Contractual Discrimination in Franchise Relationships

Abstract

• Franchisors strategically modify contracts for new franchisees (contractual discrimination). • Positive discrimination reduces existing franchisees perceptions of equity. • Reduced perception of equity increases freeriding and hurts performance. • Greater number of existing franchisees worsens franchisor performance. • Negative discrimination reduces freeriding, increases performance only for more franchisees. Franchisors often modify the contract terms offered to prospective (new) franchisees – to incentivize growth in the number of franchisees, to access capital, or to improve their financial performance. We argue that changes in contract terms offered to new franchisees (contractual discrimination across franchisees) can alter existing franchisees’ perceived equity in their relationship with the franchisor, and affect their freeriding. Specifically, we hypothesize, and show, that positive (negative) discrimination towards new franchisees reduces (maintains) existing franchisees’ perceived equity in their relationship with the franchisor, motivating existing franchisees to increase (eschew) freeriding – with impact on franchisors’ performance. To do so, we first take advantage of an exogenous event (the great recession of 2007-09) to study how 120 restaurant franchisors changed their contract terms to new franchisees and how that affected their post-recession net income (Study 1). We show that changes in contracts for new franchisees impact franchisors’ post-crisis performance, as a function of the number of existing franchisees. Second, with two experiments (Studies 2 and 3) with entrepreneurs and franchisees, we document that the observed changes in performance occur because contractual discrimination affects existing franchisees’ perceived equity and their intentions to free-ride. Thus, we contribute to the literature on equity in franchising relationships, on contract evolution in franchising, and its impact on financial performance.