Franchised Channels of Distribution

Overview

• The Agreement and Its Parties

• Cost of Capital Issues

• Agency costs, Monitoring versus Metering

• The Brand and the Advertising Fund

• Evidence on Franchising in the U.S.

Contractual: Franchising

• Specified retail format, proven successful with an established trademark.

• Lump sum, nonrefundable fee.• Payment of a royalty as a proportion of net sales

revenues.• Payment of an advertising royalty (percent of

revenues, to be spent by franchisor).• Specified territories, multi-unit operations more

prevalent.

Tying Arrangements

• Tying is "an agreement by one party to sell one product – the tying product -- only on the condition that the buyer also purchase a second product -- the tied product' -- or at least agree not to buy that product from another supplier."

• Tying product has market power

• Tied product is interchangeable

Exclusive dealings

• The principal vice of exclusives is that, if they tie up a significant portion of the market, the seller's competitors will be foreclosed from market access and competitively disadvantaged.

Territorial and customer restrictions

Rule of Reason: The issue is whether the anticompetitive effect of the restraint on intrabrand competition (among dealers selling the same brand) is outweighed by the procompetitive effect on interbrand competition (among different brands) generated by strengthening the seller's ability to compete.

Franchising and UFOC(Uniform Franchise Offering Circular)

1. Bankruptcies and predecessor firms and organization

2. Key individuals in the franchisor organization

3. Litigation pending and decisions (against franchisors)

4. Personal bankruptcies of executives within the franchise organization

UFOC (cont.)

5. Uniformity of initial franchise fees

6. Other recurring fees or payments

7. Franchisee’s initial investment

8. Obligations to purchase from designated sources

9. Obligations to purchase in accordance with approved suppliers

UFOC (cont.)

10. Financing arranged by franchisor

11. Obligations for assistance by franchisor

12. Territorial rights, vertical competition

13. Trademarks, service marks, trade names—are they the franchisor’s?

14. Patents and copyrights

UFOC (cont.)

15. Obligation of franchisee to participate in actual operation of the business

16. Restrictions on goods and services offered by the franchisee (exclusive dealings)

17. Term of contract, renewal, termination, repurchase, modification, assignment

18. Arrangements with public figures19. Forecasted sales, profitability20. Franchises started, sold, failed21. Financial statements of franchisor

Franchise Royalties

• All royalties are based on net sales

• Franchise royalty

• Advertising royalty

• Any output-based, variable component in a contractual relationship is, in essence, a royalty.

Advantages to Royalty Arrangement

• Provides a source of revenue to the franchisor retaining their commitment to the relationship.

• Avoids the need for the supplier/franchisor to have a profit maximizing markup in the channel—committed to achieving volume at the retail side of the channel.

• Maintains a competitive, lower price for consumers.

Franchisee and Franchisor Costs of Capital

• “Firms select franchising because franchisees can provide the capital necessary to achieve the geographic coverage for a brand network.”

• Costs of capital and “portfolio theory”

• Do franchisees believe they will be “above average” in earnings?

Agency Theory and Monitoring

• Employees within company-owned outlets have a higher monitoring costs than owner-operators.

• Owner-operator franchisees require monitoring for quality control, but also “metering” to assure they are not understating their revenues.

• Franchisees versus the hireling, i.e., “The Good Shepherd.”

Agency Costs and Distance

• Monitoring costs of employees reduce the value of an agent-managed firm (Jensen and Meckling 1976)

• Lower interstore distances require less monitoring costs, making company-owned outlets more likely (Rubin 1978)

• Outlets at greater distance from company-headquarters are more likely to be franchisee locations (Brickley and Dark 1987)

Distance and Encroachment

• Franchising is appropriate for development of marginal locations (Oxenfeldt and Kelly 1968)

• Franchisees express displeasure when “exclusive” territories are threatened from spatial encroachment, irrespective of franchisee or company-owned outlet development.

• Reduced interstore distances (encroachment) reduces unit revenue. (Kalnins 2004)