An incomplete contracting view of ownership rights

Under positive transaction costs the assignment of property rights is relevant for the efficiency of resource allocation <…>. In this case, the economic agents cannot conclude complete contracts regarding all relevant circumstances because transaction costs are too high to specify them in the contract <…>. Incompleteness means that there will remain some residual rights that are not included in the contract. All rights to the asset not specified in the contract accrue to the residual claimant <…>.

2.1. Intangible assets as determinant of ownership structure

The asset characteristics relevant for the determination of ownership structure is the degree of intangibility. Intangible assets refer to knowledge and skills (know-how) largely stored in the mind of men <…> that cannot be codified and easily transferred to other agents since they have an important tacit component <…>. For instance, if the know-how of a sales agent cannot be made fungible, it is critical to the market success of the product to give this person residual rights of control to improve his incentive to undertake intangible investments.

What are the intangible assets in franchising? The franchisee's intangible assets refer to the local know-how, i.e. the franchisee possesses "knowledge of the particular circum­stances of time and place" <…> that result in efficient marketing strate­gies in combination with the franchisor's system-specific know-how. The franchisor's intangible assets refer primarily to the system-specific know-how as brand name capital <…>. If the franchisor's brand name investments (e.g. national advertising) are very important to the market success of the product or service, he has to be given an important ownership stake to provide the necessary investment incentives.

2.2. Allocation of ownership rights in franchising

In this section we try to explain the ownership structure between the franchisor and fran­chisee by emphazising the role of intangible assets as determinant of ownership structure (Hart and Moore 1990). We consider two cases: In the first case agent 0 (franchisor) has an asset with an high degree of intangibility and agent 1 (franchisee) has an asset with a low degree of intangibility. Hence agent 1's asset is relationship-specific but contractible. In the second case we assume both assets have a high degree of intangibility.

Case I: Integration. We assume the only relevant assets are the marketing assets (a₀, a₁). a₀ are the system-specific capabilities (brand name assets) and a₁, the local market know-how. We now examine the case where agent 1 owns the tangible asset a^T₁ and agent 0 the intangible asset a^I₀. If agent 0 makes an intangible investment in system-specific assets and creates residual surplus, agent 1 can expropriate fractions of the surplus value. Under incomplete contracts the franchisor and franchisee must bargain for the division of the residual income. Since each agent only receives a fraction of the residual surplus, they will both underinvest under this allocation of ownership rights <…>. Since only the franchisor has intangible assets that create the residual surplus, the franchisee can expropriate a large fraction of the total residual income. Thus under this ownership structure the investment incentive of the franchisor is significantly affected. In this case, the question arises whether the franchisor should have ownership of both assets. If the franchisor owns both assets, his investment incentive is increased because he gets a larger fraction of residual income. At the same time a^T₁ is contractible and can be easily acquired by the franchisor. Consequently, the residual rights of control should be given to the franchisor as owner of intangible assets because he creates the residual income stream.

Case 2; Non-integration. We assume that brand name and local market assets show a high degree of intangibility (a^I₁, a^I₀). Therefore the system-specific know-how and the local market know-how cannot be specified in the contract. In this situation the alternative of giving ownership of both assets to agent 0 (franchisor) is not efficient. If both marketing assets were internally coordinated, the total residual surplus would be reduced because the franchisor has not the requisite outlet-specific capabilities. Hence the efficient institutional structure is ownership of asset a^I₁ by the franchisor and of asset a^I₀ by the franchisee. Although the total residual surplus is divided between the franchisor and the franchisee, the franchisor is better off under non-integration because the franchisee's higher local market capabilities create a higher residual income which could not be realized unter integration. Hence the franchisor's smaller portion of the larger residual income exceeds his larger portion of the smaller total residual surplus.

To summarize: First, if one of the agents is the holder of an intangible asset and the other of a tangible asset, the first should be the residual claimant and hence the owner of both assets. Second, if both agents own intangible assets, ownership rights should be allocated according to the distribution of intangible assets that generate the residual income stream <…>, Consequently, if both the franchisor's brand name assets and the franchisee's local market know-how are important for the creation of the residual surplus, the franchisor should own asset a₀ and the franchisee should own asset a₁.