Franchise Contracting with Debt Financing and Bankruptcy Risk

Abstract

We solve a sequential-moves game that involves three players: the franchisor, the entrepreneur, and the banks. The franchisor chooses values of contract terms (a one-time franchise fee and a royalty rate for on-going payments). The entrepreneur dynamically decides when to sign this contract and open a store, applying for debt financing to cover the initial investment. In response to the entrepreneur’s application, banks competitively determine loan rates. We find that the franchisor should use royalty cash flows and not franchise fee to extracts value from the entrepreneur. This is a new explanation of an empirical evidence that franchise contracts favor royalties over fees. To account for the possibility of the entrepreneur’s bankruptcy and bankruptcy costs, the franchisor should decrease royalty rate. However, despite lower rate, the threshold for the entrepreneur to open the store is higher in the model with financing than in the model without financing. This threshold is much higher than it would have been for the integrated system, which in turn is higher than the static break-even-NPV threshold. If a franchisor ignores financing considerations, she will suffer from having to wait longer for a store opening and from a higher entrepreneur's bankruptcy probability. We predict that the franchisor is the main beneficiary of the entrepreneur's greater initial wealth and that the franchisor will benefit if she assumes a greater share of the store's operating costs.