Reciprocal Use of Real Options in Franchise Agreements

Helle Gregersen & Tina Aae Jeppesen

Student thesis: Master thesis

Abstract

When a business party wants to expand the business to new national or international markets, franchising is one way to do it. When two parties enter into a franchise agreement, the contract will determine the allocation of risk and earnings. Due to the franchisee being the risk averse party in the partnership and the franchisor being risk neutral, conventional franchise contracts have some imbalances since the franchisee holds all the risks. Studies have shown that the introduction of real options in other types of agreements can reduce the real option’s owner’s risk of expanding to new markets, by giving the owner the right to take over or abandon a (newly established) business after a giving period. This thesis studies how the introduction of real options can contribute to reach strategic contracting between the parties, and what effect it may have on the franchise parties’ risk and profit opportunities. In particular, the reciprocal use of real options – where there is an exchange of call and put options between the franchisor and franchisee – can improve the allocation of risks and earnings in the franchising agreement. The study is based on the business law method that combines economic and legal perspectives, using economic theories to qualify the content of a legal franchise contract. Thus, it is analyzed which legal safeguards Danish franchise agreements possess and how the introduction of real options will affect the franchise parties’ incentives. It is concluded that both franchise parties have the opportunity to improve the partnership by introducing real option reciprocity into their franchise partnership despite the increased transaction cost. This is seen by an increase in the franchisor’s expected payoff and utility as well as in the franchisee’s expected utility (depending on the specific structure of the real options). Furthermore, implementation of real options eliminates many of the complications identified in conventional contracting. Such improvements give both parties an incentive to introduce real options due to the different risk preferences of the franchise parties. Additionally, the authors touch upon how alternative clauses can improve the contract in terms of reaching strategic contracting, however, this will again add additional transactional costs.

EducationsMSc in Commercial Law, (Graduate Programme) Final Thesis
LanguageDanish
Publication date2019
Number of pages124
SupervisorsBent Petersen & Kim Østergaard