Patrick J. Kaufmann and Rajiv Dant

In order to achieve the correct set of incentives for franchisor and franchisee, economic theorists have suggested that the payment for the franchise should contain not just a lump sum payment, but also a profit sharing mechanism related to the outlet's prosperity. In franchising practice, two types of payments are common: a one time, up-front franchise fee and a royalty, usually expressed as a percentage of sales, or in some cases gross margin. These two payments closely correspond to what the economic theorists have deemed as appropriate. This observation has led to a continuing controversy as to whether franchisors used these in the manner anticipated by the theorists. In this research, we seek to ascertain whether this is indeed the case.

In one economic view the initial fee acts as a device for the franchisor to extract the present value of any surplus derived from its trademark that remains after the payment of royalties. If so, these two payment types are partial substitutes for each other and a negative relationship should exist between them. That is, when the royalties rise, there will be less surplus left to extract through the initial franchise fee.

Another view of these payments is that the initial fee is independent of the extraction of surplus as defined by the economist. In franchising, the franchisor incurs numerous costs associated with recruitment, screening and training recruits to operate businesses under its name and regulations. The location of each site incurs further expense. Under this alternative view, each franchisee imposes incremental costs on the franchisor and the latter seeks to recover these costs directly through the initial franchise fee. To the extent that the complexity of a franchise operation reflects the high investments by the franchisor in its operators and their businesses, we would anticipate that a positive association would exist between the level of the fee and the royalty rate charged.

Another facet of this same view is that both of these charges reflect the level of investment by the franchisor in the brand equity of its system. This investment takes place in the level and quality of the advertising provided the franchisee, its system of new product development and quality maintenance, its design of service delivery systems, and its training and monitoring of franchisees to implement these systems. Again, we anticipate that as these investments grow, that the franchisor would seek to recoup these expenses through higher royalties and initial fees. This perspective of franchise operation leads again to the view of a positive association between these two charges.

In this study, we use survey data from the fast food industry to test these competing views. To obtain the type of data we required, we sent questionnaires to a random list of individual franchisors across all franchise systems, inquiring about average unit sales, royalties, and franchise fees. We required data at the individual franchise system level because it is here where we expect differences or similarities to emerge. Data at the system level reflect averages of the characteristics of the individual franchise operations.

When controlling for average outlet sales in a regression analysis, we found a positive relationship between initial franchise fees and royalty rates. This suggests that the franchise fee is not used to extract the surplus value of the downstream rents or represent a performance bond for the franchisee.

What are the implications of this finding for economists' view? We speculate along the following lines. The first is that other methods are employed in order to prevent franchisees from earning a significant fraction of the surplus rents generated by the system. For example, the franchisees may be continuously pressured through regulations and monitoring to expand sales by maintaining additional hours, adding new products and expensive procedures and equipment to maintain product quality. When the marginal costs of these investments exceed the marginal benefits to the franchisee, the franchisor gains disproportionately from the franchisee's investments.

Alternatively, leaving surplus for the franchisees could be a means by which the franchisor encourages franchisee effort and loyalty. By allowing the franchisee to share in the economic rents, when the outlet reaches a high level of sales, the franchisor generates enormous control and lowers costs in system operation by the reduction of turnover. In a previous study of the McDonald's system, this approach was found to be in use and proved enormously effective.

Finally, we note that the analyses that we have conducted would not be possible without average outlet sales data. Such information is helpful in understanding the motivation lying behind franchisor behavior, the treatment and well being of franchisees, and the development of regulatory systems that treat both franchisor and franchisee fairly. Yet, this information is becoming exceptionally difficult to obtain. Industry regulations that would require or encourage franchisors to report outlet sales and earnings data would be enormously useful for the further development of such insights.