Incentive effects of ownership rights

We now ask the question which ownership rights provide the appropriate incentives for the franchisee and franchisor to undertake the necessary investments in intangible assets. According to the incomplete contracting framework the allocation of ownership rights should encourage investments in intangible assets that create a large fraction of residual income. When a franchisee has a strong know-how position, franchise terms should trans­fer a substantial portion of residual rights to the franchisee. On the other hand, when the franchisor's system-specific investments are very important for the creation of residual surplus, the franchise contract must transfer a large fraction of ownership rights to the franchisor to give him incentives to make the requisite marketing investments <…>. Incentives are provided by ownership rights that include residual income rights (royalties and fees) and ownership surrogates that increase the incentive effect of the diluted residual income rights. Residual income rights are diluted because the residual surplus is divided between the franchisor and franchisee by the payment of fees and roy­alties. The following ownership surrogates may exist in franchise relationships: Exclusive dealing, exclusive territory, tying arrangement, resale price maintanence, lease control, approval and buy back rights, alienation rights and the right to control the network entry. In the following we examine the incentive effects of the residual income rights and the different ownership surrogates.

3.1. Residual income rights

Royalties. By linking the franchisor's residual income to the franchisor's investments in noncontractible assets, he has an incentive to undertake the requisite investments during the contract period. Therefore, the more important the franchisor's intangible investments are relative to the franchisees's intangible investments, the higher is the fraction of residual income created by him, and the higher should be the royalties <…>. Conversely, the more important the franchisees' intangible investments are relative to the franchisor's intangible investments, the higher should be their fraction of the residual income and the lower should be the royalties to provide the necessary incentive for the franchisees.

Initial fees. Initial fees are the remuneration for the system-specific know-how trans­ferred to the franchisee at the beginning of the contract period. The higher the franchisor's intangible assets (brand name capital <…>) at the beginning of the contract period, the higher are the rents generated by his know-how and the higher are the initial fees. In addition, a further proposition about the relationship between fees and royalties can be derived: The franchisor's specific investments depend on the initial stock of assets because a franchise with a high brand name capital requires more system-specific investments to assure a certain franchise value compared to a franchise with a low brand name capital. Therefore, the higher the franchisor's brand name capital, the higher are his intangible investments during the contract period, and the higher are the fees and royalties as residual income generated by the system-specific knowhow. These results are consistent with Ones (1992a, 1993) view. According to Ones the franchisormay recover his sunk investments through the initial fee because high sunk investments may arise when the system-specific know-how is very important for the success of the franchise. On the other hand, this incomplete contracting view is not compatible with the agency theory <…> which predicts a negative relationship between fees and royalties.

3.2. Ownership surrogates

Exclusive dealing clause. If the franchisee sells competing products that are not part of the franchise network, the franchisor's incentive to undertake relationship-specific investments will be reduced because the franchisee can benefit from the franchisor's investments without paying fees or royalties. In this case, the franchisees appropriate some of the value of the franchisor's investment in brand name capital. One solution of this interbrand free rider problem is to forbid the franchisee to sell competing prod­ucts or open up additional outlets. Exclusive dealing arrangements are used to prevent franchisees from appropriating the benefits of the franchisor's intangible investments and therefore provide the franchisor with a property right to his marketing investment <…>.

Exclusive territory arrangements. If the franchisor wants to encourage sales efforts by franchisees that increase the demand for the product and hence the residual surplus, the franchisor has to design contract terms that enable the franchisee to reap the ben­efits of its intangible investments <…>. Exclusive territory and customer terms create a property right in intangible assets so that the franchisee can earn returns on investments in local adver­tising and services. In addition, territorial restraints—especially combined with resale price maintence—reduce intrabrand free riding and encourage the franchisee to under­take intangible investments <…>. Furthermore, the franchisor can transfer the right to control network entry to the franchisees when the investments in local assets are very crucial for the success of the system <…>.

Tying arrangement. Tying arrangements are frequently used when quality control through quality specifications is very costly <…>. The more important the franchisor's brand name for the creation of the residual surplus, the more critical is quality control to protect his intangible investments in the franchise network. There­fore, the tying clause provides an incentive for the franchisor to undertake intangible investments in his franchise business by ensuring that a minimum quality standard is maintained at all franchised outlets.

Resale price maintenance.Competition among franchisees can reduce the investment incentives by creating an externality among franchisees <…>. Resale price maintenance eliminates this intrabrand free rider effect by reducing consumers' incentives to buy from franchisees mat do not provide the local marketing investments, such as promotion and after-sale services <…>. Con­sequently, the resale price maintenance agreement prevents the franchisees from freeriding and hence creates an incentive for the franchisor to undertake important intangible marketing investments,

Lease control Under lease control of the franchisor the franchisee hands over the business premises upon leaving the network. Due to the quality control and hostage function it provides high incentives for the franchisor to undertake specific investments <…>. On the other hand, the franchisee will be reluctant to invest in specific local assets unless he expects that any future residual surplus in his lease will be generated for his own account <…>. Therefore, when franchisee's outlet-specific investments are very important relative to the franchisor's system-specific investments for the generation of residual surplus, lease rights should be transferred to the franchisee to increase his motivation to undertake specific investments.

Approval and buy back rights. When a franchised business is sold the franchisor retains the right to approve the purchaser, frequently he has a right of first refusal to acquire the franchise. The approval and buy back rights ensure that the franchisee cannot expropriate the quasi rents generated by the franchisor's intangible assets. In addition, the right of first refusals allows the franchisor total control over an outlet by matching any third-party offer for it <…>. Therefore these rights "assure that the franchisor can recapture a franchise at renewal time without any capitalized brand name value accruing to the franchisee" <…>.

Alienation rights. When the franchise business is sold, franchisee retains the right to transfer outlet ownership. In addition, when the franchisee dies, the contract may specify the right to transfer outlet ownership to relatives of the franchisee. These rights provide an incentive for the franchisee to undertake outlet-specific investments by expecting to capture the rents generated by his investments during the contract period.

As a result, ownership rights include both residual rights and complementary owner­ship surrogates: The franchisor's incentive to invest in intangible assets (system-specific know-how) is higher, the higher the fees are and the more the diluted residual income rights are compensated by ownership surrogates, such as tying arrangements, resale price maintenance, exclusivity clauses, lease control, buy back and approval rights. On the other hand, the franchisee's incentive to invest in intangible knowledge assets (local market know-how) is higher, the lower the initial fees and royalties are, and the more ownership surrogates are included in the franchise agreement, such as exclusive terri­tory arrangement, exclusive customer clauses, lease and alienation rights and the right to control network entry.

The incomplete contracting approach of the ownership structure in franchising can be summarized by the following proposition:

The higher the portion of franchisor's (franchisee's) investments in intangible knowl­edge assets (know-how) are relative to the franchisee's investments to generate the residual surplus, the more ownership rights should be transferred to the franchisor (franchisee):

- If the franchisor's investments in intangible assets (promotion, advertising, manage­ment support) are high relative to the franchisee's intangible assets, the franchisor should have a large fraction of ownership rights. Therefore, the franchisor should conclude contracts with ownership rights that strengthen his investment incentive, such as relatively high initial fees and royalties, exclusive dealing clause, tying arrangement, resale price maintenance, lease control and buy back and approval rights.

- If the franchisee's intangible assets (investments in local services, promotion, human resources and procurement management) are high relative to the franchisor's intangi­ble assets, the franchisee should have a large fraction of ownership rights as residual rights of control. Hence the contract should include provisions that increase the fran­chisee's investment incentive, such as relatively lower franchisee fees and royalties, exclusive territory and customer clause, lease rights, alienation rights and option rights in the case of increasing the number of outlets. <…>

4.3. Discussion

This study presents the first empirical evidence that the structure of residual income rights in franchising may be explained by the distribution of intangible assets as firm-specific resources and capabilities. The data suggest that the allocation of ownership rights results from the different distribution of brand name and local market assets between the fran­chisor and the franchisee. Ownership rights (as residual rights of control) include not only residual income rights, i.e., royalties and fees, but also ownership surrogates as additional devices to increase the incentive effect of the diluted residual income rights. As suggested by our data, system-specific assets and the local market know-how have a strong influence on the allocation of ownership rights in franchising networks. In addi­tion, to offering a solution to an anomaly in the literature, the property rights view shows new insights about the relationship between royalties and initial fees. Contrary to the agency theoretical view, a positive relationship between royalties and initial fees results from this perspective. According to the property rights theory initial fees are the remu­neration for the transfer of system-specific know-how and royalties are the incentives to stimulate intangible investments to ensure a certain brand name value. Hence the higher the brand name capital of the franchise, the more system-specific investments are required during the contract period, and the higher are the royalties and fees.