International

Franchising
Sara Lončarević & Klara Komen

International Business course (BDiB 4)

ABSTRACT:

This research looks critically into various different research papers on the topic of
International Franchising. Analysis includes relevant ongoing matter such as successful
examples of international franchising for the purpose of answering the main research
question on whether advantages of franchising outweigh the costs. The paper also
includes additional information and evidence that authors didn’t include in their
research, but were crucial to arrive to a conclusion. Ultimately, the conclusion servers
to present that benefits and costs of franchising differ among companies and markets
they are entering.
Table of Contents

1. Introduction............................................................................................................................ 1

2. Literature Review (Advantages) ............................................................................................ 3

Competitive Advantage .......................................................................................................... 3

Efficiency ............................................................................................................................ 3
Differentiation .................................................................................................................... 4

Innovation............................................................................................................................... 4

Avoidance Of Legal Costs ...................................................................................................... 4

Knowledge Transfer ............................................................................................................... 5

Literature Review (Disadvantages) ........................................................................................... 5

Potential Conflicts - The Agency Theory ............................................................................... 5

Institutional And Transaction Cost ........................................................................................ 7

Legal Expenses ....................................................................................................................... 8

3. Research Question Discussion ............................................................................................... 9

4. Conclusion ........................................................................................................................... 11

5. References ............................................................................................................................ 12

6. Appendix .............................................................................................................................. 14

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1. INTRODUCTION

The aim of this paper is to review the literature available on the topic of international
franchising and answer the question on whether advantages of this particular entry mode
outweigh the costs. This research highlights that international franchising greatly differs from
domestic franchising and requires unique set of skills and understanding. Franchising has
grown exponentially in recent years, particularly amongst hospitality and retail industry that is
nowadays seeking international expansion in both developed and emerging markets. (Brookes,
2018.). For this paper, we used several different research papers, reports, examinations, as well
as professional publicized articles from the Emerald, JSTOR and Science direct. To furnish our
analysis with examples we included several different websites and online encyclopedias.

Franchising is common in the United States where 782,573 franchising establishments

generated 8,834,000 jobs and an economic output of $892 billion in 2015. (IHS Economics,
2016.). The rise of international franchising has created a compelling need to better understand
the capabilities needed to establish a franchising contract. Amos (2001) believes “franchisors
must have a strategic plan that incorporates international opportunities as we move closer to a
global marketplace and global economy.” Although many scholars investigated business and
financial outcomes of franchising at the firm level, they paid little or no attention to the
association between franchising and the business environment more generally, as well as to
rapid alterations of environment in which both franchisor and franchisee operate.

To begin with we must define what franchising is, what forms of franchising exists, and why
do companies use franchising as their preferential entry form. Franchising is a subcategory of
licensing by which a focal firm (the franchisor) allows another entity the right to use the whole
business system in exchange for compensation. The parties sign contract that defines the
franchising relationship. The franchisor provides the franchisee with a trademark-protected
business concept and all else necessary for its implementation such as patents, training, know-
how, services and products. The franchisee, in return, compensates the franchisor through a
mix of lump-sum payment, down-payment and royalties, and other mark-ups and contributions.
Some companies use franchising as an entry strategy to expand internationally. Other
companies, however, prefer direct investment and expand using company-owned outlets,

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which allows them greater control over foreign operations, but slows the rate of their expansion
abroad (Cavusgil, Knight, & Riesenberger, 2014).

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2. LITERATURE REVIEW (ADVANTAGES)

COMPETITIVE ADVANTAGE

Many companies decided to choose franchising as an entry mode because it gives them
competitive advantages. Researches Sun and Lee (2018.) in their paper on “Competitive
Advantages of Franchising Firms and The Moderating Role of Organizational Characteristics”
divided these advantages into two main categories: efficiency improvement and differentiation
generation.

EFFICIENCY

Their study illustrates that franchising may improve by establishing economies of scale and
reducing monitoring costs. Economies of scale are reached once company manages to cut down
unit costs, and are considered crucial accelerator of efficiency. We mustn’t forget that high
level of efficiency generates high level of productivity which is a central aspect of countries
high long term standard of living as well as a basic source of national per capita income. Many
companies opt for franchising as an entry form because it requires relatively low capital
investment, while generating a business growth. This way companies can spread their
operations across borders and increase their production volume, making themselves
accountable for immense bargaining power. Bargaining power is the ability to dominate in
negotiation process, and is increased in a franchising operation comparing to that of a purely
company-owned operation. Company starts ordering vast levels of raw material and becomes
key customer of suppliers. To sum up, firms that are highly involved in franchising can achieve
greater efficiency than those with lower or no involvement in franchising.

One of the biggest expenses of any internalization mode is monitoring cost. Monitoring costs
are financial burdens of focal companies for supervising and monitoring operations in a foreign
subsidiary. According to authors these expenses can be reduced due to franchisees’ residual
claims on the operations. Franchisees’ profits are fully linked to the success of the business;
hence they are become extremely self-motivated to make their investment exceptionally
lucrative and beneficial. According to Business Insider “People with self-motivation can find
a reason and strength to complete a task, even when challenging, without giving up or needing
another to encourage them.” To conclude, franchisors might not need to monitor franchised
operations at all, which ultimately results in reduced costs, and thus increased efficiency.

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DIFFERENTIATION

According to Business Dictionary differentiation includes efforts to make a product or brand

stand out as a provider of unique value to customers in comparison with its competitors and
results in increased product and service quality, adaptation and innovation, advertising and
promotion, and location. As previously mentioned franchisees are extremely success oriented
because their outcomes depend on the success of their franchise, so it is in their best interest to
produce higher quality marketable products and services. Also, franchisors manage to leverage
the local market knowledge from franchisees, enabling them to adapt to the needs of local
customers. The combination of extreme profit desire and new knowledge of local market can
make less painless for franchisors to separate itself from its competitors. For example, one of
the biggest franchisor McDonald’s, made both Big Mac and Egg McMuffin, two of restaurant’s
most successful menu items, based on recommendations of its franchisees.

We all know the common answer on the question what are the three most important factors
affecting the success of the business? Location, location, location! Most of the time, service-
oriented franchisors have amazing business models but are lacking financial resources to invest
into prime locations and therefore cannot form enormous differentiation advantages. This way
financial capital supplied by franchisees can help franchisors overcome resource limitations
and achieve sustainable differentiation advantages.

INNOVATION

Being very fascinated with Sun and Lee’s previous work we decided to look into another
astonishing paper made by them “Effects of Franchising on Industry Competition” (2018)
where they focus on innovation as a key benefit. As previously mentioned local market
knowledge of self-motivated franchisees is essential for franchisors to establish successful
market-specific strategies. This new acquired knowledge enables franchisors to establish new
strategies and innovative business models. These innovations make franchisors take the lead in
the market competition and encourage the entire industry to be more innovative, thereby
driving changes in the competitive structure within the industry.

AVOIDANCE OF LEGAL COSTS

Companies that focus on home market bare huge administrative and legal costs. According to
David Holmes (2018.) they are exposed to claims for rescission, damages and attorney’s fees

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for deals. Registration as a franchise eliminates exposure to fees for arrangements in the future,
as well as some of the past ones with existing dealers.

Franchising laws are usually more protective over franchisor than franchisees, for instance:
● If Franchisees is to acquire equipment from external sources, fines or royalties are
charged, even if royalties are already paid beforehand fees are charged to make up for
lost revenue at the Franchisor/affiliate level.
● Although we mentioned the importance of self-motivation of franchisees, we must
emphasize that it’s not only the profits that they are losing if they do not meet
sales/product purchase quotas, they can lose their territorial rights, be terminated and/or
ineligible for renewal.
● Most importantly there is the existence of ‘friendly divorce’ - if a franchisor is not
happy with franchisees performance or if the franchisee didn’t meet franchisors
expectations, franchisor is allowed to cancel the agreement by returning the fee.

KNOWLEDGE TRANSFER

So far, we only looked into benefits for franchisor and completely neglected franchisee. We
won’t go into too much depth, but it is important to emphasize the knowledge franchisee
acquire from franchisor. Knowledge can be characterized as either explicit or tacit. According
to Brookes (2018.) in “Knowledge transfer and isomorphism in franchise networks”; Explicit
knowledge is easily codified and transferred through training, standard operating procedures
and detailed brand and operating manuals. Tacit knowledge is acquired contextually and
therefore requires in person learning. Both of these sources are complementary and on-going
because franchisor is concerned about the quality of the products and their brand image.

LITERATURE REVIEW (DISADVANTAGES)

POTENTIAL CONFLICTS - THE AGENCY THEORY

Many different authors have examined the agency theory and claim that an agency relationship
exists between franchisors and franchisees. The relationships between franchisors and
franchisees reflects those of principals and agents. In the principal-agent relationship, the agent
is to operate in the interest of the principal. The two separate entities, franchisor and franchisee,

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are co-operative but act independently and may in reality pursue different or even contradictory
goals (Asarpota, 2014). The agency theory also emphasizes the importance of information
transfer process and asymmetry along with the monitoring costs that arise from it (Doherty,
1998).

On the other hand, the agency problem can be solved by implementing franchises. By
franchising, principal (franchisor) delegates authority and ownership to the agent (franchisee),
as stated in the contract. This view does not hold when franchisees have an incentive to
purposely reduce quality of the franchised product or service by cutting costs, which benefits
the franchisee but hurts the franchisor as well as other franchisees. Franchising is therefore
considered as a choice between the costs of monitoring franchisees and the risk of free-riding
by franchisees (Jang & Park, 2018). This type of opportunistic behaviour is more likely in
international markets because of uncertainty resulting from economic, political and cultural
differences (Shane, 1998). When market conditions are difficult to predict, and when there is
high information asymmetry, agency costs are caused by potential shirking and free riding
(Doherty & Quinn, 1999). In support of the risk of agency costs, franchisees are independent
entrepreneurs that wish to improve the business of their unit, instead of the entire franchise,
and therefore might act opportunistic (Sashi & Karuppur, 2002). Also, owners and managers
of franchise units are more motivated to work efficiently than managers of company-owned
units, because managers of company-owned units receive fixed compensation (Fladmoe-
Lindquist, 1995).

Franchisors should implement support and monitoring to minimize the risk of franchisees'
harmful and opportunistic behavior. At the same time, franchisor must develop and provide
adequate infrastructure to support the operations of the franchisee in form of systems capital,
such as operation manuals, franchise contracts, IT (Information and Technology) systems, and
even head office structures (Jang & Park, 2018). Direct monitoring of franchisees as a solution
to the agency problem brings about considerable costs and proposed incentive alignment as a
better solution (Combs & Ketchen, 1999). Master franchising can address such agency
problems as ‘’ bonding, adverse selection, information flow, shirking, inefficient risk-bearing,
free-riding, and quasi-rent appropriation’’ (Garg & Rasheed, 2003).

Information asymmetry problem can be avoided if the company has knowledge built-in non-
tacit physical goods, which can be achieved by patents and transferred on the market. The

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problem of asymmetry persists if the company knowledge is tacit, i.e. cannot be described in a
patent and had to be transferred by people. In the franchise case, the agents have detailed
information of all of their operations while principals don’t have access to this information or
cannot interpret it (Doherty & Quinn, 1999).

INSTITUTIONAL AND TRANSACTION COST

Transaction cost occurs when a product or service is transferred across a technologically

separable interface (Williamson, 1975). Transaction costs arise every time a product or service
is transferred from one stage to another. Transaction costs theory views firms as ‘’efficient
agents who can provide them at a lesser cost than if these activities were performed in-house’’
(Chang & Rosenzweig, 2001). These costs can be monitoring costs, adaptation costs and
switching costs.

Every country is different in terms of attractiveness of their business environment for new
business development. The research of Hoffman, Munemo & Watson, 2016, was dedicated to
examining institutional and transaction cost of international franchise expansion. The study
includes effects of political, infrastructural and regulatory institutions and economic stability
on international franchise expansion. Hoffman, Munemo and Watson tested regulatory
institutions by entry regulations and taxes. The quality of these factors impacted the franchise
expansion. Regulation is necessary to reduce the cost of acquiring information on the market.
Too high entry regulations, on the other hand, increase the cost of entering into the market and
harms franchise expansion.

Business regulations have large effect on not only business growth but also general economic
development of a country. Certain institutions of a country increase the transaction costs for
companies that expand into that country. Companies' entry strategies are affected by
institutions such as government, laws and property rights, as their roles are to support activities
on the market and decrease costs for the companies. The costs of doing business in a specific
country is considerably lower when the country has strong institutions. Uncertainty about the
company's institutional environment is the greatest challenge in achieving transaction
efficiency. Public services provided by the political institutions can have a large effect to a
country's citizens and businesses. Those services are public utilities, legal system and conduct
of government offices and agencies. If these services are of low quality, it will be more costly

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for companies to conduct business activities. Consistency of government policies is also a very
important factor to companies because franchise contracts vary notably across countries.
Changes in government policies can therefore cause renegotiations of such contracts (Fladmoe-
Linquist, 1996). Also, companies choose to abide by these rules and expectations in the new
environment because it brings legitimacy (Dimaggio & Powell, 1983). Transferring the
managerial skills to partner companies in culturally different countries usually involves higher
transaction costs (Baena & Cerviño, 2014). On the other hand, franchising is a way of foreign
market entry that is prevalent, because of it has relatively lower transaction costs. It allows
companies to expand rapidly with a smaller capital outlay (Sashi & Karuppur, 2002). The
franchisee bears the cost as well as the risk of that market entry (Shane, 1996). Through the
use of local franchisees in possession of ‘’ valuable assets, such as, in-depth knowledge of the
local institutional environment, cultural customs, and business practises’’, new franchisees can
lower the risk and uncertainty of market entry (Hoffman, Kincaid & Preble, 2008).

LEGAL EXPENSES

The agreements (Uniform Franchise Offering Circulars) and related documents, which must be
filled in different states, can bring notable expenses. When a separate legal entity is used for
the franchising, additional costs incur. Compliance with the legal constraints is also vital,
because even small discrepancy between actions and conditions prescribed in the contract can
activate the automatic rescission right. Some states regulate conditions under which a
franchisor is allowed to terminate the agreement and prescribe technical requirements with
which the parties must comply (Holmes, 2018).

INITIAL INVESTMENT

In order to obtain a franchising agreement, the franchisee must face some initial and ongoing
costs. Initial costs include the non-refundable initial franchise fee. Initial investments by the
franchisee does not guarantee good performance (Klein, 1995). The franchisor is allowed to
collect an initial lump sum investment by the franchisee equal to the capital value of future
premiums. The payment of the lump sum is proven to have no effect on the franchisee’s
behavior. The lump sum payment does not guarantee that the franchisee will perform as the
franchisor desires. Once paid, it becomes a sunk cost, and is irrelevant to whether or not the
franchisee decides to perform.

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3. RESEARCH QUESTION DISCUSSION

Our study investigates whether advantages of franchising outweigh the costs. Let’s first start
by looking closely into the study of Sun and Lee (2018.) on franchising generating competitive
advantages in terms of efficiency and differentiation. To recap, authors suggest that efficiency
can be reached through the expansion of customer base by entering the foreign market, with
avoidance of capital and legal investments. The increase in demand generates bigger orders of
raw material, which finally results in a boost of bargaining power with suppliers, hence increase
of economies of scale, productivity and efficiency. On the other hand, the authors state that
franchisees are motivated to reach high degree of revenue and share their knowledge of the
market with franchisor. The mix profit driven franchisees and new knowledge of local market
makes it easier for franchisors to separate itself from its competitors, simply to differentiate.

Researchers analysis is extremely comprehensive and thorough, although incomplete with

some data, such as looking into different regions of the world and analyzing their proneness to
specific alternatives. Different authors, Hoffman and Preble (2018.), examined what countries
see as a bigger franchising competitive advantage: differentiation or efficiency. The authors
use survey and archival data to describe the state of franchising in 40 countries in North and
South America, Europe, Asia and “Africa/Oceania”, which covers Australia, New Zealand,
Egypt and South Africa (table1). Globally, the best opportunities are for franchisors reaching
highest levels of efficiency by offering a low-cost product (35 percent), this is followed closely
by differentiating by offering a unique service (33 percent), a product combined with a service,
a unique product (18 percent), and lastly a low-cost service (15 percent). However, as we can
see from the table, international economic opportunities appear to be especially abundant for
the franchisors offering a low-cost product. However, we can tell that franchisor find this mode
of internalization extremely beneficial.

We know that the number one asset that every firm has is its employees. Why? Because they
leverage knowledge and lead to innovation. Sun and Lee (2018.) argue that since franchisee’s
managers are already self-motivated they are more prone to risk and implement innovative
concepts in order to make their franchisor’s products stand out from the crowd. Complying
with authors thoughts we looked into successful examples of differentiation in franchising. To
begin with it is important to emphasize that there is nothing wrong with doing something that
has already been done before as long as the innovation is it better, faster, or cheaper.” It opened

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in 1986 and until 2013 it did not use any publicized marketing. Although they were opening
hundreds of restaurants (franchisees) yearly, the sales weren’t as rapid as before. Franchisees
suggested investing into advertising and the sales grew heavily since then.

The majority of research by various authors focuses on agency costs and transaction costs when
discussing the downsides of international franchising. A few also mention legal and initial costs
but to a lesser extent. Both agency theory and transaction cost theory talk about the risks arising
from franchising and address the need of the principal (franchisor) to monitor and control the
agents (international franchisee units). These actions are necessary to minimize or prevent costs
arising from opportunistic and self-interest driven behavior. There is substantial risk connected
to expanding to international markets because of the political, economic, and cultural
differences. Information asymmetry should be mitigated by establishing patents to facilitate
the transfer of knowledge, but significant monitoring costs can still arise if the franchisors have
incomplete information about the franchisee units abroad. There are conflicting findings about
the extent of agency costs in modern international theory, and some authors find that concept
exaggerated and outdated. Legal expenses also vary in different countries, and compliance with
the legal system is crucial from the incoming companies. Initial investments are seen as costs
to the franchisees, which can be imposed by the franchisors and then cannot be avoided. The
overall consensus is that the ultimate success of the franchise programs is not solely determined
by transaction costs and agency costs. What impacts the success of franchises more are the
complementary resources and capabilities of potential partners (franchisees and stakeholders)
located in international markets.

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4. CONCLUSION

The debate on the profitability of International Franchising offers valuable theoretical insights
on international entry modes and can serve as a starting point for students and entrepreneurs
with an interest in the current situation of international business. To sum up, we looked into
competitive advantages in forms of efficiency and differentiation, put an emphasis on relevance
of knowledge transfer and innovation, as well as avoidance of legal and regulatory costs. On
the other hand, we made a thorough investigation on agency theory and highlighted the
potential conflicts that may arise, as well as weighted the soaring transactional costs and legal
expenses, along with the rate of initial investment.

We looked into numerous astonishing papers, that were extremely comprehensive and
thorough, although incomplete with some data, crucial to arrive to a conclusion. As discussed
in the paper, we would like to emphasize that there is no single answer to inquiry on whether
benefits of franchising outweigh the costs. Every company comprises of different resources,
operates in different industries, is affected by different environments, complies to different
rules and regulations etc. Companies must make comprehensives internal and external
investigation before considering any entry mode, especially today when firms’ environment is
rapidly changing. The uncertainty about the future of openness of the world in terms of trade
and political cooperation emerged and grew into a concern of those that are considering
expanding their businesses internationally. Finally, it is important to point out that the success
franchising depend on complementary resources and capabilities of potential partners
(franchisees and stakeholders) located in international markets, as well as their ability to adapt
to constantly changing environment while acquiring new skills and reaching highest levels of
efficiency.

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5. REFERENCES

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● Hoffman, R., Preble J., (2018.) - Global franchising: current status and future
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6. APPENDIX
Table 1 GLOBAL FRANCHISING OPPORTUNITIES

SOURCE: Hoffman, R., Preble J., (2018.) - Global franchising: current status and future challenges, Journal of Services Marketing, Volume
18, Number 2, 101-113

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