Academic journal article Journal of Organizational Culture, Communications and Conflict

Double Moral Hazard and Franchising: A Dual Case Study Approach

Academic journal article Journal of Organizational Culture, Communications and Conflict

Double Moral Hazard and Franchising: A Dual Case Study Approach

Article excerpt

BACKGROUND

While business franchising is a commonly known strategy, (Barthélémy 2009; Barthélémy 2011; Al Ekremi, Mignonac and Perrigot 2011) the inherent tensions between the franchisor and franchisee are less known. To many observers, franchising is a mechanism utilized by entrepreneurs in order to potentially reduce risk by acquiring the brand name and business practices of a better known firm. While sometimes true, the risk-reduction argument for buying into a franchising system may lead entrepreneurs down the path to failure. The reason for this potential derives from the incentive structure of both sides in the franchising equation, namely the original/parent company (Franchisor) and the entrepreneur who buys into the franchise system (Franchisee). In a sub-optimally designed franchise, the tension between the two sides can lead the entire system to implode.

FRANCHISING

Similar to business licensing, business franchising entails the transfer of rights from one party to another (Brown 2009). In licensing, the transfer normally includes monetary payment for the right to some asset such as a patent or copyright. In the licensing case, the party which owns the asset (Licensor) gives the legal right for another party (Licensee) to use the asset. The use is limited by the licensing agreement and can be defined as a very narrow use or a very broad use, and of course any scenario in between. A major difference between franchising and licensing is that, in the former, the franchisor is granting the right to replicate an entire business model while, in the latter, the licensor is normally granting only the use of the asset. Therefore, it is not controversial to state that franchising is a broader firm-level strategy than is licensing.

In a franchise system, there is one Franchisor but (usually) many franchisees, most of whom do not know each other personally. Therefore, the relationship is one of multiple dyads whereby the franchisor has many relationships but franchisees do not within the franchise system. There are many advantages and disadvantages to franchising to both parties including:

A major source of conflict between the Franchisor and the Franchisee is how each side is compensated and, therefore, incentivized. While all franchise agreements differ, there are some generalities which can be summarized:

* The franchisor charges the franchisee a Franchise Fee. The Franchise Fee is a lump sum payment due at the beginning of the relationship and allows the franchisee to take part in the franchise system.

* The franchisor charges the franchisee a royalty on gross revenue. This royalty consists of some percentage of the franchisee's gross revenues or sales.

* The franchisor charges the franchisee an advertisement fee which is a percentage of gross revenue. This fee is intended to pay for national or regional advertising which will help many or all of the franchisees.

* The franchisee is sometimes contractually obligated to purchase inputs from the franchisor. This is the case when the franchisee sells a product (such as a sandwich) but may not be present in a pure service (such as a real estate brokerage firm). This obligation is considered a type of compensation because the franchisor has the ability, to mark up the costs of these inputs from their original price.

AGENCY THEORY AND MORAL HAZARD

Agency Theory (Jensen and Meckling 1976; Fama 1980; Fama and Jensen 1983) is a wellknown theory derived from problems between two parties-the Principal and the Agent. Normally, the principal will delegate some type of work to the agent such as when a firm delegates work to a manager. One way to decide which party is which is to ask which has private information about some stated issue. For example, in a corporation, since managers have more information about the daily operations of the company, a manager is an agent while the shareholders, who have less information and do not have daily control over the corporation, are principals. …

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