Franchisers Protect Valuable Brands Through Higher Company Ownership
STANFORD GRADUATE SCHOOL OF BUSINESS—Companies that spend heavily on advertising to build their brand's reputation own a higher percentage of franchise outlets for that brand as a way to protect its reputation, say researchers. Moreover, contrary to popular belief, the proportion of outlets of a given brand owned by the franchise firm stabilizes within the first decade of the firm's entry into franchising and then remains steady.
"What's really clear from this research is that franchising firms tend to choose a targeted percentage of outlets that they want to operate themselves, and they stick with that," said Kathryn Shaw, the Ernest C. Arbuckle Professor of Economics at the Stanford Graduate School of Business.
She and co-researcher Francine Lafontaine of the University of Michigan examined more than 1,000 franchisors between 1980 and 1997 and found that companies rarely change their proportion of company ownership after the first seven years of franchising. The researchers then linked the amount spent on brand advertising to the percentage of franchises sold to outsiders and found what Shaw called a "very, very strong relationship" between media expenditures and company ownership.
Across industries, about 15 percent of franchise outlets are company-owned. But this varies considerably by industry and by individual firms. Specifically, franchisors with aggressively advertised brands—such as Hertz or Pizza Hut—tend to have much higher rates of company ownership. For example, among car rental agencies, Hertz is 66 percent company owned, compared with Dollar, which is only 2 percent company owned. Pizza Hut is 50 percent company owned, compared with Shakey's Pizza Restaurant, which is only 7 percent company owned.
"If your brand value is very high, you've put a lot of media expenditures into trade name value, and you therefore want more company-owned outlets so you can better control quality," said Shaw.
Franchisors are guarding against free riders—outlets not owned by the company that might be tempted to sacrifice quality and rely on the power of the brand rather than their own performance to attract customers. Some types of outlets are more at risk than others. For example, the franchise owner of a fast-food outlet located on a highway—which traditionally would have very little repeat business—has very little incentive to pay attention to serving customers who are unlikely ever to visit again. Such a franchisee might be tempted to draw customers solely on the value of the brand without "giving anything back" to the franchisor through a well-run outlet.
"When we see the name McDonald's, we feel guaranteed that we will get something known, something acceptable, as perhaps opposed to a fast-food outlet located right next door that we've never heard of," said Shaw. "But with free riding, a franchisee running a McDonald's outlet could dramatically cut costs by reducing staff and therefore quality, and still get a free ride on the brand name, banking on the efforts of all the outlets that have maintained quality."
The hypothetical fast-food outlet on a highway would reduce the risk of free riding by being owned by the franchisor who wants to protect the brand. In contrast, a franchisee located in a small town would be more inclined to provide higher quality of service to generate repeat business, said Shaw.
At issue is the art of correctly aligning incentives to maximize shareholder value. "What we like about franchising is that the model offers some very high-powered incentives to maximizing outlet profitability," said Shaw. "On the other hand, the franchisor has to guard against franchisees that attempt to maximize the profitability of their own outlets to the detriment of the brand in general."
For example, a franchise chain might advertise that its shops sell fresh donuts every day, and require that franchisees throw away day-old donuts. But throwing those away is costly to the franchisee—so the franchisee might choose to sell them anyway. Customers who are served day-old donuts may therefore come to expect that from this chain, thus damaging the overall brand's reputation.
One franchisee who chose to ignore franchisor policies about product quality and cleanliness was Raymond Dayan, the owner of the French franchise license for McDonald's. By 1982, Dayan had 12 restaurants in Paris but blatantly ignored the company's strict specifications on food products, including the quantity and quality of ingredients. In addition, he held food so long and served it so cold that McDonald's managers sent to inspect the stores found it difficult to eat. Although these shortcuts allowed him to save on costs, the reputation of the chain suffered. Ultimately, McDonald's, with the court's support, terminated his license.
One of the surprising results of the study was how little companies changed their percentage of company ownership over time. Company ownership drops dramatically for the first eight years, then it tends to level out. "During the beginning years of a franchisor, company ownership has to fall, by definition," she said. "So you go from 100 percent company ownership quickly downward as franchises get added. But at some point the proportion of company-owned to franchised outlets stabilizes, and it tends to remain stable from that point on. In other words, franchising firms both open and close down both types of outlets from that point on and thereby preserve their mix."
Targeting Managerial Control: Evidence from Franchising
Francine Lafontaine and Kathryn L. ShawThe Rand Journal of Economics, Spring 2005