The Incentive Structure in Franchise Operations: Problems and Solutions

Frederik Keil Bruhn & Kim Ammitzbøll Nielsen

Student thesis: Master thesis

Abstract

When using conventional franchise contracts as the contractual foundation of a franchise operation, a franchisee is inclined to engage in free-riding activities on behalf of the franchisor’s brand. However, the franchisor can implement measures such as monitoring, which intend to decrease the franchisee’s willingness to free-ride. Even though measures such as monitoring can be implemented, the franchisee’s incentive to perform and to invest in relation specific assets is still not improved. This is because the franchisee fears the franchisor’s hold-up, which is defined as the franchisor’s desire to take over the franchisee’s business in case it is sufficiently profitable. Measures such as monitoring, actually increase the risk of a franchisor’s hold-up. In turn, this has a negative effect on the franchisee’s incentive to perform, as a good performance will result in the franchisor taking over the given market. Even if the franchisee underperforms, he is at risk of the contract being terminated. Therefore, the franchisee finds himself in a termination dilemma. It can be argued that hold-up safeguards must be included as part of the contractual obligation between a franchisor and franchisee in order to solve the hold-up and free-riding problems. Therefore, we analyse whether applicable law provides such hold-up safeguards, which can improve incentives to perform in the franchise relationship. However, franchising is not subject to special regulation in Denmark and the general regulation does not provide any useful hold-up safeguards. This leaves it to the parties to regulate the hold-up problem in the franchise contract. Instead of applying a conventional way of contracting which leads to hold-up and free-riding problems, we hypothesize that the parties can apply a strategic approach to the contract. By so doing and taking the diverging risk preferences of the parties into account, much is to be gained for both the franchisee and franchisor. The strategic approach incentivises the parties to adopt the use of reciprocal options. By applying such options, the franchisee can expect compensation, both in case of good and bad results, which allows him to invest in relation specific assets and perform at a high level. We conclude that the use of contractual options in franchising will contribute to solving the hold-up and free-riding problems. Furthermore, reciprocal options can potentially improve the contractual risk allocation problem and thereby incentivise the franchisee to invest in relation specific assets. Last, we discuss the introduction of shoot-out clauses as a mechanism that might also be to the benefit of the parties. However, the application of shoot-out clauses comes with many difficulties that lead to the disappointing result of them not being applicable in order to solve hold-up and free-riding.

EducationsMSc in Commercial Law, (Graduate Programme) Final Thesis
LanguageDanish
Publication date2019
Number of pages128
SupervisorsKim Østergaard & Bent Petersen