MORAL HAZARD, ASSET SPECIFICITY, IMPLICIT BONDING, AND COMPENSATION: THE CASE OF FRANCHISING

I. INTRODUCTION There is a large and growing interest in the structuring of compensation to deal with the moral hazard problem. Much of this literature treats various forms of income sharing, such as piece rates and sharecropping, as a means for a principal to provide incentives to an agent. This literature has been extended to the case of two-sided moral hazard where both parties to an exchange may shirk. Another mechanism to induce effort discussed in the literature is bonding, where workers post a bond that is forgone if effort is inadequate. Klein [1980] and Klein and Leffler [1981] treat the possibility of specific assets as constituting an implicit bond, where poor performance by a firm is penalized by bankruptcy and sale of assets at a loss. This paper studies a situation where these issues coalesce: the case of compensation arrangements in franchising. The typical franchise contract calls for the sharing of franchise income between franchisee and franchisor. Additionally, franchisees may be terminated for poor performance. If franchise assets have a degree of specificity, the ensuing sale of assets at a loss provides a penalty for poor performance. We examine the determinants of franchise royalty rates and fees in this setting. While there is a literature on two-sided moral hazard and some empirical work on franchising based on this idea, none incorporates the potential influence of asset specificity. We explicitly consider the role of implicit bonding and asset specificity in conjunction with moral hazard on the part of both trading parties. We go beyond previous work in franchising by estimating the effects of asset specificity and other influences on the royalty rate. Further, part of our empirical work utilizes improved micro data on actual franchise contracts. Our approach and its implications are discussed in section II. Consistent with previous work, we expect the royalty rate to decrease (increase) as the importance of the franchisee's (franchisor's) input increases. However, more specific capital, with the threat of termination, acts as an implicit bond and substitutes for a reduced royalty rate in inducing franchisee effort. Thus, we expect royalty rates to increase with asset specificity. Also, unlike other approaches, we do not necessarily expect an inverse relationship between the royalty rate and the franchise fee. For example, the greater the importance of franchisor effort the higher the royalty rate, but the franchise fee may also increase if franchise revenue rises by enough. Our hypotheses are tested using two different data sets. An original, firm-level data set is taken from Federal Trade Commission (FTC)-required Uniform Franchise Offering Circulars (UFOC).(1) In addition, data are obtained from Bond's 1989 The Source Book of Franchise Opportunities. The data are discussed and the results presented in section III. We find substantial support for our approach. For example, factors that increase the importance of the franchisee's effort, such as the number of employees supervised, lower the royalty rate and increase the franchise fee. Also, a reduction in the specificity of the franchisee's investment due to leasing lowers the royalty rate and raises the franchise fee.(2) Section IV summarizes our findings and concludes the paper. II. THE APPROACH AND THE HYPOTHESES The typical franchising contract consists of a two-part payment by the franchisee to the franchisor. The franchisee pays an up-front, nonrefundable franchisee fee and a continuing royalty payment, usually a percentage of sales. In return the franchisee receives the right to use the franchisor's brand-name capital and a method of operation. In addition, the franchisor provides on-going support to the franchisee. However, the franchisor maintains the right to unilaterally terminate the contract if the franchisor determines that the franchisee is not delivering a product consistent with the quality guaranteed by the brand name. …