Koh et al. 2009) and growth (Castrogiovanni and Justis 2002; Imna and Debowski 2006). This is due to the fact that, as franchise systems get more mature, assets of any type (tangible, financial, etc.) are less scarce because of their gradual accumulation over time, with franchisors having less need of leveraging external resources of marginal franchisees to grow and make profits.

Duration of the franchise agreement and related termination clauses are further elements defined by the franchisor when contract design is performed.²⁵ Although contract length appears to be unimportant to achieving favorable outcomes for the network (Nijmeijer et al. 2014), the long duration of franchise relationships commonly observed in practice is explained by the franchisor’s need for its franchisees to invest both capital and effort in their outlet (Blair and Lafontaine 2011). Such investments are only worth making if the franchisee can expect to earn some reasonable return on these investments over a sufficiently long period of time. Because the long-term engagement of well-performing franchisees may in turn boost franchisor value creation, we hypothesize:

H4 . The duration of the franchising contract will be positively associated with the franchisor’s economic performance.

With regard to H3 and H4, it should also be noted that franchising contracts characterized by both higher royalties and higher duration increase motivation and commercialization efforts of franchisees as outlet managers reducing agency conflicts within the network and thus lowering franchisor’s monitoring costs. Indeed, the franchisor’s demand for premium royalties encourages franchisees to sell more so as to maximize residual rent appropriation at outlet level; this disciplining mechanism is reinforced by the security of a long-term business relationship. Franchisors implementing longer contracts forego some degree of flexibility in reacting to unexpected changes in market conditions via a dynamic modification of their franchisee pools in exchange for a more motivated, agency problem-free network. In this context, the set-up of higher advertising fees, despite their negative impact on unit profit size, may amplify the beneficial effects of franchisees’ marketing actions through financing the franchisor’s additional promotion support. Sales-based monetary incentives moderated by a long-length agreement are contractual features acknowledging the AE/AT-rooted explanation of franchising (Rubin 1978; Brickley and Dark 1987; Lafontaine 1992a).

Prior studies investigating the effects of brand recognition on franchising outcomes suggest that a franchisor’s strongly recognizable brand name is positively related to its profits, sales, growth and survival (Shane and Spell 1998; Imna and Debowski 2006; Gillis and Combs 2009). More in general, a RBV-based theory of franchising (see, for example, Combs et al. 2004) advocates that such a business strategy is successfully pursued as it allows both franchisor and franchisee to contribute mostly intangible assets (e.g. brand, reputation, human capital, organizational infrastructure) that are inaccessible and relevant to the respective party, whose redeployment may foster network value creation through generating growth opportunities (to the franchisor) and demand-enhancing or cost-cutting effects (to the franchisee). Among those resources that are shared by parties in a franchise chain is the franchisor’s strong brand. We therefore posit:

H5 . Brand recognition and high market power will be positively associated with the franchisor’s economic performance.

To further enhance a franchise system’s outcomes franchisors should be capable of properly selecting prospective franchisees. Jambulingam and Nevin (1999) argue that a direct relationship exists between effective franchisee selection and cooperation within a franchise network, suggesting that criteria other than financial are used in the screening process. Clarkin and Swavely (2006)’ study reveals that becoming a franchisee involves more than being financially or professionally qualified and that franchisors assign the highest level of importance to a franchisee’s personal characteristics, with education and specific industry experience receiving the lowest ranking in the selection process due to the fact that structured technical training and ongoing assistance are offered to new franchisees as a part of the agreement. Knott (2003) shows that franchisees’ prior (business or industry) experience may even adversely affect franchise financial performance and should be replaced by current managerial capabilities and attitudes towards business. RBV also applies to scout for franchisees embedding valuable human capital that may be crucial for propelling network growth and performance. Therefore, we ask:

H6. The higher the ranking of franchisee’s characteristics (such as financial resources, prior business and industry experience) required by the franchisor, the higher the latter’s economic performance.

Research looking at the extent, type and quality of franchisor support to the network is mostly concentrated on studying its effects at franchisee (rather than franchisor) level. It shows an overall positive effect of franchisor support on franchisee satisfaction, financial performance and survival (Knight 1984), with franchisee assessment of such support worsening over time (Grunhagen and Dorsch 2003) and a high variance among franchisees in quality and importance scores assigned to support, thus leading to different satisfaction levels (Huang and Phau 2009). In general, there is consensus on the fact that, using RBV lens, the provision of an organizational infrastructure via offering a large number of support services is beneficial for the franchisee but not for the franchisor. Offering support has indeed negative consequences on survival rates of U.S.-based franchisors (Shane 1998, 2001; Shane and Spell 1998), with the only positive effect of training, communication services and assistance to franchisees in seeking suitable locations (Shane 2001). Provision of such support services as newsletters or field visits to franchisees is associated with failures of franchisors in the German market (Grunhagen et al. 2008). Financial assistance appears to be the only type of support favorably impacting network growth (Shane et al. 2006). Based on the above, we expect the following:

H7. The provision of support offered by the franchisor to franchisees will be negatively associated with the franchisor’s economic performance with the only exception of financial assistance.

Several studies have proved that multi-unit franchising is beneficial to both franchisors and franchisees. Franchisees owning multiple outlets experience higher survival rates (Bates 1998) and lower production costs due to easier knowledge transfer (Darr et al. 1995). Large and mature franchisors pursuing a multi-unit franchising strategy have better survival chances (Shane 1998, 2001) favorably impacting network growth (Bradach 1995; Kaufmann and Dant 1996; Kaufmann and Kim 1995). In particular, Bradach (1995) suggests that multi-unit franchisors can allocate fewer resources to the search of franchisees for new units and motivate fewer franchisees to implement changes at network level thus enhancing growth and efficiency respectively. Kaufmann and Kim (1995) provide empirical evidence that the use of area development and subfranchising clauses is positively associated with the growth (in terms of units) of franchise chains. Additionally, when a multi-unit franchising strategy is pursued, passive ownership and multi-unit ownership are interconnected (Nijmeijer et al. 2014) as the former contributes to efficiency enhancement. A few studies investigate the effects of the use of the passive ownership clause in franchise agreements. While passive ownership is disadvantageous for survival of franchisees (Michael and Combs 2008), findings about franchisor’s growth and survival are mixed. Interestingly, the diffusion of passive ownership among franchisees may help a franchised network to grow (Clarkin and Rosa 2005) and augment failures and market exits within chains where local knowledge plays a vital role (Vazquez 2009).

Consistently with the above findings and the general principle underlying real options theory according to which several corporate projects—such as joint ventures (Kogut 1991), R&D activities (McGrath and Nerkar 2004) or the development of firm-level capabilities (Kogut and Kulatilaka 2001)—cannot be completed successfully without the participation of other key stakeholders (e.g., suppliers, employees), we posit:

H8. The degree of optionality embedded in contractual arrangements for the pursuit of a multi-unit franchising strategy—such as right of first refusal in direct franchising, area development agreement, subfranchising and passive ownership—allowing for greater flexibility to the franchisor will be positively associated with the latter’s economic performance.

Franchise contracts, which—as already noted—are quite long-term, usually stipulate an option to renew their duration beyond the original expiration. In most cases, franchise agreements are indeed renewed and not terminated. Typically, termination is used by franchisors as a threat to prevent franchisees from engaging in behaviors that the formers do not approve of. When this occurs, franchisors may choose not to renew to protect their brand and business format. In this respect, Williams (1996) finds that the types of outlets most subject to termination are those that are underperforming, suggesting that franchisors resort to termination to enforce performance standards or eliminate poor locations and not to opportunistically appropriate the benefits of the most profitable units by operating them directly or selling them to new franchisees under a contract involving higher payments. Such a tactic would not pay off as good-performing franchisees will be willing to invest more in their outlets, the longer the renewal period set in the agreement and the higher the probability of its renewal (Blair and Lafontaine 2011). Based on the above, we hypothesize:

H9. The longer the duration of the renewal clause by which the franchisor has the flexibility to defer the contract termination based on the fact that predetermined requirements are fully satisfied by the franchisee, the higher the former’s economic performance.

Our model, as described above, can be summarized in a comprehensive diagram (Fig. 3). In this chart, the white boxes epitomize the extant research approaches or theories of the firm explaining the phenomenon of franchising and the impact of its use on franchisors’ economic performance. Solid lines account for direct effects, which, if moderated, are represented by dotted lines. To validate the contribution of each of the above theories to the advancement of comprehension of franchising, the set of hypotheses H1–H7 is empirically tested.

Fig. 3

The multi-unit franchising strategy and its effect on franchisor’s economic performance: hypotheses’ system

The aforementioned classical franchising theory-building block of postulates is complemented by the set of hypotheses H8–H9 (grey box), which corresponds to the ROT building block. The latter is aimed at exploring and conceivably taking advantage of real options logic to better explicate the corporate decision to grow and make profits via the pursuit of multi-unit franchise strategies. All types of real options embedded in a franchise agreement and displayed in our option-based classification of multiple franchising of Fig. 2 are given full consideration in the second set of hypotheses. It should be clear that our model aims to find simple correlations between the key aspects of multiple franchising and the franchise network performance. The predicted sign of each correlation is indicated for all hypotheses included in the model.

Prior to testing the above system of hypotheses, our data sourcing and sampling strategies are described next.

5 Empirical analysis

To validate the real options framework presented in Sect. 3 and aimed at better explaining the use of multi-unit arrangements in franchise strategies, an empirical analysis of relevant assorted, cross-section evidence is conducted.

A sample of 100 global franchisors operating in various business sectors (see “Appendix”) was randomly selected from Worldfranchising.com©²⁶ a website operated by World Franchising Network which is a prominent provider of reliable, up-to-date and easy-to-use information on franchising and widely cited as a source of data in previous academic work (Dant and Kaufmann 2003; Hoffman and Preble 2003; Gillis and Combs 2009; Blair and Lafontaine 2011). The geographic distribution of the franchisors included in our sample is the following: USA (92 %), Canada (3 %), UK (2 %), Italy (1 %), Japan (1 %), Australia (1 %).

For each of the 100 U.S. franchisors the most recent Franchise Disclosure Document (FDD)²⁷ was collected (for consistency’s purpose the document considered for all firms was the one released in 2012). FDDs were provided by FRANdata, which is regarded as one of the most reliable industry’s sources of objective information and analysis outputs on franchising, with clients such as the International Franchising Association (IFA), extensively used by other strategy scholars (e.g., Michael 2000).

Most observations included in the final dataset used in our empirical analysis were obtained from Worldfranchising.com© and the FDDs associated with each franchisor. Data on brand recognition and global ranking of franchisors were respectively drawn from BrandFinance ^{® 28} and Franchise Direct ^®.²⁹ It should be noted that the choice of a cross-section dataset is warranted by the fact that all key clauses included in franchise agreements are relatively stable over time. Indeed, once a FDD is designed by a franchisor, future changes to terms and conditions are scattered and infrequent unless the base business model is disrupted.

To design the analysis the franchisor’s economic performance, measured by its ROA, has been chosen as dependent variable and independent variables have been grouped into five classes concerning business format of franchised operations, franchisor brand strength, franchisee requirements, franchisor support, real options embedded in the franchisor contract. The first four classes of variables may be labeled as business model-related. The fifth class includes variables aimed at reflecting real options-based managerial flexibility embedded in the franchise contract. Two additional variables accounting for key features of the franchisor’ industry relevant to a real options analysis, such as the sector volatility and the level of the franchisor’s market power, are considered.

As already indicated, it should be highlighted that a portion (top part) of our independent variables play the further role of serving as a proxy for the main research streams and theories of the firm that have been so far applied to explain franchising strategies. Hence, such a set of variables allows us to empirically test the model outlined in Fig. 3 with regard to the standard and most popular theories of franchising. Our model is then enhanced with new variables (bottom part) accounting for real options theory with the aim of better understanding the phenomenon at hand. Definition and source of all variables, with associated franchising theories proxied for by each (or a group) of them, are summarized in Table 1 and related descriptive statistics in Table 2. Correlations among explanatory variables are reported in Table 3.³⁰

Table 1 Variables’ definition

Table 2 Descriptive statistics

Table 3 Correlation matrix

To run our empirical analysis we employ a multiple regression model estimated with the ordinary least squares (OLS) method. More specifically, three distinct incremental models (Model 1, 2 and 3), with an increasing explanatory power, are estimated. Models 1 and 2 provide new empirical evidence to support prior research concerning the effects of the franchising business model (format, brand strength, franchisee requirements, franchisor support) on franchisor performance. Model 3 sheds new light on the value-creating consequences associated with the managerial flexibility exploitable by franchisors through the appropriate design of franchise contracts. To do so, Model 3 applies real options logic. By complementing the performance incentives for the use of franchising provided by the research mainstreams, real options theory, added with Model 3, obtains an R-squared of 54.1 %. The results of our analysis (with p-values shown next to estimates of coefficients) are presented in Table 4.

Table 4 Regression analysis

Notwithstanding its comprehensiveness and the resulting interesting findings, Model 3 falls short of clearly detecting, among business model and real options characteristics of a franchise network and its underlying contractual arrangement, the most important drivers of a franchisor’s economic performance. To make Model 3 more parsimonious, three further alternative specifications (3A, 3B, 3C) are thus developed by testing only a core set of the suggested variables, each per franchising theory. None of these further models includes the age of the franchise chain because, as discussed below, its contribution to franchisor performance is irrelevant.

More specifically, Model 3A includes business format variables such as the size of franchised operations (to total), plans of opening outlets overseas, the amount of the franchise fee, the contract duration; the strength of franchisor brand; the aggregate score of requirements for select franchisees; the provision of local advertising as a means of franchisor support to the network; the entire set of real options-based variables. Model 3B differs from the previous one because it does not contain the proportion of franchised units and the variable accounting for the use (or not) of the subfranchising strategy to enable the inclusion of the related interaction term (with drop of the second interaction involving industry volatility and use of area development). Model 3C is the most parsimonious one (with only 11 regressors) insofar it differs from the previous one by maintaining only those real options-based variables that are statistically significant (right of first refusal, passive ownership), as well as one control variable (degree of industry concentration), and eliminating interactions. Model 3C obtains an R-squared of 38 %. The results of such supplemental empirical analysis are presented in Table 5.

Table 5 Restricted alternative specifications of model 3

6 Discussion

The coefficient for franchised units is positive across all models and is close to significance in Model 1, providing modest support for H1, which accounts for the RM-based explanation of franchising. In line with previous work, we find that a dual distribution network strategy is likely to improve the franchisor’s performance as the number of franchised units increases relative to owned ones due to risk minimization. The franchisor takes a portfolio approach to managing its operations by allocating franchised units to riskier locations and proprietary ones to safer areas/regions. Hedging the riskiness of locality enhances the probability of success of newly-added outlets, thus boosting value creation through an increase in the return from assets in place.

Support for H2 (and associated theory on the international development of a franchise network—FI) is found involving a positive and highly significant (p < 0.05) coefficient for the variable overseas plans in Model 3 (as well as Model 2, albeit with lower significance). It implies that a franchisor planning to open stores internationally may experience a higher financial performance. However, consistently with McIntyre and Huszagh (1995)’s findings, this result is not in conflict with the fact that an increase in the domestic units (positive and significant coefficient across all models) may also cause financial return to rise because the domestic extent of the franchise network is irrelevant to the franchisor’s willingness to internationalize it.

The group of variables associated with monetary payments (initial investment, franchise fee, royalty rate) due to the franchisor have all positive coefficients showing consistency with the findings of prior literature. More specifically, the variable initial investment, which underlies the flow of fees accruing to the franchisor for the leasing services provided to the franchisee to allow for disbursement of the dollar amount required to start operating a new franchised outlet, has a highly significant coefficient in Model 3 (and close to significance in Model 1), providing good support for H3. The greater the amount of the initial investment and associated potential financial fees paid by the franchisee to the franchisor, the higher the latter’s performance. This finding confirms the relevance of the resource scarcity (RS) rationale in leading companies to leverage others’ capital to foster their own growth.

Interestingly, the use of franchisor age as a control variable to legitimize the RS perspective of franchising shows, based on the negative sign of its coefficient, that the obtainment of a marginal franchisee for an aged franchisor may have an unfavorable effect on profitability (measured by ROA) because any incremental income is allocated to an already large corporate asset base with lower benefits arising from leveraging others’ investments. This would then discourage the expansion of a franchise network as the latter gets more mature. However, in line with prior research, the insignificance of such variable further confirms the validity of RS for explaining the spread of franchising even at later stages of a company’s life-cycle.

The coefficient of the variable royalty rate is positive and significant across all models with high significance (p < 0.05) in Model 2, unquestionably supporting H3. Not surprisingly, the level of the royalty rate imposed by the franchisor is likely to positively impact its performance, more than any other contractual term.³¹ Consistently with previous findings, our empirical analysis also shows that a long duration of the franchise contract, which inevitably attracts more franchisees and engages them in harder work at managing their outlets to extract the highest possible rents well above the hurdle rate of their investments, may play a moderating role in influencing the extent to which premium royalties favorably impact the franchisor’s economic performance (the coefficient of the variable contract length is positive but insignificant across all models). The sales-boosting role of the advertising fee (captured by the positive sign of the related coefficient in Model 2) is also not statistically relevant. H4 is thus very modestly supported. This combined finding corroborates the interest-aligning role attributed to the franchising business model with beneficial effects for both franchisors (lower outlet monitoring costs, higher network performance) and franchisees (lower capital outlays, higher unit profit) (administrative efficiency—AE/agency theory—AT).

As confirmed by the positive coefficients of the group of variables associated with brand recognition (top franchisor, brand strength, multi-branded group), which show a good statistical significance (p < 0.05) in Model 1 (multi-branded group) (very close to significance also in Model 3), a franchisor operating a top branded franchise system and using a (multi-brand) portfolio approach is likely to experience a higher performance than a single, unbranded peer. Hence, our findings, in line with what suggested by previous literature, provide some degree of support for H5 and a RBV-based explanation of franchisor strategies.

The effect of franchisee requirements on franchisor performance is negligible and statistically insignificant proving that RBV does not always hold to explicate the recourse to franchising. Thus, H6 is not supported. More specifically, the breakdown of the franchisee requirements’ aggregate score used in our model and the execution of an auxiliary regression analysis accounting for single components (financial net worth, business experience, specific industry experience, education) conform to what prior studies have found out, that is unmeasured factors, such as personal characteristics and general business attitude of franchisees, are given more importance than financial capability and industry experience in the selection process performed by franchisors.

Consistently with prior studies highlighting the detrimental effect of provision of franchisor support to franchisees on the former’s economic performance, we find that the increasing availability of training ³² raises the system’s operating costs attenuating the network’s profit-making mechanism. The same logic applies to local advertising. Indeed, both findings related to training and local advertising show negative but insignificant coefficients in both Model 2 and Model 3. Opposite effect on performance is deployed by financial assistance (positive but insignificant coefficient) because of the related fees accruing to the franchisor by franchisees. H7 is thus modestly supported. The RBV rationale behind the role of franchisor in promoting the creation of an organizational infrastructure across franchisees is also mildly supported, but with clear negative consequences on network performance.

Beyond the business model of franchising explained by extant theories of the firm, there exist unexplored issues concerning the managerial flexibility offered by such type of contractual framework to franchisors, which can be investigated by utilizing real options theory. Next is the description of these results obtained in Model 3.

The findings related to the variables proprietary option, expansion option and growth option support our core argument that the franchisor pursuing a multi-unit franchise expansion strategy domestically and internationally does so by optimally exercising a portfolio of real options, whose inherent managerial flexibility has extra value impacting on performance. Domestic expansion via sequential acquisition of incremental franchised units is carried out by the exercise of options (of proprietary and simple nature) to expand an exclusive territory that are embedded in the right of first refusal attached to direct franchising and in the area development agreement. Interestingly, the coefficients of both variables (proprietary option, expansion option) are positive but only that of the expansion option is statistically significant (p < 0.10), implying a sharper effect (in terms of both magnitude and statistical power) of the area development arrangement on franchisor’s performance. Also rather intriguing is the magnitude (5.4) of the (positive but not significant) coefficient of the variable associated with subfranchising, which captures the real effect of the growth option embedded in such contractual form on franchisor performance. The pursuit of a staged multi-unit franchise strategy, where the exercise of an earlier option to enter a new product or geographical market with little involvement of the original franchisor (but greater effort of the subfranchisor) gives rise to the follow-on option to expand the network internationally at distance by leveraging the platform of local (sub)franchisees, strongly accelerates the creation of growth opportunities with related performance enhancement. This seems to occur at a pace (5.4) that is six times that of the opening of franchised units (instead of those company-owned) (0.8) and as more than twice as the use of area development (2.2).

Based on the positive sign and rather strong statistical significance (p < 0.05) of the coefficient of the variable shared option, our study also demonstrates that passive ownership can advance the development of franchised operations by encouraging specialization (financial vs. retail/market expertise) and risk-sharing between franchisees and delegated outlet managers. Indeed, a franchisor allowing for delegation within its network increases the degree of participation with positive spillover effects on its performance.³³ Overall, H8 is strongly supported.

As evident in Model 3, if the contract renewal clause is viewed as a deferral option exercisable by the franchisor upon fulfillment of predetermined requirements by the franchisee (and the duration of the agreement is not rigidly defined ex ante), the degree of flexibility for the franchisor gets increased. Franchisor flexibility consists of both securing longer contracts to franchisees to stimulate their efforts and dismissing bad-performing franchisees behaving in ways that are detrimental to the chain to safeguard its reputation. Hence, the greater the number of years by which the franchising contract is renewable, the higher the franchisor performance. In line with real options logic, our findings show that—supplementary to what emerges from H4—having flexibility (instead of rigidity) for postponing the length of the contractual relationship between franchisor and franchisee, if circumstances warrant (that is, when the positive contribution of the network can be certified based on appropriate KPIs), may have a moderate favorable impact on the core firm performance. Modest support is thus found for H9.

6.1 Robustness checks

To check the robustness of our results concerning the real option-like features of multi-unit franchising we run controls including expansion announcements made by franchisors on new outlet openings in the next 12 months (expansion factor), the level of volatility characterizing each franchisor’s sector (industry volatility) and the franchisor market power. The positive sign of the first two control variables is in line with the expectation that more outlets and volatility allow the franchisor to leverage the flexibility embedded in the franchise contract raising up the value that can be squeezed out of multiple franchise clauses. Based on the negative (and highly significant at 5 % level) coefficient of the variable measuring franchisor industry concentration, those franchisors possessing a high market share of concentrated industries experience an increasingly lower performance as they strengthen the pursuit of a multi-unit franchise strategy. Further controls are run by testing interactions.³⁴

6.1.1 Restricted models

Of all restricted, alternative specifications of Model 3 outlined in Table 5, we concentrate on Model 3C. It confirms support for H2 through a positive and highly significant (p < 0.05) coefficient for the variable overseas plans and H3 due to a positive and significant (p < 0.10) coefficient for the variable royalty rate (even more significant, at 5 % level, in Models 3A and 3B). The validity of the RS theory of franchising is reinforced by the positive and statistically significant (p < 0.10) coefficient of the variable franchise fee, which implies the favorable impact of a rise in the level of such fixed form of payment due by franchisees to franchisor on the latter’s economic performance. Model 3C is also characterized by the positive sign and statistical significance (p < 0.10) of the coefficient associated with contract length, thereby advocating the implementation of a long-term duration of franchise arrangements which in turn stimulate the continuous and fruitful engagement of franchisees. The longevity of contracts, further stretched with the aid of postponement options embedded in renewal clauses, besides supporting H4, reinforces the favorable impact of the use of premium royalties on franchise network performance wiping out agency distortions in franchisor-franchisee relationships (joint effect of H3 and H4).

Improving on Model 3, H6 is here significantly supported (p < 0.05) suggesting that franchisee requirements set contractually by a franchisor to build up its own network have a positive influence on performance. This validates the RBV perspective on franchising with regard to the importance of human capital (especially personal traits and business attitude) embodied in those franchisees selected to expand the chain and profit from market opportunities.

Contrary to what emerges from Model 3, the optionality embedded in multi-unit franchising strategies such as direct franchising through the exercise (if optimal) of the right of first refusal (proprietary option) to incrementally expand units in an exclusive territory is deemed to create value at network level (with a rather strong statistical significance, p < 0.05). Separation between capital investment and retail management via passive ownership is also confirmed as a corollary of a successful multiple franchising strategy. Nonetheless, as previously shown, multi-unit franchise options should be exercised in less concentrated industries to avoid excessive market power accumulation.

6.1.2 Addressing the endogeneity bias

To address the endogeneity potentially determining a simultaneous causality bias in our model, we conduct an instrumental variables (IV) estimation. Potentially endogenous variables are the number of franchised units (proportionally to total) (H1), the level of the royalty rate (H3), the pursuit of new unit openings internationally (captured by overseas plans) (H2), the amount of the franchise fee (H3) and that of the advertising fee (H3), as all factors may be influenced by the economic success of the franchisor. Indeed, the franchisor may (1) face an increasing demand for opening new franchised outlets from would-be franchisees, (2) be prone to imposing higher royalty terms, franchise or advertising fees on them or (3) plan to expand internationally in the wake of a successful consumers’ reception of products (or services) offered via franchised operations and related booming sales (which can in turn allow for an increase in value extraction at franchisee level). To account for such a bias, the best available—though weak—instruments we can employ are corporate reputation (brand strength, top franchisor, multi-branded group), which historically and thus gradually accrues to franchisor for various reasons (e.g., emotional perceptions) other than pure economic success, and its age (franchisor age). The idea here is to demonstrate that the causal arrow runs from franchise fixed and ongoing payment terms and outlet opening planning to network economic success, rather than vice versa. A strong corporate brand and reputation, accompanied by market knowledge (both gained over the years with increasing maturity), fosters the opening of new franchised outlets and the upgrading of running/fixed payment terms (royalties, franchise and advertising fees), which in turn drive economic performance.

The IV estimation is conducted so that the above four instruments are firstly adopted to instrument the proportion of franchised units and royalty rate terms, and secondly overseas plans and franchise/adverting fees so as to get overidentified coefficients in each of the two distinct 2-stage least squares (2SLS) regressions. More specifically, for our exogenous variables (excluded from Model 3) to be valid instruments, they must be sufficiently correlated with the included independent variables but uncorrelated with the error terms. Because the model is overidentified, we can test whether the latter uncorrelation exists or not performing the test of overidentifying restrictions [Sargan (1958)’s or Basmann (1960)’s test]. For both IV regressions such a test shows that no correlation exists between select instruments and structural error terms.³⁵

Based on the 2-SLS IV estimation findings, we also perform the Durbin-Wu-Hausman (1974)’s test of endogeneity, which is typically aimed at determining whether endogenous regressors in a given model are in fact exogenous. Such test suggests that the there is no threat of endogeneity in our main Model 3 (and its restricted variation, 3C) as all key suspect regressors of business format are exogenous.³⁶

Interestingly, the second-stage regression further improves previous findings (Model 3, Model 3C), whereby the coefficient associated with the royalty rate gains in magnitude (31.01) and statistical significance (p < 0.01) and the coefficient related to franchised units displays a greater magnitude (4.27) approaching statistical significance. On the front of unit expansion plans, both coefficients of overseas plans and domestic units are still statistically significant (p < 0.10). Coefficients of residual regressors are stable in terms of magnitude and sign (and, partially, statistical significance).

More importantly, the FDD—which represents one of the main sources for our dataset—contains characteristics of the franchise business model that are only subject to changes in the long run. This implies that FDDs released in 2012 (the key year of our empirical analysis) naturally carry terms and conditions that are set and offered by the franchisor to potential franchisees well in advance in the negotiation process at least over a 5-year period. In essence, although FDDs are typically re-issued every year, they may only have gone through minor refinements. This feature of franchise contract design reduces the risk of potential endogeneity biases in respect to franchisors’ current performance.

The overall sketch of global-scale franchisors resulting from our empirical analysis can be summarized as follows. The franchisor improves its economic performance by leveraging its branded operations via establishment of domestic and, more importantly, foreign outlets in exchange for negotiating high (leasing-related) financial tariffs, franchise fees and royalties with new franchisees, mostly selected on the basis of their personality and general business orientation. The business relationship with franchisees often requires small property investments for outlet origination (on franchisee side) and is entrenched via the long-term duration of contracts. The use of multi-unit franchise arrangements for domestic and international expansion (e.g., direct franchising, area development), enriched by risk-sharing mechanisms (e.g., passive ownership) fostering specialization at franchisee level, in highly volatile and lowly concentrated industries magnifies network value creation via flexibility enhancement.

7 Conclusions

Based on a combined use of data sources on the U.S. franchising industry (e.g., FRANdata, Worldfranchising.com©, Franchise Direct ^®), our study is the first to reveal that multi-unit franchise strategies possess interesting real options features. This article has implications for researchers, managers and policy-makers. On the research side, we take a first step towards the application and empirical validation of real options theory to franchising. Our findings suggest that a more accurate portrayal of franchising is obtained by accounting for managerial flexibility incorporated in frequently used clauses such as area development and passive ownership. Contract design can thus facilitate franchisor’s strategic capital budgeting decision-making as management may initially undertake (domestic or international) market expansion investments and then revise (e.g., defer) them later to seize value-creating, growth opportunities as they arise once market uncertainty resolves itself and better information is available. A limitation of our analysis, which also represents a promising avenue for future research, lies in the fact that our focus is on the types of real options exercisable by the franchisor neglecting the franchisee’s (if existing). If the latter exist, other scholars are urged to investigate further the availability of strategic options across a franchise network taking the perspective of franchisees.

On the managerial side, the main practical implication of this study is that negotiations between franchisor and franchisee on contractual terms under uncertainty may be conducted more effectively if all opportunities/options embodied in a franchising agreement are identified and appraised in light of real options theory. The recognition of the option characteristics of the franchise contract may also allow both parties for its better customization aimed at a more appropriate power rebalancing between them as well as individual value appropriation.

Finally, given the fact that main street businesses operating via franchising are a steady and proven pillar of GDP growth and job creation for most developed countries, our innovative real options approach to acknowledging the growth and value-enabling characteristics of the franchise business may persuade policy-makers to put more effort into new initiatives to improve its impact on the real economy. Policy-makers should take actions to: (a) preserve the franchise business model by assuring the independence of local franchise small business owners; (b) promote a balanced regulatory environment for franchise networks (e.g., avoidance of rules that reduce flexibility for small business owners/employers and training and advancement opportunities for workers; rule simplification to attenuate overly burdensome compliance duties for franchisors); (c) foster franchise growth through a revision of tax codes (e.g., reduction of complexity and tax rates) and an enhancement of credit access (e.g., through government loan programs) for franchise owners.

Hopefully, this study will spur further understanding of how multi-unit franchising works and influences corporate performance opening a new path for doing research on such a widespread form of organizational design through the lens of real options theory.

Appendix

Sample of 100 Global Franchisors

FDD	#	Franchisor	Industry	Macro-industry	Country
2012	1	Papa Murphy’s	Fast-food restaurants	Food-related	USA
2012	2	Jack in the Box Inc.	Fast-food restaurants	Food-related	USA
2012	3	Carl’s Jr.	Fast-food restaurants	Food-related	USA
2012	4	Arby’s	Fast-food restaurants	Food-related	USA
2012	5	Buffalo Wild Wings Grill and Bar	Fast-food restaurants	Food-related	USA
2012	6	Burger King Corporation	Fast-food restaurants	Food-related	USA
2012	7	Church’s Chicken	Fast-food restaurants	Food-related	USA
2012	8	Domino’s Pizza	Fast-food restaurants	Food-related	USA
2012	9	Jimmy John’s Gourmet Sandwiches	Fast-food restaurants	Food-related	USA
2012	10	KFC	Fast-food restaurants	Food-related	USA
2012	11	Long John Silver’s	Fast-food restaurants	Food-related	USA
2012	12	McDonald’s	Fast-food restaurants	Food-related	USA
2012	13	Papa John’s International	Fast-food restaurants	Food-related	USA
2012	14	Pizza Inn	Fast-food restaurants	Food-related	USA
2012	15	Subway Restaurants	Fast-food restaurants	Food-related	USA
2012	16	Taco Bell	Fast-food restaurants	Food-related	USA
2012	17	Papa Gino’s Pizzeria	Restaurants (Sit-Down)	Food-related	USA
2012	18	Denny’s	Restaurants (Sit-Down)	Food-related	USA
2012	19	Bennigan’s Grill and Tavern	Restaurants (Sit-Down)	Food-related	USA
2012	20	Big Boy Restaurant and Bakery	Restaurants (Sit-Down)	Food-related	USA
2012	21	Teriyaki experience	Restaurants (Sit-Down)	Food-related	Canada
2012	22	Coffee Beanery	Retail food	Food-related	USA
2012	23	7-Eleven, Inc.	Retail food	Food-related	USA
2012	24	Circle K	Retail food	Food-related	USA
2012	25	General Nutrition Centers	Retail food	Food-related	USA
2012	26	Gloria Jean’s Gourmet Coffees	Retail food	Food-related	USA
2012	27	Baskin-Robbins	Frozen desserts	Food-related	USA
2012	28	Ben and Jerry’s	Frozen desserts	Food-related	USA
2012	29	Cold Stone Creamery	Frozen desserts	Food-related	USA
2012	30	Dairy Queen	Frozen desserts	Food-related	USA
2012	31	YogenFruz Canada Limited	Frozen desserts	Food-related	Canada
2012	32	Cinnabon	Baked goods	Food-related	USA
2012	33	Dunkin’ Donuts	Baked goods	Food-related	USA
2012	34	Panera Bread Company	Baked goods	Food-related	USA
2012	35	Sotheby’s International Realty	Real estate	Home, clothing, health, education and leisure	UK/USA
2012	36	Coldwell Banker Real Estate	Real estate	Home, clothing, health, education and leisure	USA
2012	37	Century 21 Real Estate	Real estate	Home, clothing, health, education and leisure	USA
2012	38	RE/MAX International	Real estate	Home, clothing, health, education and leisure	USA
2012	39	Re-Bath Corporation	Building and construction	Home, clothing, health, education and leisure	USA
2012	40	American Leak Detection	Building and construction	Home, clothing, health, education and leisure	USA
2012	41	Pirtek USA	Building and construction	Home, clothing, health, education and leisure	Australia
2012	42	RadioShack	Retail stores	Home, clothing, health, education and leisure	USA
2012	43	Snap-on Tools	Retail stores	Home, clothing, health, education and leisure	USA
2012	44	Ace Hardware	Retail stores	Home, clothing, health, education and leisure	USA
2012	45	Health Mart	Retail stores	Home, clothing, health, education and leisure	USA
2012	46	Matco Tools	Retail stores	Home, clothing, health, education and leisure	USA
2012	47	Aaron’s sales and Lease Ownership	Home-related	Home, clothing, health, education and leisure	USA
2012	48	Shoebox New York	Clothing and accessories	Home, clothing, health, education and leisure	USA
2012	49	EmbroidMe	Clothing and accessories	Home, clothing, health, education and leisure	USA
2012	50	Furla	Clothing and accessories	Home, clothing, health, education and leisure	ITA
2012	51	Plato’s Closet	Clothing and accessories	Home, clothing, health, education and leisure	USA
2012	52	Amramp	Health and fitness	Home, clothing, health, education and leisure	USA
2012	53	Caring Senior Service	Health and fitness	Home, clothing, health, education and leisure	USA
2012	54	Home Helpers/Direct Link	Health and fitness	Home, clothing, health, education and leisure	USA
2012	55	Anytime Fitness	Health and fitness	Home, clothing, health, education and leisure	USA
2012	56	Home Instead Senior Care	Health and fitness	Home, clothing, health, education and leisure	USA
2012	57	Pearle Vision	Health and fitness	Home, clothing, health, education and leisure	USA
2012	58	Mathnasium Learning Centers	Education-related	Home, clothing, health, education and leisure	USA
2012	59	Kumon North America	Education-related	Home, clothing, health, education and leisure	Japan
2012	60	Sylvan Learning Centers	Education-related	Home, clothing, health, education and leisure	USA
2012	61	Gymboree Play and Music	Child-development related	Home, clothing, health, education and leisure	USA
2012	62	Hilton	Lodging	Home, clothing, health, education and leisure	USA
2012	63	Choice Hotels International	Lodging	Home, clothing, health, education and leisure	USA
2012	64	InterContinental Hotels Group (IHG)	Lodging	Home, clothing, health, education and leisure	UK
2012	65	Motel 6	Lodging	Home, clothing, health, education and leisure	USA
2012	66	Hilton Garden Inn	Lodging	Home, clothing, health, education and leisure	USA
2012	67	Homewood Suites by Hilton	Lodging	Home, clothing, health, education and leisure	USA
2012	68	Radisson Hotels and Resorts	Lodging	Home, clothing, health, education and leisure	USA
2012	69	Ramada Franchise Systems	Lodging	Home, clothing, health, education and leisure	USA
2012	70	CruiseOne	Travel	Home, clothing, health, education and leisure	USA
2012	71	Plan Ahead Events	Other professional services	Professional services	USA
2012	72	Martinizing Dry Cleaning	Other professional services	Professional services	USA
2012	73	Maid Brigade	Other professional services	Professional services	USA
2012	74	Maids, The (the Maids)	Other professional services	Professional services	USA
2012	75	UPS Store, The	Other professional services	Professional services	USA
2012	76	Allegra Print & Imaging	Printing	Professional services	USA
2012	77	Kwik Kopy Business Centers	Printing	Professional services	USA
2012	78	Minuteman Press International	Printing	Professional services	USA
2012	79	Proforma	Printing	Professional services	USA
2012	80	Sir Speedy	Printing	Professional services	USA
2012	81	Coffee News	Printing	Professional services	USA
2012	82	Spherion	Personal services	Professional services	USA
2012	83	Express Employment Professionals	Personal services	Professional services	USA
2012	84	ServiceMaster Clean	Maintenance services	Professional services	USA
2012	85	Maids, The	Maintenance services	Professional services	USA
2012	86	Weed man	Maintenance services	Professional services	Canada
2012	87	Vanguard Cleaning Systems	Maintenance services	Professional services	USA
2012	88	Jani-King International	Maintenance services	Professional services	USA
2012	89	Chem-Dry Carpet and Upholsery Cleaning	Maintenance services	Professional services	USA
2012	90	Stratus Building Solutions	Maintenance services	Professional services	USA
2012	91	Liberty Tax Service	Business-related	Professional services	USA
2012	92	Pronto Insurance	Business-related	Professional services	USA
2012	93	Jan-Pro Cleaning Systems	Business-related	Professional services	USA
2012	94	Padgett Business Services	Business-related	Professional services	USA
2012	95	AAMCO	Automotive	Professional services	USA
2012	96	Meineke Car Care Centers	Automotive	Professional services	USA
2012	97	Midas	Automotive	Professional services	USA
2012	98	Express Oil Change	Automotive	Professional services	USA
2012	99	Dollar Rent A Car	Automotive	Professional services	USA
2012	100	Thrifty Car Rental	Automotive	Professional services	USA

1. Source: Worldfranchising.com©