Real options in franchise contracting: an application of transaction cost and real options theory

Ilir Hajdini,Josef Windsperger

doi:10.1007/s10657-020-09665-3

Abstract

Previous research has not explained the use of real option clause in franchise contracting. The real option clause has two economic functions: To reduce transaction costs by mitigating opportunism risk and to increase strategic rents by exploiting the profit potential from future upside opportunities under uncertainty. We argue that franchisors will more likely use a real option clause (ROC) in franchise contracts under high behavioral uncertainty, high franchisors’ transaction-specific investments relative to franchisees’ and long contract duration. In addition, by combining transaction cost theory and real option theory, our study provides a new explanation for the impact of environmental uncertainty on the use of ROC in franchise networks by showing that there exists a U-shaped relationship between environmental uncertainty and the franchisor’s use of ROC. Overall, the data from German and Swiss franchise systems provide support of the research model.

Highlights

Firms choose different governance structures to safeguard their specific investments and exploit profit opportunities under uncertainty
Our study provides a new explanation for the impact of environmental uncertainty on the use of real option clause (ROC) in franchise networks by showing that there exists a U-shaped relationship between environmental uncertainty and the franchisor’s use of ROC
We find that the proportion of company-owned outlets shows a positive effect on ROC supporting the view that a high Proportion of company-owned outlets (PCO)—as proxy for a strong brand reputation—requires more contractual control

Summary

Introduction

Firms choose different governance structures to safeguard their specific investments and exploit profit opportunities under uncertainty. Previous research has mainly applied transaction cost theory (TCT) to show that hierarchical structures are more efficient to preserve transaction-specific investments in presence of contractual hazards (Williamson 1985, 1991; Gatignon and Anderson 1988; Zhao et al 2004). A higher level of control facilitates coordination under increasing environmental uncertainty and protects firms’ interests in preserving transactionspecific investments from possible exploitation (Zhao et al 2004). Under a high level of uncertainty, it is more valuable for the firm to obtain real options, which offer the right to increase equity investments when upside opportunities arise (Trigeorgis and Reuer 2017)

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Discussion

Conclusion