Relationship between Risk and Incentives in Franchise Contracting

Abstract

The relationship between risk and incentives in franchise contracting is still an unsolved issue in the literature. According to the standard principal-agent model, a trade-off emerges between the franchisee's protection against risk and incentive motivation. Contrary to this traditional view, we argue that the relationship between risk and incentives can be positive. In franchise contracting, this implies that the royalty rate decreases with risk. Using a unique panel dataset combining French franchise and financial data, we address this issue empirically and analyze the impact of a risk- and incentive-adjusted royalty rate on performance. The data support the hypothesis of a negative relationship between risk and the royalty rate, which contradicts the standard prediction of the agency theory. Furthermore, the estimation of random effect models provides evidence that chain performance increases with a risk- and incentive-adjusted royalty rate.