The RAND Corporation
Targeting Managerial Control: Evidence from Franchising
Author(s): Francine Lafontaine and Kathryn L. Shaw
Reviewed work(s):
Source: The RAND Journal of Economics, Vol. 36, No. 1 (Spring, 2005), pp. 131-150
Published by: Blackwell Publishing on behalf of The RAND Corporation
Stable URL: http://www.jstor.org/stable/1593758 .
Accessed: 20/05/2012 02:32
Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at .
http://www.jstor.org/page/info/about/policies/terms.jsp
JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of
content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms
of scholarship. For more information about JSTOR, please contact [email protected].
Blackwell Publishing and The RAND Corporation are collaborating with JSTOR to digitize, preserve and
extend access to The RAND Journal of Economics.
http://www.jstor.org
RANDJournalof Economics
Vol.36, No. 1, Spring2005
pp. 131-150
Targeting managerial
from
franchising
control:
evidence
Francine Lafontaine*
and
Kathryn L. Shaw**
Franchisors simultaneouslyoperate outlets under two distinct incentive schemes:franchising
and companyownership.Using an extensivepanel dataset,we show that experiencedfranchisors
maintaina stable level of corporateownershipover time.However,the targetedrate of company
ownershipvaries considerablyacrossfirms.Weshow thatfranchisorswithhigh brandnamevalue,
measuredby majormedia expendituresand otherproxies, have high rates of companyownership.
Weargue thatfranchisors with valuable brandshave high rates of companyownershipso they
have incentives to exert more control and they can betterprotect their brandsfrom franchisee
free-riding.
1. Introduction
*
Over the last thirtyyears an extensive theoreticalliteratureon incentive contractshas been
developed, but there has been only limited testing of alternativemodels. Consider,for example,
two standardincentive pay contracts:a firm may compensate its managersusing a flat salary
and rewardthem with promotionsbased on personalperformanceevaluations(a "subjective"pay
plan), or the firmmay pay a salarybut also rewardmanagerswith profitsharingor stock options
(an "objective"pay plan based on an agreed-uponmeasuredoutcome). Firms often use both
incentive mechanisms.But underwhat conditions should a firmrely more heavily, for example,
on profit sharing than on promotions?The literaturehas considered this question extensively
for high-level executive compensation,but much less is known about pay plans for lower-level
managersor employees.1
Franchisingfirmsprovidean opportunityto assess firms' choices of incentivepay schemes.
Franchisorstypicallyeitherown a given outletandpay its managera salarywith promotion,raises,
and bonuses as incentives,or they franchise,in which case the managerowns the assets andearns
* Universityof Michigan;[email protected].
**StanfordUniversityand NBER; [email protected].
We gratefullyacknowledge financialsupportfrom the National Science Foundation(NSF) undergrantno. SBR9312083, and from the Stephen M. Ross School of Business at the Universityof Michigan, for this research.We thank
participantsat a numberof conferences and seminarsfor theirhelpful comments and suggestions. We also thankWendy
Petropoulosand RobertPicardfor their invaluableassistance.The usual caveat applies.
1For reviews of the
empirical literatureon incentive pay, see Gibbons (1998), Gibbons and Waldman(1999),
Lazear(1995, 1999), Jensen and Murphy(1999), and Prendergast(1999).
Copyright? 2005, RAND.
131
132 / THERANDJOURNAL
OFECONOMICS
the profits that the outlet generates (minus the royalty rate or fee paid to the franchisor).Most
franchisorshave both company-ownedand franchisedoutlets, but firms differ in the degree to
which they rely on companyownershipversus franchising--some chains are entirelyfranchised
while others have a large percentageof outlets owned and controlledby the companydirectly.2
The question,then, is why do companieschoose differentrates of ownership?
We hypothesize that franchisingfirms with greaterinvestmentsin their brandname will
own more of their outlets. Managersof franchisedoutlets maximize their own profits, not the
profitsof the franchisingfirm.The factorsthatcontributeto the profitsof an individualoutlet do
not necessarily correspondto those that contributeto the profits of the chain. In particular,the
franchisorplaces a greatervalue on the chain'sbrandname andreputationthando the franchisees,
due to the free-riderproblem:the franchiseeprofitsonly from the brandto the extent it increases
its local profits,whereas the franchisorbenefits from increases in sales induced by the brandin
all outlets in the chain.Thus, the franchiseehas an incentiveto underinvestin activitiesthatfoster
brandname value relative to the chain (Brickley and Dark, 1987; Blair and Kaserman,1994).
To overcome this, the franchisingfirmmay choose to own outlets outrightinsteadof franchising
them and hire managerswhose actions are monitoredmore carefully and who are paid a salary
largely on the basis of a performanceevaluationthat takes into accountboth outlet performance
and the maintenanceof brandname value (see Bradach(1997) for evidence of lower-powered
incentivesin companyunits).The incentivesof these managersto maximize an outlet'sprofitsare
not as high poweredas those of franchisees,but in turn,they also have less incentiveto increase
theirprofitsat the expense of the chain or of the brandname value. In that sense, they affordthe
chain the opportunityto bettercontrolthe value of its brand.
The choice describedhere for franchisingfirms-between using the low-poweredincentives
of a subjectivepay plan versusthe more high-poweredincentivesof an objectiveprofit-basedpay
plan-arises often for firms outside of franchising.For example, in large firms, division heads
can be given the objective of maximizingthe profitsof their division, but such an objective can
result in actions that undermineprofitabilityelsewhere in the firm (Wulf, 2002). Alternatively,
firms may offer managersa compensationplan that makes pay a weighted function of a vector
of objective outcomes, such as division-level profits,firm-levelprofits, stock marketvalue, and
so on. The difficultywith such paymentschemes is thatalthoughthey recognize the multitasking
natureof the manager'sjob, they can become very complicated.In the end it may be preferableto
offer lower-poweredincentivesfor all tasks, thatis, to use a salarywith promotionopportunities
(Holmstromand Milgrom, 1991).
An extensive empirical literaturehas examined franchising firms' choices of companyownershiprates.3However,prior studies have relied largely on cross-sectionaldata. We use an
unbalancedpanel dataset that follows almost 5,000 U.S. and Canadianfranchisorsfor various
intervalsfrom 1980 throughto 1997 to addresstwo questions:Do franchisingfirms change the
extent to which they control outlets directly over time as they learn more about the underlying
factors that influence the value of franchising?Second, why do some franchisingfirms choose
to operatemore outlets directly than do others?These two questions are addressedsequentially
below, and the results are summarizedin Section 5. Briefly,we find that the degree of company
ownershipfalls when these firmsbegin franchising,but establishedfirmstargeta stable percentage of company ownership (Sections 2 and 3). This finding of a stable company-ownedshare
in establishedchains contradictsa numberof theories of franchisingthat imply that franchisors
should systematicallyincrease or decrease their reliance on franchisingover time. It also contradictsthe conclusion from cross-sectional analyses in which authorshad found a decreased
relianceon companyownershipover time. We also findthatfirmswith high company-ownership
2
There are, of course, many otherexamples of firmsthat simultaneouslyorganizetransactionsin more than one
way: firmsboth make andbuy certaininputs,or use both employees and subcontractorsto performcertainfunctions(see,
e.g., Bakerand Hubbard(2004) on the use of both owner operatorsand hireddriversin U.S. trucking).
3 This literaturehas consideredfactors that extend
beyond the incentive pay issues emphasizedhere. See Dant,
Kaufmann,and Paswan(1992), Dnes (1996), Lyons (1996) and Lafontaineand Slade (1997,2001) for reviews.
? RAND 2005.
LAFONTAINE
ANDSHAW / 133
shares, and thus fewer high-poweredincentives, have higher-valuedbrandnames. We conclude
thatestablishedfranchisorschoose high company-ownershipshareswhen franchiseefree-riding
is most likely to be problematic(see Section 4).
2. Companyownership withinfirms over time
*
A brief overview of the literature. Most models of franchisingareprincipal-agentmodels
that focus on the optimal sharing rules for profits and imply that the terms of the franchise
contracts should vary across the franchisedunits (see, e.g., Mathewson and Winter, 1985). If
each franchisoruses only one franchisingandone managerialemploymentcontract,these models
imply that those units where high-poweredincentives are very valuableto the franchisorwill be
franchised,while others will be operatedundera managerialemploymentcontract.The extent
of company ownershipin a chain thus depends on outlet and franchiseeheterogeneityin these
models: there is no predictionthat the percentagethat is company-ownedshould be explicitly
targetednor that it should vary systematicallyas firms become established,only that it should
vary with the averagecharacteristicsof outlets and franchiseesin the chain.
Other theoretical explanations for franchising imply instead that the extent of company
ownershipshould change systematicallyas chains become betterestablished.Some models, for
example, assume that franchising is more profitablethan company ownership, but that firms
operatesome units eitherto signal high quality(Galliniand Lutz, 1992) or to crediblycommit to
upholdthe value of the brandname (e.g., Scott, 1995). In these models, firmsreducethe extent of
companyownershipovertime as theirqualitylevel is revealed,or as they"developa reputationfor
maintaininga certainlevel of quality"(Scott, 1995,p. 76). Othermodelsof franchising,bycontrast,
assume that company ownershipis the preferredmode of operation,but that franchisingallows
firmsto obtainaccess to some scarceresource,be it capital(CavesandMurphy,1976), managerial
talent (Norton, 1988), or local information(Minkler,1990; Lafontaineand Bhattacharyya,1995;
Prendergast,2002). As they become establishedandbetterable to access these resourcesdirectly,
franchisorsreducetheirrelianceon franchisingand increasecompany-ownedshareover time.
A numberof authorshave examined the empiricalrelationshipbetween the percentageof
companyoutletsandfranchisorage (e.g., GalliniandLutz, 1992;Lafontaine,1992a;Martin,1988;
Minklerand Park, 1994; Scott, 1995; Thompson, 1994). Using cross-sectionaldata, most have
found systematic evidence of lower company-ownedshare for more established firms. Gallini
and Lutz (1992) and Scott (1995) interpretthese results as evidence supportingthe signallingor
reputationeffects describedabove.
The data. Our longitudinaldataset allows us to revisit this issue. We have information
o
from 1980 through 1997 for more than 1,000 franchisorsper year, resulting in a total sample
size of 19,162 observations.The datacontaininformationon (1) the numberof company-owned
and franchisedoutlets, (2) the years of business and franchisingexperience, (3) royalty rates,
advertisingfees, and franchisefees, and (4) a set of variablesdescribingthe franchisor,including
the amountof capitalrequiredto open an outlet, andthe type of businessit is involvedin. Largely
due to entryinto andexit from franchising,but also to nonresponses,our datasetis an unbalanced
panel:the numberof franchisorsincludedeach year is ratherstable,but the firmsvary from year
to year.4We have 4,842 differentfranchisorsin our dataset,and so only about4 observationsper
firmon average.(See the Appendixfor more on our data sources and sample.)
Table 1 gives descriptivestatisticsfor the main variablesof interestfor our overallsampleof
19,162 observations.We show bothmedianandmeanvaluesof these variables,as the distributions
are often quite skewed. Note that the maximumnumberof franchisedand of companyunits in
our data are for McDonald's.
o
Changes in percentage company-owned as firms gain experience: cross-sectional
results. As a first step towardexamining the evolution of the degree of vertical integrationin
4 This could
? RAND 2005.
give rise to selection bias in our analyses-however, see footnote 21.
134
/
THE RAND JOURNAL OF ECONOMICS
TABLE 1
Descriptive Statistics
Name
Variable
Numberof Franchised
Units
Numberof Company
Units
TotalOutlets
Percentage
Company-Owned
Yearsof Franchising
Experience
Median
Mean
Standard
Deviation
Minimum
Maximum
28
2
34
9
7
172.64
35.05
207.69
22.2
10.56
638.92
234.05
788.15
28.7
9.84
0
0
1
0
1
15,394
4,982
19,599
100
77
franchisedchains, we presentin Figure 1 the simple cross-sectionalmean value of the companyowned share as a function of years in franchising for all the firms in our data, and then for
subsamplesbased on whetheryearly growthis positive (posGrowth),negative (negGrowth),or
nil (zeroGrowth).In Figure2 we show the correspondingdatafor a small set of sectorschosen to
highlight sectoraldifferences.
There are three striking features in Figures 1 and 2. First, no matter what sample one
focuses on, the percentage company-ownedfalls precipitously during the first seven or eight
years in franchising.This is not surprising:firms almost always begin franchisingafter having
opened a few company-ownedoutlets, and so they are 100% company-ownedinitially. This
percentagethen can only fall in the early years in franchising,and indeed it does fall sharply.
This is the negative relationshipbetween franchisingexperience and company ownershipthat
has been noticed in earliercross-sectionalanalyses.5Second, Figure 1 shows thatafterthis initial
decline, thepercentagecompany-ownedstabilizesin ouroverallsampleandin thedifferentgrowth
subsamplesat about 15%on average.We foundthe same stabilizationat 15%for size subsamples
(above and below average size), and, perhapsmost surprisingly,for the set of chains we know
will exit franchisingin the next three years and for those that continueto franchisebeyond that.
Third,Figure2 shows thatthereare,however,sectoraldifferencesin the "targetrates":restaurant
chains, for example, stabilize at a relativelyhigh percentagecompany-ownedon average,while
the constructionand maintenancesectors have a much lower averagerate.
O
Changesin percentagecompany-ownedas firmsgain experience:longitudinalresults.
Figures 1 and 2 show a fairly constant rate of company ownershipon average for established
FIGURE1
PERCENTAGE
BY FIRMEXPERIENCE
COMPANY-OWNED
AND YEARLYGROWTH
,,
c
70
o1 60
---- --
.*
0
. 5
oE
8 40
?
30
\3
X
20-
A
\
.\
\
'\
..
,
-
4
j
6
_
..
,
(1
0 2
Fullsample
Positivegrowthsubsample
Negativegrowthsubsample
Zerogrowthsubsample
8
1
I J
I
I
I
I 2
10 12 14 16 18 20 22 24 26 28 30andup
Yearsof franchisingexperience
5
Regressions of percentagecompany-ownedon linear,quadratic,cube, and quarticterms, or even higher-order
terms in experience, always yield large negative and significantcoefficients on the first-orderterm in our data, as per
earliercross-sectionalanalyses.
? RAND 2005.
LAFONTAINEAND SHAW /
135
FIGURE2
BY FIRMEXPERIENCE
PERCENTAGE
COMPANY-OWNED
AND SECTOR
o 60
c
,
o 50 -
-
Automotive
Business services
---- Restaurants
Constructionand maintenance
Retail
---
\
a- 40
oE
c
A'
..\
30
20
---
\\
a)
-............
....
..--..^
10-,
0
2
I
I
I
4
6
8
i"
I '- rl'
T
'
I
10 12 14 16 18 20 22 24 26 28 30 and up
Yearsof franchisingexperience
franchisors.However, this constantrate could arise from offsetting patternsacross firms rather
than from individualfirms all keeping a fairly constantproportionof company units. Our goal
in this subsection is to establish that in fact the relativelyconstantrates in Figures 1 and 2 arise
from stable proportionsat the firmlevel. We do this firstby modelling the within-firmevolution
of companyownershipwith franchisingexperience,namely:
ACit = f (franchising experience)it + eit,
(1)
where ACit is the within-firmchange in the percentagecompany-ownedfor franchisori at time
t and the residualseit representunexplainedvariationin ownershippatterns.
Using Kernel regressionwith differentbandwidths,we show in Figure 3 how the average
within-firmchangein companyownershiprelatesto franchisingexperiencein ourdata.This figure
shows thatthe change in percentagecompany-ownedis highly negativeon averagefor firmswith
little experience,but thatit increasesdramaticallyduringthe next severalyears in franchising.It
reacheszero afterthe firstseven years or so, and stabilizes at that level.
Based on this and earlier figures, we constructparametricspline functions that model the
change in percentagecompany-ownedunits as firmsgain experience.The chief advantageof the
parametricapproachis that we can devise statisticaltests to answertwo questions:(1) does the
percentagecompany-ownedreally stabilize over time, meaning that more years of franchising
FIGURE3
KERNELRESULTSFOR THE CHANGEIN PERCENTAGE
COMPANY-OWNED
FOR
DIFFERENTBANDWIDTHS
5
(2, 3, 4, YEARS)
a
E
I
-4
co -2
a-
O
-10
. -12
O
0
[
5
I
10
I !
15
20
I
25
Yearsof franchisingexperience
? RAND 2005.
I
30
I
35
40
136 / THERANDJOURNAL
OFECONOMICS
TABLE 2
Resultsfor the Changein Percentage
SplineRegession
Company-Owned
Yearsof FranchisingExperience
Numberof
Observations
Full sample
13,022
Constant
1-3
-27.34
6.42
(-30.85)
(24.81)
4-7
8-45
.43
-.01
(4.92)
(-.33)
Growthrates:
Positive
Negative
Zero
7,857
-36.30
8.40
.60
.02
(26.02)
1.24
(5.36)
3,063
(-32.96)
-2.31
(.76)
-.05
2,102
(-.87)
-8.07
(1.67)
1.68
(-2.59)
.40
(-1.62)
.001
(-4.98)
(3.46)
(2.19)
(.02)
-.50
Near exit status:
Yes
No
4,609
8,413
-26.46
6.26
.37
.01
(-17.47)
-28.13
(13.86)
6.58
(2.26)
.46
(.18)
-.01
(-25.76)
(20.93)
(4.58)
(-.63)
Numberof units:
Above average
Below average
2,579
-8.23
1.62
.44
-.002
10,443
(-4.30)
-27.70
(3.12)
6.51
(4.19)
.44
(-.21)
-.01
(-27.92)
(22.38)
(4.19)
(-.26)
Sector:
Automotive
1,072
-24.98
5.65
.61
1,592
(-8.04)
-13.80
(6.29)
3.09
(2.10)
.47
-.004
Restaurants
3,466
(-5.58)
-20.29
(4.28)
4.29
(1.89)
.73
-.004
Constructionand
1,199
(-10.95)
-34.35
(8.03)
8.42
(4.32)
.25
(-.16)
.005
(-11.73)
(9.85)
-37.68
9.46
(.86)
-.08
(.08)
.02
(-19.46)
(16.61)
Business Services
Maintenance
Retail
2,599
(-.41)
-.0
(-.20)
(-.09)
(.50)
Note: t-statistics in parentheses.
experiencehas no effect on it anymoreaftera certainpoint?and(2) aretheresignificantdifferences
across sectors or other subsamplesof firmsin the extent to which they stabilize?
The spline regressionresults for the estimationof equation(1) are shown in Table 2. They
confirmwhat we saw in Figure 3, namely thatfor the firstfew years in franchisingthe change in
percentagecompany-ownedis largeandnegative(theproportionof companyunitsis decreasing).
This negative change becomes smaller during the first seven or so years in franchising.After
that time, the change in the percentageof company ownershipwithin firms no longer relates to
franchisingexperience,thatis, the coefficientsin the last column are never significantlydifferent
from zero. Furthermore,F-tests show that after this time there are no significantdifferencesin
datapatternsacross sectorsor for differentsubsamplesbased on differentgrowthlevels (positive,
negative, and nil), or chain size (above or below mean), or for firms that are going to exit from
franchisingwithin the next threeyears and those thatwill continuefranchisingbeyond that.Note
thatwe testeda largenumberof alternativespline functions,all of which were rejectedby the data.
Forexample,if we permitthe linearrelationshipto varywithinthe experiencelevels 8 through45,
we find no significanteffects. Thus, the data imply that there is no need for more cutoffs within
this period.
While the spline results in Table 2 confirm the lack of change with experience after the
first seven years in all our subsamples,this result again could be due to some offsetting cross? RAND 2005.
LAFONTAINE
ANDSHAW / 137
firmpatterns,i.e., some firmsexperiencingpositive, and other firmsnegative, averagegrowthin
percentagecompany ownership.What we want to establish next is that the change stabilizes at
zero within firms. We do this by looking at firms for which we have enough data to estimate a
within-firmexperienceeffect, namely the 619 firms (representing5,472 observations)for which
we have at least five years of data on ACit afterthey become established(i.e., beyond their first
seven years in franchising).Note that consistent with the hypothesis that within-firmgrowth is
zero, 61 of the firms in this subset show no variationat all in ACit (the change is exactly zero
in every period in the data) and another527 firms have means for ACit that are insignificantly
differentfrom zero (at the .05 level, two-sided test). This leaves only 19 firms with an average
ACit that is negative and significantlydifferentfrom zero, and 12 firms for which it is positive
and significantlydifferentfrom zero.
To explore the within-firmeffects further,we now rewrite(1) as
ACit =
f (franchising experience)it +
zi + St + eit,
(2)
where,/i is a firm-specificfixedeffect andSt is a yearfixedeffect. Whenwe estimate(2) for the 558
firmswith nonconstantACi, the coefficientson franchisingexperienceand on the year dummies
arenot significant,andthe firmfixedeffects arealso insignificantas a group(F(557, 4439) = .96).
If we estimate this with randomeffects, we also cannotreject the hypothesisthat the varianceof
the tzi's is zero. Finally, if we estimate a variantof (2) where we allow randomcoefficients on
franchisingexperience, the coefficient on franchisingexperience is not differentfrom zero and
we cannotreject parameterconstancy.In sum, we concludedearlierthatthe mean growthrateof
percentagecompany-ownedis zero across all these firms.The results here suggest that there is
no significantdifferencein the growthrates across firms,either:firm-specificmean growthrates
in company ownershipare all basically zero. Thus, firms appearto be targetingdiffering levels
of Ci, but not differinggrowthrates for this variable.
We conclude that company ownershipdeclines duringthe initial years in franchising,but
after that adjustmentphase, there is no evidence of systematic changes in company ownership
over time within firms. The theoreticalmodels described above that imply changes over time
would seem inconsistentwith the data.
3. Howfirms maintaintheir stable rates of company ownership
*
The results above imply that the percentage of companyownershipremainsfixed afterthe
earlyyearsin franchising.In this section we askhow firmsachievethis constantrate.Using simple
cross-sectional means, Figures 4 and 5 show that firms change their numberof both companyowned and franchisedoutlets as they grow or decline. At every level of franchisingexperience,
firms that experience positive growth open mostly franchisedunits, but not all. Perhapsmost
surprising,however,is that firmsthatare shrinkingin size on averageclose down both company
and franchisedoutlets at all experiencelevels. The "stable"percentageof companyunits in our
data thereforeis not an artifactof lack of growth.The data suggest instead that, consistent with
Caves and Murphy (1976) and Scott (1995), firms set a goal for this percentage and actively
maintainit. This conclusion is reinforcedby companies' stated strategyas reportedin various
sources. For example, Hamstra(1998) reports that Burger King's goal is to own and operate
15% of its restaurants.Sasser and Pettway (1974) point out that "Wendy'sexpansion strategy
was based on a 'balanced'developmentof company-ownedand franchisedstores"(p. 104) and
"WaffleHouse was expandingon two majorfronts:company-operatedunits, andfranchisedunits
... It was expectedthatan eventualbalanceof the system wouldbe reachedat 30%companystores
and 70% franchise stores"(p. 139). Finally, when asked, franchisemanagersanswer questions
on what they perceive to be the optimalpercentageof companyunits in a chain.6
6
See Ozanne and Hunt (1971) and Lafontaineand Kaufmann(1994). The latterpoint out that franchisorsnot
only have targets,but also thatmost chains operatewhat they see as the optimalproportionof companyunits. In the vast
majorityof cases, this proportionis neither0% nor 100%.
? RAND 2005.
138 /
THE RAND JOURNALOF ECONOMICS
FIGURE4
THE CHANGEIN THE NUMBEROF COMPANYUNITSBY EXPERIENCELEVEL
25
=
3
20
- 20-
'
E0
15 -
o
-Full sample
-Positive growth subsample
--- Negative growth subsample
----Zero growth subsample
10-
\
\
/
/
\
--28
30and up
/
/
5 0
0
c-
-57
a) -10 -15
2
I
6
1
4
I
8
I
10
1
12
I
14
I
16
I
18
I
20
I
22
I
24
26
Years of franchising experience
We concludethatthe percentageof companyunitsin franchisedchainsis not simplya passive
outcome that arises from the combinationof unit-levelmarketand franchiseecharacteristicsand
the need to choose the rightcontractfor each unit, as simple agency-theoreticargumentssuggest.7
Instead, firms actively add and subtractboth company and franchisedoutlets to maintaintheir
targetlevel of companyownership.8
4. Explaining the differences in target levels of company ownership
*
Thus far, we have shown that once franchisorsbecome established, they target a given
level of companyownership--thatis, the percentageof outlets thatare company-ownedis stable
within firmsover time and the percentageis maintainedthroughactive variationin the numbers
of franchisedand company-ownedoutlets. However, the targetlevels vary significantlyacross
firms.The firm-specificnatureof the company-ownershiptargetscan best be shown empirically
FIGURE5
CHANGEIN THE NUMBEROF FRANCHISED
UNITSBY EXPERIENCELEVEL
100
80o -
-
60 -
-""
- --
40 -
.
-20 - "
Fullsample
Positive growth subsample
Negativegrowth subsample
Zero growth subsample
/
_
-
-20
--
.....--
-
- .. -
-.
-40 -6 0
2
I
4
I
6
I
8
I
10
I
12
I
14
I
16
I
18
I
20
I
22
I
24
26
I
28
30 and up
Yearsof franchising experience
7 Decisions aboutwhich outlets to own and franchisecould lead
to a constantcompany-ownedshareundersuch
argumentsif most firms systematicallyowned outlets, say, in urbanareas,and franchisedin ruralareas,and expandedat
the same rate in both types of markets.But in fact firmstend to expandinto further-awaymarketsover time.
8 Choosing a particularpercentagecompany-owneddoes not
preventfranchisorsfrom also choosing which units
are franchisedand which are companyoperated.Evidence suggests thatlarger,urbanunits that are close to headquarters
are more likely to be companyowned (see Lafontaineand Slade (1997,2001) for reviews).
? RAND 2005.
LAFONTAINE
ANDSHAW / 139
as follows: if we restrict our sample to established franchisors(those with more than 7 years
of franchisingexperience and at least 15 units) and run an OLS regression of the percentage
of company ownership as a function of a set of explanatoryvariables and firm-specificfixed
effects, firm-specificfixed effects are highly significantas a group, and their introductionraises
the R2 from 19%to 92%.9Thus, it is clear from the datathatdifferentfranchisorsadoptdifferent
targets.McDonald's 1995 annualreportmentions that "About21% of McDonald's restaurants
are operatedby the Company.We maintaina global base of Company-operatedrestaurantsto
generateprofits,link our interestswith franchisees,develop managementtalent,gatherresearch,
and test ideas for better restaurantexecution"(p. 11). In this section, we ask specifically what
affects the targetpercentagecompany-ownedthatfranchisorschoose.
Theoretical arguments. The empiricalevidence that company ownershipstabilizes at a
O
fixed rate suggests that we reject two classes of models. First, agency models implying that
companyownershiprates dependonly on the characteristicsof the set of outlets and franchisees
arerejectedbecausesuchmodels arenot likely to producestableownershiprates-the rateswould
varyovertime, alongwiththe characteristicsof the outletsandtheirmarkets.Second,the signalling
and the reputation-basedmodels, as well as the capital access argument,all imply systematic
changes in the percentagecompany-ownedover time. These are rejected given the stability of
the ownershiprates. We thereforeturnto two other argumentsfrom the literatureto explain the
cross-firmdifferencesin the targetcompanyownershiprates.The firstrelates to franchiseefreeriding and the resulting need for the franchisorto control downstreamoperations.The second
relates to franchisees'need to ensurethattheirfranchisorswill not behave opportunisticallyand
underinvestin the brandex post. We now brieflydetail both of these.'0
Franchisee free-riding and franchisor's need for control. Under a franchise agreement, the
franchiseeowns the assets andearnsthe profitsgeneratedby the outlet (afterpaymentof royalties
on sales). Consequently,franchiseeshave strongincentivesto protectthe value of theirassets and
to keep costs down and sales up. Unfortunately,as pointedout by, e.g., Brickley andDark (1987)
and Blair and Kaserman(1994), franchiseesmay maximize their profitsat the expense of other
franchisees or the chain as a whole. For example, franchisees may use lower-qualityinputs or
advertiseless to reducetheir costs but, in the process, lower brandname value. Franchiseesmay
also altertheir productofferings to bettersuit their local markets,or oppose the implementation
of new productionprocesses and new productofferingsthatthey don't think will do well in their
market-even if the innovationbenefits other stores in the chain. All these behaviorsaffect the
extent of standardizationin the chain and thus the value of operatingundera common brand.
The problem, fundamentally,is one of externality:because of the common brand, each
franchisee'sprofitsdependon decisions made by othersin the chain. In fact, the interdependence
from the common brand is a large part of what franchisees buy into when they join a chain.
The more valuable the brandis, the more franchisees benefit from belonging to the franchise
system, but the more they can also profitfrom free-riding.If franchiseeswere paid a fixed salary
as corporatemanagersare, they would have no incentive to free-ride.In that sense, franchisees'
free-ridingandtheirtendencyto caterto theirmarkettoo mucharethecosts of using high-powered
incentives for them (Klein, 1995; Lafontaineand Raynaud,2002).
Franchisorsrely on variouscontractualrestraintsto curbfree-riding,such as requiringsome
minimum advertisingand service levels or developing strict product-mixguidelines. But such
restraintsare costly to enforce and still may not preventall the behaviorsthat franchisorsworry
9 The F-test for the
significanceof the fixed effects is F(1562, 6320) = 42.3, with a p-value of zero. We referto
OLS resultsratherthanTobitdespite our limited dependentvariablebecause goodness-of-fitmeasuresin Tobitare not as
interpretable.The explanatoryvariablesarethose in column4 of Table4. The 22 sectordummiesaccountfor 6 percentage
points in the base R2 (i.e., the 19%).
10The "windowon the industry"argument(HarrisandWiens, 1980)
implies thatcompanyunitsprovidefranchisors
with informationaboutmarketsthatthey can use to assess franchiseebehavior.See also Bradach(1997) andLewin (1998)
for other synergy argumentsfor contractmixing. Although these models offer valid reasons for franchisorsto operate
some outlets directly,they providelittle guidanceas to what the optimalmix is or what it relates to.
? RAND 2005.
140 / THERANDJOURNAL
OFECONOMICS
about. Those with more valuablebrandsthen may need to operatemore outlets directly so that
they can exercise more directmanagerialcontrolover downstreamoperations.1
Aligningfranchisorincentives. A numberof authorshavealso emphasizedthe ongoing role of the
franchisorin maintainingthe value of the franchisedbusiness:the franchisorputs forth effort in
advertisingandpromotingthe brand,in monitoringfranchisees,andin screeningnew franchisees,
all of which securethe benefitsto franchiseesof being partof the chain and are necessaryfor the
long-termprofitabilityof the chain. Models of franchisingthat have explicitly incorporatedthe
franchisor'srole (and the difficultyinherentin motivatinghis behavior)have shown that output
sharingwill be necessary to motivatethe franchisor-or, as statedby McDonald's, to "link the
franchisor'sinterestswith those of its franchisees."This can be achieved,for a single franchisorfranchisee pair, with an appropriatechoice of royalty rate.12As noted by Caves and Murphy
(1976), Lafontaine(1992, 1993), and Scott (1995), in a multiunitcontext, an alternativeway to
give franchisorsincentives is to have them operatemore units directly.Thus here also, company
ownershiprates should rise with (desired)brandname value.
The model and data for targeting analyses. The implicationfrom the argumentsabove is
a
thatin equilibrium-that is, once they have become established-franchisors with more valuable
(desired) brands will operate more outlets directly. We test this hypothesis by estimating the
following regression:
Cit = aXit + bZit + eit,
(3)
where Cit is the percentageof company-ownedoutlets by firm i at time t, Xit is a vector of
variablesrepresentingthe importanceof the brand,and Zi, is a set of controls, such as sector
dummies.13The specificationfor the residualseit is describedbelow.
We explore this relationshipempirically using only those observationsfrom our sample
where the firm has been franchisingfor more than 7 years and has at least 15 outlets. Table 3
shows descriptivestatisticsfor this new sample.Note thatthe percentagecompany-ownedis zero
for 26% of our observationsin this sample, indicatingthat a sizable set of franchisorsultimately
choose to be fully franchised.
We use three primarymeasures of the (desired) value of the brand. The first and most
importantmeasure is the yearly majormedia advertisingexpendituresreportedin LNA/Media
Watch for each brand/yearin our "stable"sample (Media). The second is the advertisingfee,
namely the percentageof their sales thatfranchiseesare requiredby contractto contributeto the
chain's advertisingfund (AdvertisingFee). The thirdis the numberof years that the franchisor
spent in business developingthe system before it began to franchise(YearsBefore Franchising).
The last two measures were collected from the same sources as all our other franchisingdata.
However, they are not ideal proxies for brand name value in that the advertisingfee data is
somewhat incomplete,14and while Years Before Franchising proxies the amount of time a
franchisorhas investedin developinghis businessformat,this investmentis not linked as directly
to brandnamevalue. Thus, we soughta moreaccuratemeasureof brandnamevalue andcollected
the dataon yearly mediaexpendituresfrom an externalsourceandmatchedit to ourprimarydata.
11See Bai and Tao
(2000) for a multitaskmodel where franchisors-who cannot invest in the brand-can direct
company managersto put their effort towardgeneratinggoodwill while franchiseesconcentrateon local service. This
model thus implies that franchisorsneeding more goodwill effort will have to operatemore companyunits.
12
See Rubin (1978). Also see Lal (1990) and Bhattacharyyaand Lafontaine(1995) for formal models.
13 The
implicationhereis thathigherbrandvaluecauses morecompanyownership.But if the incentivemechanisms
work, high companyownershipwill also result in less free-ridingby franchiseesand highereffort by the franchisorand
thus yield higher brandvalue in the future.Because brandname value is a long-termconcept requiringseveral years of
advertisingdata, we cannotreally assess causality using lags. Ourgoal then is simply to show thatconsistent with these
arguments,we find a positive relationshipbetween brandvalue and companyownership.
14
Some franchisors(manyin the early years of ourdata)do not separatetheiradvertisingfee from the royaltyrate
that they requirefranchiseesto pay. Thus, our measureof advertisingfee underestimatesinvestmentsin advertisingfor
an unknownnumberof firms.
? RAND 2005.
LAFONTAINEAND SHAW /
TABLE3
141
DescriptiveStatisticsfor the "Stable"Sample
Standard
Variable
N
Median
Mean
Deviation
PercentageCompany-Owned
Media (in $1,000)"
7,906
3.70
13.44
20.02
0
100
7,906
0
7,906
0
21,445.2
7.46
0
Media per Outleta
2,780.6
2.27
598,752.5
259.7
AdvertisingFee (% of sales)
YearsBefore Franchising
7,906
1.00
1.57
1.87
0
13
7,906
4
7.86
10.93
1
128
State Law: Termination
7,906
0
.37
.42
0
1
Numberof Outlets
7,906
101
396.49
15
19,599
Training(in days)
Numberof Employees (per outlet)
5,693
15
18.80
1,093.89
17.18
0
290
3,547
5
9.21
13.48
0
150
CapitalRequired(in $1,000)
7,670
98.5
231.89
1,472.23
0
82,500
ExperienceRequired(of franchisees)
Numberof States Franchisingin
4,073
0
.27
.44
0
1
5,950
16
19.73
16.22
0
50
Minimum
0
Maximum
a For those firms that have positive expenditureson media, the medians (in $1,000) are Media: $436 and Media per Outlet: $1.95.
The data for the last five variablesare availableonly for subsets of firmsin our data,hence the smallersample sizes.
We introducea numberof control variablesthat capturedifferent aspects of the business
format and thus may relate to the value of the brandor of chain membershipfor franchisees.
In addition to sectoral dummy variables mentioned above, these include a measure of chain
size (Number of Outlets) and its geographicaldispersion (Number of States Franchisingin),
a variable indicating whether the franchisoris headquarteredin a state that restricts contract
terminationpossibilities (State Law: Termination),15the amountof initial trainingprovidedto
franchisees(Training),measuresof the size of individualoutlets (CapitalRequiredand Number
of Employees), and whetherfranchiseesmust have priorexperiencein the business (Experience
Required).Summarystatistics for all these are also shown in Table 3. Of course, many of these
arejointly determinedalong with the percentagecompany-ownedpolicy of each franchisor--we
take that into considerationin interpretingour resultsbelow.
a
Regression results. We test our hypothesis-that high (desired) brand-namevalue is
associatedwith highcompanyownershiptargets- using a Tobitestimatorbecausea fairnumberof
observationshave0%companyowned. We also reportresultsbasedon a between-Tobitestimator,
where we use firm-specific averages as data points and, as a standardway to deal with the
unbalancednatureof our data,weight each observationaccordingto the numberof observations
per firm that is used to calculate the firm-specificaverages.In interpretingresults, we focus on
the between estimatorfor several reasons. First, we have shown above that firms change their
targetedlevel of company ownershipvery little over time. Hence, using the full-stackeddataset
can amountto the redundantuse of multiple observationson the same company (see Bertrand,
Duflo, and Mullainathan,2004). Second, by using the between estimator,we are showing how
brandname value mattersas an explanationof the variationacross firms in the data. Finally,
the between regressions have the advantageof "averaging"all our explanatoryvariablesover
time, makingour media expenditurevariablein particulara less volatile and more representative
measureof long-terminvestmentin brandvalue.In otherwords,withthe betweenestimator,we are
examininghow, on average,the percentagecompany-ownedvaries across firmswith something
thatapproachesthe accumulatedstock of advertisingexpendituresfor each brandover the period
duringwhich we observe it in our data,ratherthanthe flow of such expendituresyear afteryear.
15This is a dummy variableequal to one if the chain is
headquarteredin one of the fifteen "good cause" states,
namely Arkansas,California,Connecticut,Delaware, Hawaii, Illinois, Indiana,Iowa, Michigan, Minnesota,Nebraska,
New Jersey,Virginia,Washington,and Wisconsin.
? RAND 2005.
142 /
THE RAND JOURNALOF ECONOMICS
TABLE 4
Percentage Company-Owned Regressions
Detailed Sectors
AggregateSectors
Tobit
Between
Tobit
Between
Tobit
Between
(1)
(2)
(3)
(4)
(5)
(6)
(7)
2.93
3.32
2.40
2.77
(20.27)
-.005
(22.10)
-.085
(10.07)
(18.18)
(8.33)
-.087
(11.78)
(14.39)
(6.26
(1.96)
(Media per Outlet)3
.0007
.0010
.0006
.0008
(Media per Outlet)4
(11.49)
-.000002
(4.89)
-000002
(9.62)
-.000001
(4.09)
-.000002
(1028)
.54
(4.39)
.52
(8.64)
.36
(3.68)
(3.37)
.45
(4.85)
.54
(2.40)
.53
(7.35)
.53
(10.93)
-,004
(4.87)
-.003
(1158)
(YearsBefore)2
(10.80)
-.004
(4.46)
.02
(4.69)
-.15
(2.08)
-.27
(4.91)
Outlets(in 00s)
(2.70)
(Outlets)2
.0001
.0016
(1.99)
.0030
.0007
State Law
(.27)
-4.84
(2.87)
-4.25
(2.02)
-3.55
(1.25)
-3.52
(7.91)
No
(7.06)
No
(3.01)
No
Media per Outlet
(Media per Outlet)2
AdvertisingFee
per Outlet
YearsBefore
1.10
.56
(7.60)
(.38)
Sector dummies
-.106
-.069
-.004
-.03
(.53)
(5.98)
X2(22)
= 653.4
X2(# = 0)
N
Tobit
Tobit
Tobit
Tobit
X2(34)
=824.2
7,906
X2(36)
=1,074.3
7,906
X2(36)
=262.5
1,563
x2(58)
=1,727.7
7,906
(5.20)
1.82
(14.62)
-.053
(10.07)
0005
(8.25)
-.000001
2.21
(6.88)
.068
(4.35)
.0006
(3.41)
-.000001
(7.46)
.27
(3.06)
(3.73)
.60
(1.92)
.52
(5.09)
-.003
(11.93)
(5.51)
-.005
(2.08)
-.12
(6.46)
38
.45
(.87)
.0016
(1.12)
-2.90
(2.51)
X2(22)
= 125.6
X2(58)
=388.1
1,563
-.006
03
(.61)
-.0002
(.46)
-1.38
(2.42)
2(270)
= 3,012.8
X2(306)
=4,087.1
7,906
.30
(2.92)
-.02
(.18)
.0001
(.11)
-.97
(.87)
X2(270)
= 619.0
X2(306)
=881.4
1,563
Note: t -statisticsin parentheses.Also in regressions:Canadiandummy,yeardummies(for 1980-1997), andfranchisingentry-yeardummies
(see footnote 20). The full-sampleTobitshave 2,070 observationscensored at zero, and 5,836 uncensored.The between-Tobitshave 266
observationscensored at zero, and 1,297 uncensored.
Our three measures of brandname value-Media per Outlet, AdvertisingFee per Outlet,
and Years Before Franchising-have strongpositive independenteffects that are all significant
regardlessof whetherwe use a quadraticor quarticfunctionalform for Media (Table4, columns
1 and 2), whetherwe use a Tobitor between-Tobit(column 3) estimator,and whetherwe include
more or fewer detailed sectoral dummy variables (columns 4 through 7).16 Not surprisingly,
likelihood ratio tests indicate that in combination,our measuresof brandname value also have
a significant effect on the proportionof company units in a chain in all our regressions.17To
give a sense of theirimportance,we note that Media per Outlet,AdvertisingFee per Outlet,and
YearsBefore Franchisingincreasethe R2 of a weighted least-squarebetweenregressionwith the
regressorsin column 3 by 13 percentagepoints, while Media per Outletand AdvertisingFee per
Outlet by themselves increasethe R2 by 10.5 percentagepoints. Finally,the most economically
importanteffects arise from ourMedia variable.In column 1, where Mediaper Outletis included
16If Media is includedinsteadof Media
per Outlet,the significanceof Media is essentially the same as for Media
Outlet.
The AdvertisingFee performsbest in our regressionswhen it is dividedby the numberof outlets, suggesting
per
thatthis fee has a smallerimpacton company-ownershiprates for large franchisors.
17
For example, for column 3, an LR test of the joint significanceof the coefficients of the Media per Outlet and
AdvertisingFee per Outletvariablesgives x2(5) = 174.5, whereasa joint test for the coefficientsof all threeof our brand
name variablesgives X2(7) = 216.9, both significantat the .01 level.
? RAND 2005.
LAFONTAINE
ANDSHAW / 143
in quadraticform, the coefficientvalues imply thatthe effect of Mediaper Outletis positive at all
relevantrangesbut peaks at $110,000. When we use a quarticspecification-to reflectthe highly
nonlinearnatureof the relationshipthatwe foundin alternative,less parametricspecifications(not
reportedhere)- the effect of Mediaper Outletrises, thenplateaus,thenrises againat substantially
higher levels.18The Media per Outlet coefficients in the between-Tobitregressionsalso imply a
sizable impact:at the mean value of Media per Outlet,a one-standard-deviation
increasein these
expendituresimplies thatthe percentagecompany-ownedgoes from 15%to 28%.19
We include severalcontrolvariablesin our regressionsin Table4, for surveyyear (dummies
for years 1980-1997), vintage (dummies for the year in which the firm began franchising),
company size (total numberof outlets), and the State Law dummy variable defined above. In
addition,differenttypes of businesses are likely to face differenttypes of customers-customers
who respond more or less to brand value-and to be characterizedby different production
technology and varyingmonitoringopportunities,all of which would affect the incentive issues
that are centralto franchisingand thus should affect the optimalmix of companyand franchised
units. To control for these, we include 22 sector dummy variablesin columns 4 and 5 (see the
Appendix for a list). For columns 6 and 7, we rely on a more detailed definitionof sectors: for
example, in the automotiveservices sector,we separateout firmsin "Detailing,WindowTinting,
Rustproofing"from "MufflerShops" from "Oil Change & Lube Shops" from "Transmission
Repair"and from "AutoPartsRetailing."The resultis a set of 271 very detailedsectors,many of
which containonly a few franchisors.
The survey-yeardummies show no systematicpatternand are never significantas a group
in our between regressions. The vintage dummies, on the other hand, show a patternof rising
companyownershipratesthatis significantwhenwe controlfor sectors.20 Thisresultsuggeststhat
morerecententrantsinto franchisingtargethigherpercentagesof companyownershipon average.
This effect possibly reflectsthe increasedmaturityof industriesin which franchisorsoperate,and
the resultingincreasein the importanceof brandname value for new entrantsin these industries.
Turningto the company-sizevariable,the numberof outletshas a weaknegativeeffect on company
ownershipin our basic Tobit model in column 2, but this effect is not robust-it disappearsin
models that control for sectors. Contraryto Brickley, Dark, and Weisbach(1991), we find that
the State Law variablehas a negativeeffect on the targetcompany-ownedpercentageschosen by
firms. However,this effect is much smaller when we control for detailed sectors-to the point
where it becomes insignificantfor the between-Tobitwith these detailedsectorcontrols.Finally,
resultsin Table4 confirmthe importanceof sectoraldifferencesin the settingof targetpercentage
company-owned.In columns4 through7, the sectordummyvariableshave a significanteffect as a
group(see LR tests in Table4). To give a sense of the importanceof the sectoreffects, if we addthe
22 aggregatesectordummyvariablesin a betweenweightedleast-squareregressionof percentage
company-ownedon the variablesin column 3, the R2 rises from .16 to .22. If we insteadintroduce
the 270 detailed sector dummies, the R2 rises to .44. We conclude that differences in demand
and in productiontechnology,which affect the importanceof the franchisorand franchiseeinput
(see, e.g., BhattacharyyaandLafontaine,1995), anddifferencesin monitoringpossibilitiesacross
sectors play an importantrole in explainingdifferencesin company-ownershiprates.
Are there any variablesthat can account for the differences in ownershiprates across the
18As it is our focal variable,the effect of Media per Outlet was estimatedundernumerousfunctionalforms. We
found the quarticsuperiorto all these. For example, undera spline function with seven breakpoints, the patternin the
coefficients is still quarticand there is no significantgain from the less-constrainedspline function.We also plotted the
predictedvalues of PercentageCompany-Ownedgiven Media per Outlet and found that the combined linear-squaredcubic-quarticeffects imply sensible turningpoints, thoughthe levels overshootsomewhat.
19One
possible interpretationof the importantrelationshipbetween Media and PercentageCompany-Ownedis
that these are complementaryorganizationalpractices.This is entirely in the spiritof our model. A differentmodel, in
which Media is endogenousto PercentageCompany-Owned,cannotbe identifiedwith our data.
20If we use a linear
term instead of a series of vintage dummy variables,its coefficient
year-started-franchising
is .15 (2.5) and .21 (3.3) in columns 5 and 7 of Table 4 respectively. The franchisorentry years in the regressions
are segmentedas follows: < 1927 (omitted), 1927-1959, 1960-1964, 1965-1969, 1970-1974, 1975-1979, 1980-1984,
1985-1989,1990-1997.
? RAND 2005.
144 /
THE RAND JOURNALOF ECONOMICS
TABLE5
PercentageCompany-OwnedRegressionswith AdditionalControlVariables
WithAggregate
SectorFixedEffects
Between
To
bit
Between
Tobit
(17.53)
2(37) = 1, 157.1
.45
.38
(9.26)
X2(37)= 319.6
.44
.27
(12.23)
2(59)= 1,467.0
.42
.31
(6.83)
X2(59)= 387.3
.44
(15.30)
X2(28)=700.9
.91
(8.49)
X2(28)= 233.3
.89
(4.86)
X2(37)= 1,078.8
5.68
(2.38)
X2(37)= 268.4
7.28
(10.87)
X2(50)= 920.4
.54
(2.83)
X2(59)= 1,682.1
4.89
(6.37)
X2(50)= 303.2
.65
(1.71)
X2(59)= 387.6
6.63
(6.46)
X2(28)= 664.1
-.36
(14.38)
X2(37)= 1,043.7
(3.94)
X2(28)= 202.1
-.32
(6.71)
X2(37)= 285.7
(5.55)
X2(50)= 1,010.5
-.29
(10.97)
X2(59)= 1,418.8
(3.51)
x2(50)= 281.4
-.28
Tobit
Training
Required
N = 5,693; n = 1, 292
Numberof Employees
N = 3,547; n = 1,021
($M)
CapitalRequired
N = 7,670; n = 1,534
Experience
Required
N = 4,073; n = 1,018
Numberof States
N = 5,950; n = 1,333
.36
(5.40)
2(59)= 370.9
Note:Eachcell represents
a separate
withonlythevariableof interestaddedto thoselistedin column2 of Table4 (andsector
regression
dummiesas appropriate).
Thecoefficient(t-statistic)
is displayedforthevariablelisted,butthex2 testsareforthewholeregression
(all
forTobit,n = number
/ = 0). N = number
of observations
of observations
forthebetween-Tobit
model.
detailedsectors?Aftercreatinga datasetof samplesize 271 containingsector-specificmeansfor all
our variables,we estimatedweighted Tobitregressionsof sectormeans of PercentageCompanyOwned on sectormeansof all our X variables,using the numberof franchisorsper detailedsector
as weights. Threevariableswere significantin explainingthe cross-sectordifferencesin company
ownership: media expenditures (Media), the geographical dispersion of the chains (Number
of States), and whether franchisees have to have prior experience in the business (Experience
Required).
In sum,we findthatbrandnamevalueis animportantfactorexplainingbothwithin-sectorand
cross-sectordifferencesin percentagecompany-owned.21Using the dataon sectormeans, media
expendituresexplain a portion of the substantialcross-sector variationin company-ownership
rates. Using the entire datasetacross all firms, media expendituresexplain a significantamount
of the within-sectorvariationin ownershiprates(as representedby the regressionsin Table4 that
controlfor sector fixed effects).
Finally,we returnto the regressionsin Table4 andincludea series of additionalvariablesthat
also indirectlysupportthe hypothesisthatfirmswith higherbrandnames own a largerpercentage
of company units (see Table 5). We add variables one at a time because each is available for
a different set of franchisors.Also, because we want to assess how these variablesperformin
explaining some of the cross-sectoras well as within-sectordifferencesin percentagecompanyowned, we presentresults with and without aggregatesector dummies,but not with the detailed
sector dummy variables.Note that the effects of these variablesshould be interpretedwith care
given that severalof them may be jointly determinedwith percentagecompany-owned.
The additional variables provide furtherevidence that trade name value is importantin
setting ownershiprates. TrainingRequiredhas a significantpositive coefficient-an extra four
21In
reachingthis conclusion we have assessed possible selection bias due to samplingresponse.Firms leave our
sample either because they are no longer franchising-in which case theirproportionof companyunits will stabilize at
100%if they remainin business-or because of nonresponses.Nearly 50% of the experiencedfranchisorsin our sample
dropout of the survey before they leave franchising(see the Appendixfor details). We cannotidentify which firmsdrop
out for which reason but have verifiedthat the probabilityof droppingout of our sample is uncorrelatedwith any of our
variablesexcept sector (some sectors have higherdropoutrates).
? RAND 2005.
LAFONTAINE
ANDSHAW / 145
days of training requiredby the franchisoris associated with an increase in target company
ownershiprateof almost one percentagepoint. Firmsthatplace a high value on theirbrandname
must requiremore trainingto maintainproductquality and to convey the more highly developed
businessformatthatmaintainsthe higher-valuebrand.In fact, trainingandmediaexpendituresare
highly correlatedin our data(a correlationof .52 for experiencedfirms).Similarly,the resultthat
franchisorswith physicallylargerunits (higherCapitalRequiredto purchasea franchiseor higher
Number of Employees per outlet) tend to own more units also supportsthe brandname-value
argument:franchisorshavemoreat stakewith everyunitin chainswhereunitsarelarge,operations
are more complex in such units, and they can generatehigher externalities.Consequently,and
consistentwiththepriorempiricalliterature,we findthatfranchisorsprotectthe brandby operating
more of these large units directly.22Also, franchisorsthat require franchisees to have prior
experiencein the business (ExperienceRequired)maintaina higherrate of companyownership.
Neitheroutlet size norpreviousexperiencerequiredhavean effect on percentagecompany-owned
that is consistent with simple franchisee incentive arguments,yet both are consistent with our
franchisorcontrolargument.However,consistentwith franchiseemonitoringarguments,we also
find,as othershave,thatgreatergeographicaldispersion(Numberof States)is associatedwithless
companyownership.Note finally thatwhen we include these additionalvariables,the coefficient
on media is largely unaffected-it remainsthe dominantfactor explaining company-ownership
rates.
z
Targeting managerial control: a closer look at cross- and within-sector differences. At
this point, our regressionshave shown thatthereis substantialcross-sectorvariationin company
ownership, and that brand name value explains a significant amount of variationin the rates
of company ownershipboth across and within sectors. To make things more concrete, in this
subsection we display in detail some of the within- and cross-sector differences in company
ownershipand show the relationshipwith brandname value for a subsetof sectors.
Figure 6 depicts the extent of within- and cross-sector variationin percentagecompanyowned for establishedfranchisorsin the largest25 of our narrowlydefinedsectors, where sectors
are shown in decreasingorderof the proportionof franchisorswith less than5%company-owned
assets. This figureconfirmsthe large variationin the "target"percentagecompany-ownedacross
these sectors: for example, there is very little company ownershipin printing,real estate, auto
repair, tax services, and car rental, but many franchisorshave high percentages of company
ownershipin fast food and other restaurants.However,Figure 6 also shows that within each of
these very narrowlydefinedsectors,thereremainsconsiderablevariationin the ratesof company
ownership.
Ourfranchisingdatahave a uniquefeature- they areobtainedfrompublicsources,so we can
revealcompanynames.Table6 displaysthe company-specificmeanvalues,calculatedoverall the
observationsthatarebeyondthe firstseven yearsin franchising,for ourkey variables(Percentage
Company-Owned,Numberof Outlets,andMediaper Outlet)for chainsin fourdetailedsectorscar rentaland threetypes of fast food: chicken, hamburger,and pizza. The companiesare sorted
by decreasing average percentagecompany-owned,and the sample is restrictedto those firms
with more than 150 outlets (to limit the size of the table).
The most striking evidence comes from auto rental companies. The two companies with
the largestper-outletmedia values, Hertzand National,targethigh levels of companyownership
(66% and 40% respectively). In contrast,a numberof firms targetcompany-ownershipshares
below 1% (Econo Car, American International,Holiday, Ugly Duckling, and Rent-a-Wreck).
These firms are sizable franchisorsbut much less presentin the media. Moreover,the firms that
most people perceive as advertisinghigh-qualityservice (Hertzand National)have much higher
levels of company ownershipthan those firms that advertiselow-cost service (such as Budget,
Thrifty,and Dollar).
Similar conclusions apply to fast-food chicken and pizza-large nationalchains with large
22 See Lafontaineand Slade
? RAND 2005.
(1997, 2001) for reviews of the empiricalevidence on this.
146 / THE RAND JOURNALOF ECONOMICS
FIGURE 6
THE DISTRIBUTIONOF PERCENTAGE COMPANY-OWNEDFOR THE LARGEST 25
DETAILEDSECTORS
*
PrintingServices
Brokersand Real EstateAgents
50%
U 5/-15%
AutoRepair:
Transmission
15-50%
>
50%
Maintenance:Janitorial
Accounting,Bookkeeping,andTaxServices
Food-Snacks:
IceCream
Rental-Car
Carpet,Upholstery,and DraperyCleaning
E mployment
Agencie-Others NEC
FastFood-SubmarineSandwiches
Cosmetic-HairCare
Auto-Muffler
Shops
FastFood-Donuts
Fast Food-Mexican
HotelsandMotels
Fast Food-Pizza
Fast Food-Sandwiches,Soups, and Salads
Food-Retail:ConvenienceStores
ItalianRestaurants
Fast Food-OthersNEC
Restaurants
Family
FastFood-Chicken
Auto-Oil
ChangeandLube:Shops
Fast Food-Hamburgers
TenporaryHelp-OthersNEC
0
20
40
60
80
100
advertisingbudgets tend to own a sizable percentage of their outlets, while those that spend
relativelylittle on media, with few exceptions,have small sharesof companyunits. The evidence
is least clear in the hamburgersector.But even here, McDonald's and Wendy's targetcompany
ownership levels above 25%.23Moreover, most firms (with the exception of Sonic) in the
hamburgersector in fact have above-averagelevels of both media and companyownership.
In sum, based on our earlierregressionresults, we concluded that thereis a strongpositive
relationshipin general between brandvalue and the percentagecompany-owned.A glimpse of
the raw data for firms in severalnarrowlydefined sectors reinforcesthis conclusion.
5. Conclusion
*
Using an extensive longitudinaldataseton franchisingfirms,we have shownthatestablished
franchisorsmanage their portfolio of company and franchisedunits to maintaina stable level of
corporatecontrol and ownership over time. That is, franchisorswith eight or more years of
experienceand at least 15 outlets maintaina constantpercentageof company-ownedoutlets as
they gain experience--company ownershipratesdo not rise or fall with experienceor learning,or
with success or failure. On average,establishedfranchisorsmaintainabout 15%of their outlets
23Franchisorswith high company-ownershipshareshave especially stablelevels of this over time. But when large
corporatechainsbecome involvedin franchising,as Carl'sJuniorandJackin the Box did, the adjustmentperiodprobably
goes beyond the first seven years in franchising,so our data most likely do not reflecttheirtargetratesyet.
? RAND 2005.
LAFONTAINEAND SHAW /
TABLE6
147
Company-LevelData
Company
Percentage
Co-own
Number
of Outlets
Media per
Outletin $000
Numberof
Observations
Car Rentals
HertzRent-A-Car
66.1
NationalCar Rental
39.5
Budget Rent A Car
ThriftyRent-A-Car
Dollar Rent A Car
2.6
8.0
1.8
1,601
951
2,937
699
9.07
4
9.78
4
3.99
17
5.22
17
15
.9
1,501
360
2.04
Rent-A-Wreck
.28
11
Ugly Duckling Rent-A-CarSystem
Holiday-PaylessRent-A-CarSystem
.5
359
.50
8
.3
182
.00
7
AmericanInterational Rent A Car
Econo Car
.1
1,294
161
.09
11
.00
2
4.02
17
.0
Chicken
Church'sChicken
67.3
Grandy's
56.8
1,310
189
15.75
8
Bojangles of America
El Polio Loco
48.7
231
7.07
7
38.8
245
35.71
1
KFC
26.1
12.18
16
PioneerTakeOut
24.1
7,976
288
5.35
9
Popeye's Chicken& Biscuits
Lee's FamousRecipe CountryChicken
14.6
746
8.95
14
14.6
262
3.47
13
FamousRecipe FriedChicken
5.8
225
1.17
2
Golden Skillet FriedChicken
2.6
159
.96
6
Hamburger
KrystalRestaurants
73.9
338
18.51
2
Carl'sJr.Restaurant
68.1
588
16.73
2
Jack in the Box
62.4
996
27.25
2
Whataburger
CheckersDrive-InRestaurants
57.2
344
5.50
7
48.2
481
7.99
1
46.2
520
19.37
1
37.0
710
7.79
3
13
Rally's Hamburgers
BurgerChef
Wendy'sOld FashionedHamburger
31.8
31.2
3,084
192
23.15
BurgerQueen
McDonald's
3.56
1
26.5
11,067
33.22
18
BurgerKing
Sonic Drive-InRestaurant
14.1
5,366
28.79
14
9.8
1,155
5.30
16
Pizza Hut
49.2
4,549
11.77
7
Domino's Pizza
29.6
10.90
13
Pizza Inn
27.8
2,919
610
2.40
15
Little CaesarsPizza
27.7
14.91
14
Dino's Pizza
13.3
1,777
167
.39
5
6.9
391
5.50
13
1.3
472
5.36
18
.0
237
1.87
7
Pizza
Shakey's Pizza Restaurant
RoundTablePizza
HungryHowie's Pizza & Subs
Note: Excludes franchisorswith no media data, those with fewer than 150 units, and Canadianfranchisors.
as company-owned, with the other 85% owned by franchisees. However, we have also shown that
the average rate of company ownership varies considerably both across and within sectors.
Past empirical work had not identified this practice of targeting a fixed rate of company
ownership, and had instead concluded that company ownership declines with experience.
Company ownership does decline for the first seven years of experience. Since franchisors start
? RAND 2005.
148 / THE RAND JOURNALOF ECONOMICS
with 100% company-ownedoutlets, this percentagecan only go down as they add franchised
outlets. We find thatby the end of seven years, on average,companieshave achievedtheir target
rate of corporateownershipand thereafterthis rate becomes very stable.
Given strong evidence that firms targetspecific but differentrates of company ownership,
what factorsdeterminefirms' optimaltargetedrates?We show thatbrandname value, measured
various ways but most importantlyby the level of media expendituresper outlet, is a primary
determinant:franchisorswith high brandname value targethigh rates of company ownership.
We arguethathigh ratesof companyownershipare needed in chains with more valuablebrands
because franchiseeshave increasedincentivesto free-rideon the brandname as it becomes more
valuable.To counterthis effect, franchisorsneed to exert more managerialcontrol, and they do
so by owning and operatinga largerpercentageof theiroutlets. Moreover,high ratesof company
ownershipgive franchisorsa largerstake in the business and thus higher-poweredincentives to
undertakegreaterinvestmentsin advertisingand new productdevelopmentto maintainbrand
name value. Hence, both in termsof controllingfranchiseefree-ridingand in termsof franchisor
incentives, one expects higher rates of company ownership in franchised systems with more
valuablebrands.The evidence we presentsupportsthis implicationfrom the theories.
Appendix
*
Our franchisor-leveldata come from two main sources. For the period from 1980 to 1992 inclusively, the main
source of data is Entrepreneurmagazine's"AnnualFranchise500" surveys.The data for a given year are obtainedfrom
the following year'ssurvey,as these arepublishedearlyin the year.But in the surveyprovidingthe 1993 data,the magazine
covered fewer firms than usual, and in the following surveys, it stopped reportingadvertisingfees. For those reasons,
startingwith the 1993 data, we use the Source Book of Franchise Opportunities,now called Bond's Franchise Guide,
which by then also had become a yearly publication,as our main source of data.This has the addedadvantagethatthere
is more detailed informationon each franchisorin our data from thatpoint onward.
As noted in the text, our datasetis a very unbalancedpanel. Of the 4,842 in our data, 1,461 are observedonly once.
Only 41 firmsare found throughoutthe 18 years of data.Still the bulk of our 19,162 observations(14,079 of them) come
from firms we observe four times or more in the data. The change in the composition of our sample of franchisorsover
time is due first and foremost to entry and exit from franchising.About 15%of the franchisorscovered in the survey
each year havejust startedfranchising.Also, thereis considerableexit from franchising:about 140 franchisingfirmsstop
operationseach year,accordingto the U.S. Departmentof Commerce(1988). TheFranchiseAnnualandBond'sFranchise
Guide reporteven higherexit rates. However,our panel is unbalancedalso because we have been fairly conservativein
matchingfirmsacross years. If we could not find an exact or very convincing matchin termsof firmname (and address)
over time, we kept the firmsseparate.Finally,of course, the dataare unbalancedbecause firmsthatanswerthese surveys
one year may decide not to respondthe next year.Firmsaremore likely to respondto the surveyswhen they wish to grow
and thus find value in the visibility thatthese listings provide.Thus, our datamay be biased in favorof new or expanding
firms. Half of the established franchisorsin our data leave the sample before they stop franchising,where information
on whetherthey are still franchisingat any point in time is obtainedby searchingthroughFranchiseAnnual-a very
inclusive franchisorlisting-and the Entrepreneursurveysfrom 1993 to 1997 (see Lafontaineand Shaw (1998) for more
on this). Using this information,we have verifiedthat presence in the survey conditionalon a firm's still being involved
in franchisingis not correlatedwith any of our variablesof interest,and thatresultsfor stayersand dropoutsdo not differ
significantly.
Finally, we have classified all the franchisorsin our data among the following 23 sectors:Automotive(the omitted
categoryin all our regressions),Business Services, Business Supplies, Contractors,Cosmetic Products& Services, FastFood, Full-Service Restaurants,Education,Health & Fitness, Hotels and Motels, Maintenance,PersonalServices, Real
Estate, Recreation,Rental, Repair, Retail-BuildingMaterials,Retail-Clothing,Retail-Food, Retail-Furnishing,RetailOther,Retail-Used, and Travel.We furtherrefinedthis classificationto generateour 271 detailed sectors.
References
BAI, C. AND TAO,Z.. "ContractMix in Franchising."Journalof Economicsand ManagementStrategy,Vol. 9 (2000), pp.
85-113.
BAKER,G.P. AND HUBBARD,T.N. "Contractibilityand Asset Ownership:On-BoardComputersand Governancein U.S.
Trucking."QuarterlyJournalof Economics,Vol. 119 (2004), pp. 1443-1479.
S. "HowMuchShouldWeTrustDifference-in-DifferencesEstimates?"
M., DUFLO,
BERTRAND,
E., ANDMULLAINATHAN,
QuarterlyJournalof Economics,Vol. 119 (2004), pp. 249-255.
S. AND LAFONTAINE,F. "Double-SidedMoral Hazardand the Nature of Share Contracts."RAND
BHATTACHARYYA,
Journal of Economics, Vol. 26 (1995), pp. 761-781.
? RAND 2005.
LAFONTAINEAND SHAW /
149
D.L. "A Note on Incentive IncompatibilityUnder Franchising."Review of Industrial
BLAIR,R.D. ANDKASERMAN,
Organization,Vol. 9 (1994), pp. 323-330.
BOND,R. Bond's FranchisingGuide. Oakland,Calif.: SourceBookPublications,1997.
BRADACH,J.L. "Using the PluralFormin the Managementof RestaurantChains."AdministrativeScience Quarterly,Vol.
42 (1997), pp. 276-303.
J.A. ANDDARK,F.H. "The Choice of OrganizationalForm:The Case of Franchising."Journal of Financial
BRICKLEY,
Economics, Vol. 18 (1987), pp. 401420.
,AND WEISBACH,M.S. "The Economic Effects of FranchiseTerminationLaws."Journal of Law and
,
Economics, Vol. 34 (1991), pp. 101-132.
CAVES,R.E. AND MURPHY,W.F."Franchising:Firms,Markets,and IntangibleAssets."SouthernEconomicJournal,Vol.
42 (1976), pp. 572-586.
DANT, R.P., KAUFMANN,P.J., AND PASWAN,A.K. "OwnershipRedirectionin FranchisedChannels."Journal of Public
Policy and Marketing,Vol. 11 (1992), pp. 33-44.
DNES,A.W. "TheEconomic Analysis of FranchiseContracts."Journalof Institutionaland TheoreticalEconomics,Vol.
152 (1996), pp. 297-324.
GALLINI,NANCYT. AND LUTZ, N.A. "Dual Distributionand Royalty Fees in Franchising."Journal of Law,Economics,
and Organization,Vol. 8 (1992), pp. 471-501.
Journalof EconomicPerspectives,Vol. 12 (1998), pp. 115-132.
GIBBONS,R. "Incentivesin Organizations."
AND WALDMAN, M. "Careersin Organizations:Theory and Evidence."In O. Ashenfelter and D. Card, eds.,
Handbookof LaborEconomics, Vol 3b. New York:North-Holland,1999.
M. "BK to IncreaseNumberof Company-ownedUnits."Nation's RestaurantNews, June 22, 1998, p. 6.
HAMSTRA,
Canadian
HARRIS,R.G. ANDWIENS,E.G. "GovernmentEnterprise:An Instrumentfor theInternalRegulationof Industry."
Journalof Economics,Vol. 13 (1980), pp. 125-132.
B. ANDMILGROM,
P. "MultitaskPrincipal-AgentAnalyses: IncentiveContracts,Asset Ownership,and Job
HOLMSTROM,
Design."Journalof Law,Economics,and Organization,Vol. 7 (1991), pp. 24-52.
M.C. ANDMURPHY,
K.J."PerformancePay andTop-ManagementIncentives."In K.F.Hallock andK.J.Murphy,
JENSEN,
eds., The Economics of ExecutiveCompensation.Cheltenham:EdwardElgar, 1999.
KLEIN,B. "TheEconomics of FranchiseContracts."Journalof CorporateFinance, Vol. 2 (1995), pp. 9-37.
F "Agency Theory and Franchising:Some EmpiricalResults."RAND Journal of Economics, Vol. 23
LAFONTAINE,
(1992a), pp. 263-283.
."How and Why do Franchisorsdo What They do: A Survey Report."In PJ. Kaufmann,ed., Sixth Annual
Proceedings of the Society of Franchising.Universityof St-Thomas, 1992b.
. "ContractualArrangementsas Signaling Devices: Evidence fromFranchising."Journalof Law,Economics,and
Organization,Vol. 9 (1993) pp. 256-289.
AND BHATTACHARYYA, S. "The Role of Risk in Franchising."Journal of CorporateFinance, Vol. 2 (1995), pp.
39-74.
ANDKAUFMANN,
P.J."TheEvolutionof OwnershipPatternsin FranchiseSystems."Journalof Retailing,Vol. 70
(1994), pp. 97-113.
AND RAYNAUD, E. "ResidualClaims and Self Enforcementas Incentive Mechanisms in FranchiseContracts:
Substitutesor Complements."In E. Brousseauand J.M. Glachant,eds., The Economics of Contracts:Theoryand
Applications.New York:CambridgeUniversityPress, 2002.
AND SHAW, K.L. "FranchisingGrowth and FranchisorEntry and Exit in the U.S. Market:Myth and Reality."
Journalof Business Venturing,Vol. 13 (1998), pp. 95-112.
AND SLADE, M.E. "RetailContracting:Theory and Practice."Journal of IndustrialEconomics, Vol. 45 (1997),
pp. 1-25.
. "IncentiveContractingand the FranchiseDecision." In K. Chatterjeeand W. Samuelson, eds.,
AND
Advancesin Business Applicationsof Game Theory.Boston: KluwerAcademic, 2001.
LAL,R. "ImprovingChannelCoordinationThroughFranchising."MarketingScience, Vol. 9 (1990), pp. 299-318.
E. PersonnelEconomics.Cambridge,Mass.: MIT Press, 1995.
LAZEAR,
. "PersonnelEconomics: Past Lessons and FutureDirections."Journalof Labor Economics, Vol. 17 (1999), pp.
199-236.
LEWIN,S. "Innovationand Authorityin Franchise Systems: An Explorationof the Plural Form."Mimeo, Iowa State
University,1998.
LNA/MEDIA
WATCH.
Ad $ Summary. Variousyears.
LYONS,B.R. "EmpiricalRelevance of Efficient ContractTheory: Inter-FirmContracts."OxfordReview of Economic
Policy, Vol. 12 (1996), pp. 27-52.
R.E. "Franchisingand Risk Management."AmericanEconomicReview,Vol. 78 (1988), pp. 954-968.
MARTIN,
F.G. AND WINTER,
R.A. "TheEconomics of FranchiseContracts'.Journalof Law and Economics,Vol. 28
MATHEWSON,
(1985), pp. 503-526.
A.P. "AnEmpiricalAnalysis of a Firm'sDecision to Franchise."EconomicsLetters,Vol. 34 (1990), pp. 77-82.
MINKLER,
AND PARK,T.A. "Asset Specificity and VerticalIntegration."Review of IndustrialOrganization,Vol. 9 (1994),
pp.409-423.
? RAND 2005.
150 /
THE RAND JOURNALOF ECONOMICS
NORTON,S.W. "AnEmpiricalLook at Franchisingas an OrganizationalForm."Journal of Business, Vol. 61 (1988), pp.
197-217.
OZANNE, U.B. AND SHELBYD.H. TheEconomicEffectof Franchising.U.S. Senate,Select Committeeon Small Business.
Washington,D.C.: GPO, 1971.
C. "TheProvisionof Incentivesin Firms."Journalof EconomicLiterature,Vol. 37 (1999), pp. 7-63.
PRENDERGAST,
. "The Tenuous Trade-OffBetween Risk and Incentives."Journal of Political Economy, Vol. 110 (2002), pp.
1071-1102.
RUBIN,P. "TheTheoryof the Firmand the Structureof the FranchiseContract."Journalof Law and Economics,Vol. 21
(1978), pp. 223-233.
W.E. ANDPETTWAY,
S.H. "Caseof Big Mac's Pay Plans."HarvardBusiness Review,Vol. 52 (1974), pp. 30-46,
SASSER,
156-158.
FA. "Franchisingvs. CompanyOwnershipas a Decision Variableof the Firm."ReviewofIndustrialOrganization,
SCOTT,
Vol. 10 (1995), pp. 69-81.
R.S. "The FranchiseLife Cycle and the Penrose Effect."Journal of Economic Behavior and Organization,
THOMPSON,
Vol. 24 (1994), pp. 207-218.
UNITEDSTATES
DEPARTMENT
OFCOMMERCE.
Franchisingin the Economy,1986-1988. Washington,D.C.: GPO, 1988.
WULF,J. "InternalCapitalmarketsand Firm-levelCompensationIncentivesfor Division Managers."Journal of Labor
Economics, Vol. 20 (2002), pp. S219-S262.
? RAND 2005.