The Structure of Ownership Rights in Franchising: An Incomplete Contracting View

Abstract

The paper offers an explanation for the structure of ownership rights in franchising networks which emphasize the role of intangible assets. By applying the incomplete contracting theory of the firm we argue that the structure of ownership rights depends on the distribution of intangible assets between the franchisor and the franchisee. The higher the franchisor's (franchisee's) intangible assets relative to the franchisee (franchisor), the more ownership rights should be transferred to him. This hypothesis was tested by using data from the Austrian franchise sector. The empirical results are supportive of the hypothesis. 1. Problem The franchise relation involves the sharing of intangible assets between the franchisor and the franchisee, i.e., the brand name of the franchisor and the local know-how of the franchisee. These assets represent proprietary knowledge that cannot be easily transferred because investments in such assets are costly if not impossible to observe and monitor (Teece 1980). The franchisor faces the problem of maximizing the returns to his intan- gible assets when they are dependent on local intangible investments of the franchisee. Therefore, substantial residual risk for local outlets is borne by the franchisee who has the residual rights of control of the local promotion and services. Since these investments cannot be specified in the contract, asset ownership is critical to the market success of the product or service. The present article focuses on a property rights explanation of the ownership structure in franchising networks by emphazising the role of intangible assets as determinant of ownership structure. By applying the incomplete contracting theory of the firm (Hart and Moore 1990; Hart 1995) we argue that ownership should be given to the franchisee when he has to make intangible investments that generate a large fraction of residual income. Ownership increases the bargaining power concerning the division of residual income and therefore gives incentives to make intangible ex ante