A study on behalf of Flavors of Spain

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December 2013

University of Groningen

Faculty of Economics and Business

MSc Business Administration – Small Business & Entrepreneurship

Thesis supervisor: C.H.M. Lutz PhD Second supervisor: E.P.M. Croonen PhD

Author: T.B. van het Ende Student number: s2032724

E-mail: T.B.van.het.Ende@student.rug.nl T.B. van het Ende

Developing and maintaining a

harmonious franchising relationship

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Chapter 1 - Introduction

1.1 Research objective

This thesis is written on behalf of Flavors of Spain, a new venture that entails a combination of retail and hospitality services, inspired by Spanish market halls. Two experienced entrepreneurs are planning to launch a pilot-store in the south of the Netherlands and grow the formula through franchising in short term. In order to assist the entrepreneurs with their business plan, this study is intended to cover one of the main topics concerning the successful development of a new franchising system; the franchisor-franchisee relationship. It will examine existing franchising literature in order to develop a model of dynamic franchising relationship management. Next, the model will be verified at two relevant case franchising systems and ultimately serve to provide recommendations for Flavors of Spain.

According to Shane and Spell (1998), roughly three quarters of all new franchising systems fail within the first twelve years of operation and over half of new franchisors cease to franchise during the first four years (Shane, 1996). Findings of the study on franchisee survival by Bates (1997) suggest that new and small franchisees are more likely to discontinue operations than independent start-ups. Also, the survival patterns of new franchisors largely mirror those of conventional small businesses, with high attrition rates in the formative years, rather than being a sure-fire recipe for success (Stanworth, Purdy, English & Willems, 2001). After all, the majority of new franchising systems are in fact themselves small businesses, obliged to develop the management and administrative structures normally associated with a medium-sized business, but often without the income levels accompanying this scale of business.

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recommendations on how a new franchisor like Flavors of Spain can develop and maintain a harmonious relationship with its franchisees.

The main goal of this thesis is therefore to provide Flavors of Spain with these recommendations, based on existing literature and verified at two relevant franchising systems in the Netherlands. In order to achieve this goal, this thesis will start off by examining the nature of the complex relationship between franchisor and franchisee. The first step is to discuss the reasons a firm chooses to franchise and thereby to engage in a relationship with franchisees. The reason for franchising is the most debated topic in franchising research (Elango & Fried, 1997) and this thesis will outline the most important theoretical milestones. Although it is written from the perspective of a franchisor that has already made the decision to franchise, the theories that explain the franchising decision are considered important for understanding the nature of the franchising relationship.

Next, this thesis will discuss the areas of conflict in the franchising relationship and the potential consequences of conflict. This will enhance understanding of the importance of franchising relationship management. The next step is to examine various variables that are known to be important in preventing conflict and opportunistic behavior. These will be used to develop a conceptual model of franchising relationship management by the franchisor, containing the most important constructs of harmonious franchising relationships.

Recognizing that high quality relationships are an important antecedent of franchisee and franchisor success, franchisors should strive for stability on a high level. To achieve this, it is important to note that expectations and valuations of the franchisee towards its franchisor may vary during the relationship life-cycle. Consequently, the franchisor should take different measures in each of the life-cycle phases in order to effectively manage the relationship (Blut et al, 2011). Researchers have shown increasing interest in the way the franchising relationship progresses through time. The franchisor-franchisee relationship is often compared with marriage or parenthood, because the relationship shows different phases in which different approaches to manage the relationship are necessary. Therefore, the next goal is to supplement the examination of franchising relationship theory with an examination of existing franchising lifecycle theory. Insight in the franchising relationship lifecycle is expected to contribute to the dynamic character of the model, considering the nature of current franchising relationship literature is usually static. By discussing which approaches and measures are required during the different phases of the franchising relationship, the research model becomes particularly interesting for a future franchisor like Flavors of Spain, which has yet to go through all phases.

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1.1.1 Main research question

Even if the franchisor meets the expectations of its franchisees during the honeymoon phase, as the entrepreneurial enthusiasm begins to diminish it is hardly possible to avoid a downturn in the phases that follow. Nevertheless, if the franchisor anticipates the changing expectations of the franchisee, measures can be taken to reduce the magnitude of the downturn and to stabilize and sustain the relationship during the franchising lifecycle (Blut et al, 2011). In short, realizing a harmonious franchising relationship during the honeymoon phase is relatively easy. To sustain this relationship through the following phases is the real challenge. Therefore, the main research question of this thesis is: How can Flavors of Spain develop and maintain a harmonious relationship with its franchisees?

Several sub-questions have been developed to support the main research question.

1.1.2 Sub-questions

- What is franchising and why do firms choose to franchise?

- What is the nature of the franchising relationship and what are the areas of conflict? - What are the potential consequences of conflict in the franchising relationship? - What are the most important antecedents of harmonious franchising relationships? - What are the various phases of the franchising relationship life-cycle and how do

these affect the relationship?

- How does Oil & Vinegar manage the relationship with its franchisees? - How does DA manage the relationship with its franchisees?

The performance of the entire franchising system is strongly dependent upon the coordination and cooperation between franchisor and franchisees (Pitt, Napoli & Van der Merwe, 2003). The careful harmonization of the franchising relationship, serves to minimize the risk of franchisee default; a persistent hazard which can severely impair the value of a franchise (Davies, Lassar, Manolis, Prince & Winsor, 2011). Key to managing the relationship is a thorough understanding of the most important variables that influence the harmony of the franchising relationship. In this regard, a conceptual model of franchising relationship management is developed.

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then explained and the results from the case study are presented and discussed. The thesis concludes by highlighting the key findings of the study, followed by recommendations for Flavors of Spain. Finally, research limitations and suggestions for future research are considered.

1.2 Definition of franchising

Franchising is an important means of doing business for many entrepreneurs. Its role in the growth of global entrepreneurship and new ventures in a variety of industries should not be underestimated (Kidwell, Nygaard & Silkoset, 2007). Moreover, its importance in the provision of services, jobs and self-employment opportunities continues to increase (Stanworth, Stanworth, Watson, Purdy & Healeas, 2004). For many entrepreneurs, franchising provides the best of both worlds. It includes large company advantages such as economies of scale in marketing and production, while also providing for small business advantages at the unit level.

The term ‘franchising’ has various meanings in different research disciplines, including economics, law, management, marketing, and management science (Elango & Fried, 1997). It is therefore important for this thesis to discuss the different forms of franchising as distinguished in literature and to provide a clear definition.

Combs, Michael and Castrogiovanni (2004) discuss that, commensurate with its economic importance, franchising has captured the attention of a wide array of researchers. Whereas there are advantages of attracting scholars from many academic disciplines, an important disadvantage is the lack of a uniform definition of what franchising entails. Strategic management sees franchising as an organizational form, while it is seen as an important distribution channel from the perspective of marketing. Also, franchising is seen as a vehicle for entering business ownership from the perspective of entrepreneurship research (Shane & Hoy, 1996). In order to create a more uniform view of franchising, researchers have begun to take stock of this ever-growing research field by providing literature reviews that attempt to draw appropriate conclusions and guide future inquiry (Combs et al, 2004).

The study of Elango and Fried (1997) takes a broad view by reviewing research on franchising’s role in society, the reasons firms engage in franchising and the way franchisees are managed. They define franchising as an organizational form in which a company grants an individual or another company the right to do business in a prescribed manner over a certain period of time in a specified place in return for royalties or the payment of other fees.

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under the franchisor’s trade name to produce and/or market goods or services according to a format specified by the franchisor. This latter definition covers most modern varieties of franchising and no barriers appear to exist to incorporating quasi-forms (Stanworth et al, 2004).

Kneppers-Heijnert (1988) distinguishes three most important forms of franchising: - Product-distribution franchising

- Trade mark franchising - Business format franchising

However, the first two types are not considered to be franchising in the Netherlands. The use of the term ‘franchising’ is restricted to business format franchising in the Netherlands (Croonen, 2006). Internationally, business format franchising has also become the distinctive mode that most clearly differentiates franchising from other distribution models (Lindblom & Tikkanen, 2010). The distinguished feature of such business format franchising is that the franchisor offers a complete business format to the franchisees. The franchisor is therefore expected to provide the franchisees with all of the elements necessary to operate the business (Sorenson & Sørensen, 2001).

Business format franchising is also the type of franchising Flavors of Spain intends to apply. Therefore, this thesis focuses on business format franchising and uses the following definition of Davies et al (2011) for the term ‘franchising’.

Franchising involves an organizing firm (as franchisor) selling a proven business format that entitles a semi-autonomous franchisee to the rights to market goods or services under the organizer’s brand name.

Under business format franchising, franchisees not only sell the franchisor’s products or services (with the franchisor’s trademark), but also run the business according to a system provided by the franchisor. The franchisees thus obtain the use of a system and support (including training and mentoring) provided by the franchisor, but the franchisees are usually required to follow the franchisor’s operating norms (Lindblom & Tikkanen, 2010).

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Chapter 2 – Theoretical framework

2.1 Reasons for growth through franchising

The most discussed topic in franchising research is the reason why firms choose to grow through franchising, rather than expand through company-owned units. This thesis draws together much of this research by discussing the two key theories used to explain franchising; resource scarcity and agency theory. The first step is to understand why firms choose to grow in the first place.

New and small franchising systems lack many of the economies of scale that are available to larger systems, such as those in purchasing, administrative overhead and promotion (Shane, 1996). Since economies of scale exist in many activities in which franchisors engage, the larger the franchising system is, the lower the per-unit cost of operation (Martin, 1988). Especially when new franchisors enter industries with established competition, it is important that they quickly grow to a size at which they can operate at a competitive cost (Shane, 1996). Until they reach this minimum efficient number of outlets, new franchising systems have a competitive disadvantage. Similarly, Combs and Castrogiovanni (1994) state that rapid expansion may be essential to build the economies of scale in purchasing and advertising necessary to compete effectively against more established firms. Oxenfeldt and Kelly (1969) argue that this need to achieve economies of scale pressures firms to expand at a rate beyond what is possible using only internally generated resources. This assumption led to the resource scarcity theory, which is the first theory explaining the franchising phenomenon.

2.1.1 Resource Scarcity

Even though company-owned units are preferred by franchisors, because the franchisor’s share of returns is higher, entrepreneurs use franchising to leverage franchisees’ knowledge and capital. Access to these resources allows firms to overcome resource scarcities and quickly build economies of scale in advertising and purchasing (Combs et al, 2011).

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the franchisor is experiencing significant growth, thereby supporting the notion that resource constraints drive the decision towards franchising.

However, Combs and Ketchen (1999) found that high-capital firms use more franchising, which challenges the assumption of Oxenfeldt and Kelly (1969) that young, small firms will franchise more heavily. Other contradicting results come from Combs, Michael and Castrogiovanni (2009), who found that most mature firms do not trend toward company ownership, while resource scarcity theory argues that mature firms will use their resources to buy back previously franchised outlets. In reality, most managers express no desire to buy back franchised outlets (Lafontaine & Kaufmann, 1994). Thus, although researchers agree that resource scarcity is an important reason for franchising, the contrasting results indicate that it is not the only reason. The fact that franchising continues when resource scarcities are eliminated leads to the conclusion that there must be other important reasons why companies engage in franchising.

2.1.2 Agency theory

Because the resource scarcity view also fails to explain why franchising is used by many businesses that clearly have full access to capital markets, researchers have developed an alternative view based on organizational economics and in particular agency theory. According to Eisenhardt (1989), agency relationships exist in any joint effort in which one party (the principal) delegates authority to a second (the agent). Because each is assumed to be self-interested and to possess divergent goals, the principal must expend resources to ensure that the agent acts in the principal’s best interest (Jensen & Meckling, 1976). The agency view is one of the major milestones in literature that explain the existence of franchising (Combs, Ketchen & Short, 2011). The theory proposes that in company-owned outlets, managers (the agents) will tend to shirk in their duty to the firm (the principal) because their compensation is fixed and unrelated to their outlet’s performance. As a result, high monitoring costs will be incurred by the firm to insure that its managers act in the firm's best interest.

Franchising is seen as a solution to this agency problem (Rubin, 1978). By contractually providing franchisees with residual claims on their outlet’s profit, franchisees work hard without being directly monitored by the franchisor (Combs et al, 2011). Therefore, the high costs involved in monitoring the actions of company-employed managers are saved. The literature review by Elango and Fried (1997) concludes that franchised outlets are likely to perform better than company-owned units, because the contract between the principal (franchisor) and agent (franchisee) is designed to keep their financial interests closely aligned.

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monitoring the outlet costly. On the other hand, when store operations can be largely standardized, company ownership is facilitated, because the ability of the outlet’s manager to follow the dictated standards is relatively easy to observe (Combs & Ketchen, 1999). Research has provided much support for agency theory’s explanation for franchising. Consistent with the assumptions of agency theory, franchising is used more when physical and cultural distance is high (Brickley & Dark, 1987) and when operations require local market knowledge and judgment (Lafontaine, 1992).

An important problem in franchising that is acknowledged by agency theory is that franchisees might take actions that increase local profits, but harm the franchisor’s reputation. Many firms may choose not to rely on franchising due to these perceived opportunism risks that may harm the brand’s reputation (Scott, 1995). Examples are understaffing and not participating in system-wide promotions (Brickley & Dark, 1987). For many franchisors however, the monitoring cost advantages of franchising appear to outweigh these free-riding fears (Michael, 2000).

2.1.3 Combining agency theory with resource-scarcity

Resource scarcity theory has provided us with the insight that franchisors benefit from the capital and local managerial resources that franchisees provide. In addition, as agency theory explains, the main beneficial resource is a local manager who is highly motivated to maximize performance, because this eliminates the need for a costly middle management structure to frequently visit, monitor, and evaluate local managers.

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2.2 The problematic franchising relationship

Now that the reasons for franchising are explored and the decision to franchise is made, the new franchisor faces many challenges, not the least of which is the relationship with franchisees. Maintaining a harmonious franchisor-franchisee relationship is a major determinant of franchising system growth and success, though one of the most difficult and frustrating challenges in franchising (Floyd & Fenwick, 1999), given the very different goals and objectives of franchisors and franchisees (Chiou, Hsieh & Yang, 2004). The franchisor and franchisee are legally distinct organizations, but they are mutually interdependent in terms of responsibilities to the franchising system and economic rewards. Moreover, they are operationally indistinguishable to consumers (Parsa, 1996). The franchisor relies upon its franchisee to perform at expected levels and within specified guidelines, whereas the franchisee depends upon its franchisor for support (Croonen & Brand, 2013). According to Davies et al (2011), the profitable and comprehensive exploitation of market opportunities depends heavily upon the dedicated and unconditional compliance of all franchising partners.

As discussed before, franchising provides a solution to the agency problem by aligning the financial interests of the principal (franchisor) and agent (franchisee). However, difficulties arise in several other areas, because the franchising relationship is characterized by fundamental interests that are often dissimilar and sometimes even diametrically opposed (Davies et al, 2011). Although both parties are keen to maximize the performance of the entire franchising system and brand name, each might have different ideas on how performance is maximized. Moreover, the main priority of the franchisee is to maximize performance of its own outlet. An important difference between company-owned outlets and franchised outlets is that the franchisor has limited power over the franchisee, besides the contract. This means that, to some level, franchisees often have the freedom to operate their outlet in a way that maximizes the performance of their outlet, but harms the system-wide uniformity and eventually might harm the performance of the entire system. The relationship therefore sets the stage for potential disagreement and tension between the parties over the course of the franchising relationship.

2.2.1 Areas of conflict

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1967), at some point conflict may damage the quality of relational exchanges (Pondy & Huff, 1985). Conflicts can threaten the survival of the relationship (Davies et al, 2011) and the success of the franchising system is therefore strongly determined by the ability of the franchisor to manage conflict (Fulop & Forward, 1997).

In order to manage conflict, it is important to gain understanding of the most common sources of conflict in the franchising relationship. Conflicts can arise from many areas in the relationship and recent investigation into the sources of conflict suggests that the full range of factors generating conflict have not been fully revealed (Frazer et al, 2012). However, in their study to identify the most common ones, Frazer et al (2012) report the following main sources of conflict:

- Compliance with the system - Permitted levels of autonomy - Profitability

- Pricing and sourcing of goods - Quality of provided training - Misrepresentation issues - Site suitability

- Territorial issues

- Communication problems

Underlying these areas of conflict are certain fundamental areas of conflict. An important fundamental area of conflict is the fact that the franchisor seeks standardization and control of franchisees in order to maintain brand reputation, whereas franchisees strive for autonomy in operating their own entrepreneurial ventures (Davies et al, 2011). According to Dant and Gundlach (1998), franchising represents one form of entrepreneurship where dependence and autonomy can coexist synergistically. However, financial interdependence between two entrepreneurially motivated partners, combined with the asymmetrical exercise of power within the relationship, can lead to frustrating conditions for franchisees (Davies et al, 2011). It is the franchisor that generally determines how the assets and economic rewards are distributed within the relationship and what the responsibilities of each partner are. The conditions are worsened by the fact that franchisees typically invest their own capital into an enterprise which they initially do not fully understand.

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incompatibility between autonomy and control, conflict and diminished compliance within franchise relationships are inevitable (Kidwell et al, 2007). This makes the necessary balance between system uniformity and entrepreneurial autonomy a major challenge in franchising.

Conflicts between franchisors and franchisees regarding economic rewards are common as well (Garg & Rasheed, 2006). As a franchise relationship is created, the issue arises as to how economic rents should be shared by franchisees and the franchisor (Elango & Fried, 1997). The franchisors' sources of revenue are initial franchise fees, royalties, rental of premises, sale or leasing of equipment, supplies and raw materials, sale of franchise products and sale of territorial rights (Woll, 1969). The franchisor's claim to an income stream is generally superior to those of its franchisees, because franchise royalties are typically based upon gross sales figures, whereas franchisee profitability is greatly influenced by operating costs. As a result, franchisors may implement a strategy of sales or market share growth without considering the stores’ operational costs, thereby harming the profitability of franchisees (Phan, Butler & Lee, 1996). Two studies by Bush, Tatham and Hair (1976) and Zeller, Achabal and Brown (1980) confirm this, as they found that the goals of franchisors and franchisees are clearly conflicting. The franchisor aims to maximize system revenue and the individual franchisees aim to maximize their outlets’ profits.

In addition, a franchisee is contractually limited to the financial returns from its outlet, while the franchisor gains its income from all franchised outlets combined. This can lead to considerable variance in levels of satisfaction and trust among the partners, because franchisors can remain profitable even when many individual franchisees are not (Davies et al, 2011).

A third fundamental area of conflict is the difference between franchisee expectations and reality. Frazer et al (2012) found that a strong majority of franchisees initially hold unrealistic expectations to profit potential and the quality and extent of franchisor-provided services. An important ingredient in the formation of franchisee expectations is information provided by the franchisor. According to Frazer et al (2012), some franchisors act opportunistically by deliberately misleading potential franchisees in order to increase unit sales and sustain growth in their systems. However, the formation of unrealistic expectations is not always due to the franchisor. Frazer et al (2012) also found many instances in which franchisees dismissed factual information in favor of retaining the false perception that franchising represents a bulletproof business model. They found that franchisees often hear what they want to hear or do not spend enough time understanding the business before they enter it. The resulting misconceptions significantly contribute to higher levels of conflict in their franchise networks.

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Fundamental area of conflict Related area of conflict (Frazer et al, 2012) Formula standardization versus franchisee autonomy Compliance with the system

Permitted levels of autonomy Misrepresentation issues Distribution of assets and economic rewards between

partners

Profitability

Pricing and sourcing of goods Franchisee expectations versus reality Quality of provided training

Site suitability Territorial issues Communication problems

Table 1: Fundamental areas of conflict related to areas of conflict as found by Frazer et al (2012).

As discussed above, the franchisor-franchisee relationship is characterized by major goal conflicts. As a result, franchisees may engage in opportunistic behavior by disobediently disregarding the franchisor’s goals in pursuit of their own entrepreneurial interests (Gassenheimer, Baucus & Baucus, 1996). Franchisors have both short-term goals (e.g. making profit) and long-term goals (e.g. developing the brand name). However, franchisees are less concerned with the long-term goals (Bartélemy, 2008) and may be tempted to harvest the benefits of a chain’s brand name without upholding its quality standards. Thus, the relationship between franchisee and franchisor can be damaged by a franchisee's decision to engage in opportunistic behavior by free riding on franchisor brand reputation.

2.3 Opportunistic behavior

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costs. Such free riding might however negatively affect other outlets and the overall brand. If a franchisee withholds effort and successfully free rides on the franchisor's brand name, this may reflect poorly on perceived brand quality and lead to poor organizational performance (Kidwell et al, 2007). The problems can worsen when monitoring difficulties occur due to a growing network of franchisees. In their recent study on opportunistic behavior, El Akremi, Mignonac and Perrigot (2010) argue that two forms of opportunistic behavior are particularly harmful to the efficiency and survival of franchise chains; deviation from standards and withholding information.

2.3.1 Deviating from standards

As discussed before, one of the fundamental challenges of the franchising relationship for the franchisor involves maintaining uniformity throughout the system. However, the local market knowledge of franchisees is a valuable resource that, according to resource scarcity theory, is one of the main reasons companies choose to franchise in the first place. Franchising is a way to penetrate geographically (and culturally) separated markets, which may have different consumer preferences, income levels or competition levels. Franchisees’ efforts to adapt to their local environments through experimentation and innovation can add value to the entire system (Watson, Stanworth, Healeas & Purdy, 2005). As a result, many franchisors choose to allow and sometimes even encourage franchisees to respond to local market conditions and thereby deviating from system standards. However, in order to maintain system uniformity, franchisors usually restrict deviation from core components of the business format (Michael, 2000). Deviating from core format leads to misrepresentation of a franchise and creates image ambiguity for customers. It jeopardizes performance and survival of franchise outlets (El Akremi et al, 2010).

Franchisees may perceive that outlet ownership gives them the right to exercise entrepreneurial initiative, rather than conform to the franchisor’s norms (Baucus, Baucus & Human, 1996). Therefore, franchisees might engage in deviation from system standards, even when restricted by the franchisor. Kaufmann and Eroglu (1999) confirm these findings by stating that franchisees’ competitive desire to maximize profits within their own geographical environment can lead to unauthorized deviation from standards.

2.3.2 Withholding information

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system. Withholding information from a franchisor could threaten the system by preventing system-wide adaptations to changing markets (Bradach, 1997). Nevertheless, franchisees have incentive to keep this valuable information to themselves. According to Dant and Nasr (1998), withholding information can hinder the franchisor to enforce formal controls and to know whether the outlet’s results stems from environmental conditions or the franchisees’ own efforts. Also, as argued by resource scarcity theory, franchisors tend to buy back profitable outlets after they have acquired sufficient information to serve the market directly (Dant & Kaufmann, 2003). Although empirical findings are inconclusive regarding this claim, it is a fact that some franchisors employ this strategy. So, reducing the risk that their own outlet may be repurchased is another reason for franchisees to conceal information from the franchisor (El Akremi et al, 2010).

2.3.3 Franchisor opportunism

Research on opportunistic behavior in the franchising relationship has generally been written from the franchisor’s perspective. As a result, relatively little is known about opportunistic behavior by the franchisor. In order to emphasize the importance of a harmonious franchising relationship, also in the interest of the franchisee, it is considered important to address franchisor opportunism as well.

The relationship between the franchisor and the franchisee, regulated by the contract between them, is typically characterized by an inherent and necessary imbalance of power and information in favor of the franchisor. Abuse of this power can lead to opportunistic practices. Although one could object that franchisors have a reputation-based incentive to refrain from behaving opportunistically, such a commitment mechanism is likely to be weak for young systems (Azoulay & Shane, 2001). Examples of franchisor opportunism are misleading contract agreements, misrepresentation of the franchise business case, unfair termination of contracts, unfair profit distribution and the use of coercive power (Lawrence & Kaufmann, 2010).

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Another source of franchisor opportunism is asymmetric information in the franchising relationship. When buying a franchise, the franchisee does not always have sufficient and reliable information in order to make an informed decision. This can create uncertainty for the franchisee’s future business operation and contribute to the power imbalance in a franchise relationship (Zhang, 2011).

The power imbalance is enhanced by the high sunk costs when buying a franchise. Franchisees pay franchisors large up-front fees to buy the rights to establish a new outlet. Moreover, new franchisees are often required to purchase specific assets, like signs, menus, equipment and training that cannot be recovered or easily put to other uses. Since franchisor-specific investments are worth more in the system than outside, these assets generate quasi-rents (Carney & Gedajlovic, 1991). The franchisee may be locked into the relationship by these high sunk costs that make it unattractive to sell the franchise (Grimes, 1997). The result is a power imbalance which makes franchisees vulnerable or economically imprisoned to the demands of the franchisor (Zhang, 2011).

2.4 Solutions through relationship management

Thus far, this thesis has emphasized on the importance of franchising relationship management by discussing current literature on the nature of the relationship, the most important areas of conflict and the potential opportunistic behavior that is consequential. Relationship inefficiencies are expected to result when their relational sentiments are weakened (a state often characterized by limited communication and greater levels of opportunistic

behavior). Therefore, it is essential that both franchisors and franchisees maintain strong intra-franchise relationships to avoid ex post costs associated with conflicts and/or opportunistic behavior (Dant, Weaven & Baker, 2013).

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examine how the franchising relationship develops over time and how the different phases affect the management of the relationship.

This study intends to incorporate the concept of franchisee satisfaction as the most important antecedent of harmonious franchising relationship. Basically, it is proposed here that enhancing franchisee satisfaction in the system improves the loyalty of the franchisee and the harmony of the franchising relationship. Franchisors should see franchisee satisfaction as a vehicle for building harmonious, long-term franchising relationships.

2.4.1 Franchisee satisfaction

Franchisee satisfaction can be defined as a positive affective state resulting from the assessment of both economic and non-economic aspects of the working relationship with the franchisor (Geyskens, Steenkamp & Kumar, 1999). Franchisee satisfaction is widely linked to the quality of franchisor support, upon which they are economically dependent. It has been repeatedly related to acceptance of the control and influence imposed by their franchisors (Davies et al, 2011).

This section will provide an overview of the most important factors that influence franchisee satisfaction, resulting in knowledge about the antecedents of franchisee satisfaction and the associated managerial implications. However, the first step is to gain understanding of why franchisee satisfaction is important for the franchisor.

Research emphasizes the importance of the franchising relationship unanimously, as discussed before in this thesis. Floyd and Fenwick (1999) state that maintaining a harmonious franchisor-franchisee relationship is a major determinant of franchising system growth and success. Similarly, Elango and Fried (1997) argue that the franchisor is urged to maximize franchisee satisfaction, because by satisfying the franchisee, the franchisor provides an incentive for the franchisee to meet the franchisor's goals.

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- The pleasantness of the relationship between franchisees and the franchisor - The performance of franchisees

- Their involvement in the organization

- Their intentions to remain in the franchising system

The study by Morrison (1997) suggests that efforts to improve franchisee satisfaction are definitely worth the investment. Enhanced satisfaction among franchisees will eventually lead to greater contributions and commitment. Gauzente (2003) argues that long-term commitment of the franchisee is essential for maintaining the continuity of a franchising system. He also confirms that the franchisee’s intention to remain in the formula is determined by franchisee satisfaction (Gauzente, 2003). Hing (1995) found the following additional positive effects of franchisee satisfaction for the franchisor. A satisfied franchisee:

- Recommends the franchise organization to others. Since 75% of new franchisees seek advice from other franchisees, this word-of-mouth advertising is very useful for the franchisor.

- Believes the success of his outlet is due to the franchisor. As a result of the franchisor’s positive image, the franchisee is less likely to engage in discussion with the franchisor (whether or not in public).

- Is more likely to extend the contract. Lower franchisee turnover reduces recruitment and training costs and increases loyalty and trust. Moreover, a lower number of new franchisees will reduce the risk that new franchisees entail, because it is uncertain whether they are suitable as franchisees. It also reduces administration costs.

Similarly, Hunt and Nevin (1974) found that satisfied franchisees: - Are less likely to voluntarily terminate their contract.

- Are less likely to sue the franchisor, individually or jointly. - Cooperate with the franchisor better.

- Have better morals.

- Are less likely to search for and use protective regulations.

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franchising performance by Elango and Fried (1997). In a recent study, Davies et al (2011) discuss prior studies to explain the interrelationships between franchisee satisfaction, conflict, trust, and compliance. They found that franchisee satisfaction is directly associated with the effectiveness of franchising relationships.

Now that the importance of franchisee satisfaction for the franchising relationship is discussed, the next question is which factors influence franchisee satisfaction and what the franchisor can do to enhance these factors. Therefore, the next sections will examine the most important antecedents of franchisee satisfaction.

2.4.2 Operational satisfaction

Schul, Little and Pride (1985) found that franchisee satisfaction is related to the franchisee's perceptions of the quality of interactions with the franchisor, the quality of operational support offered by the franchisor, the attractiveness of the reward structure, and the autonomy and fairness of the relationship. Geyskens et al (1999) distinguish between two different components of satisfaction: economic satisfaction and non-economic satisfaction. The first part of satisfaction is achieved by the degree to which expectations concerning profit and revenue are met. The satisfaction level with regard to the fees is also covered by this part. The non-economic part of satisfaction is about the relation and cooperation between both parties (Geyskens et al, 1999). Both elements of satisfaction are also found in the study of Ruekert and Churchill (1984), who add two additional components of satisfaction (product and operational support).

Croonen (2006) conducted research into franchising relationships and distinguished two categories of characteristics that are important to assess whether the franchise partners are suitable (compatible) for each other. The first category identifies three characteristics that indicate the extent to which the franchisor and franchisees perceive to fit together with regard to operational cooperation:

- Operational compatibility regarding capabilities - Operational compatibility regarding profitability

- Operational compatibility regarding trust and fair dealing

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franchisor. The next sections will further explain these variables and their influence on overall franchisee satisfaction.

Satisfaction regarding the franchisor’s capabilities

The first component of operational satisfaction concerns the franchisee’s satisfaction with regard to the franchisor’s capability to carry out its role in the relationship. According to Chiou et al (1994), the services provided by the franchisor are the basis for improving the quality of franchise relationships and have an important role in establishing franchisees’ overall satisfaction and commitment. Indeed, the quality of franchisor services has been suggested by many researchers to be critical to relational quality and franchisee satisfaction (Hunt & Nevin, 1974; Hing, 1995; Chiou et al, 2004; Combs et al., 2004; Spinelli & Birley, 1998).

Croonen (2006) mentions the following important franchisor capabilities: automation, purchasing prices, logistics, communication, information provision, and the degree and quality of supporting its franchisees. Similarly, Watson and Johnson (2009) argue that franchisor services include initial and on-going training, research and development, advertising and marketing support, market research, management assistance, supply provision, and so on. Franchisors are required to provide franchisees with operational support in return for the fees they receive. Monroy and Alzola (2005) argue that the operational support offered by the franchisor is an important mechanism by which the franchisor can promote uniformity and control within the system. The importance of these services to franchisees is recognized unanimously by researchers. In fact, the training and managerial assistance provided by the franchisor is one of the key reasons why individuals become franchisees (Peterson & Dant, 1990). Thus, franchisees are likely to become dissatisfied with the relationship if they perceive these services to be inadequate (Watson & Johnson, 2009). Spinelli and Birley (1998) suggest that franchisees will develop a behavioral zone of tolerance in which franchisors are perceived to meet or exceed a tolerable service level. However, if the franchisee believes the services are falling short, dissatisfaction and conflict will arise. On the other hand, if franchisees evaluate the service assistance favorably, their trust in the franchisor will strengthen (Chiou et al, 2004).

Satisfaction regarding profitability of the relationship

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profitability is considered to be an essential ingredient in good franchisor-franchisee relations and the franchisee’s satisfaction regarding profitability is expected to play a major role in overall satisfaction.

Satisfaction regarding trust and fair dealing

The third component refers to the franchisee’s trust in the franchisor’s commitment to the alliance. As explained earlier, the franchising relationship is characterized by mutual interdependence. Even though the relationship is generally governed by formal contracts, such contracts can never specify all possible contingencies, and therefore relationships are governed by informal mechanisms as well, such as trust (Croonen & Brand, 2013). According to Nooteboom (1999), having trust in the franchising partner is to accept or neglect the subjective probability that a partner will not utilize opportunities for opportunism even if it is in its interest to do so. In other words, the franchisee trusts that the franchisor is committed to the alliance and will not behave opportunistically, for example by putting minimum effort in the alliance, while reaping its full benefits (Medcof, 1997). When one franchise partner trusts the other, it means that he believes that the other is likely to cooperate, even if he is not coerced to do so and has no direct material interest (Nooteboom, 1999). Ring and Van de Ven (1994) introduce the concept of fair dealing, which is closely linked to the concept of trust. They argue that an equal division of inputs or outcomes is not required, but both franchising partners should at least perceive that its benefits are proportional to its investments. In other words, both partners should have the impression that the costs and benefits are fairly divided. This concept is indeed related to trust, because it requires the partners to represent the costs and revenues of the alliance truthfully (Croonen, 2006). The franchisee’s trust in the franchisor’s fairness and commitment to the relationship is expected to positively influence overall franchisee satisfaction.

Whereas previous research has treated trust as a one-dimensional factor, Davies et al (2011) contribute by examining the influence of trust from two distinct perspectives, derived from franchisees' perceptions of franchisor competence and franchisor integrity.

Franchisees’ trust in franchisor competence is similar to the concept of satisfaction regarding the franchisor’s capabilities, as it relates to the franchisor’s capability of providing the level and quality of support necessary. Davies et al (2011) identify the effort and capabilities demonstrated by the franchisor as franchisor competence.

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trust, of which the first is resulting from franchisee satisfaction regarding the franchisor’s capabilities. This study includes both dimensions of trust in the assessment of satisfaction regarding trust and fair dealing.

2.4.3 Strategic compatibility

In addition to the factors of operational compatibility, Croonen (2006) discusses five factors of strategic compatibility, which determine how the franchise partners fit together strategically:

- The positioning of the formula in the market - The degree of formula hardness

- The degree of formula innovation

- The organization of franchisee strategic participation - The type of growth objectives

Operational compatibility deals with the question “Can we make it work?” while strategic compatibility deals with the question “Should we cooperate?” (Niederkofler, 1991). The strategic choices of the franchisor affect the franchisee and therefore influence franchisee satisfaction. The positioning and hardness of the formula are factors in which a certain fit with the franchisee is particularly important (Croonen, 2006). The fit with the market positioning is important because the franchisor’s chosen strategy must match the method of the franchisees. If, for example, the franchisor considers the product to be suitable for a small niche market, while the franchisee serves a wide market in its region, there is no fit between both strategies. As a result, the franchisee may be dissatisfied with the marketing of the franchisor, while the franchisor is dissatisfied with the franchisee’s performance. Dissatisfaction may also emerge when there is no fit between the franchisee’s expectations with regard to formula hardness and the actual degree of franchisee autonomy. It is also important that the chosen strategy is clear to both parties.

This thesis includes strategic fit in the factors that determine franchisee satisfaction. The satisfaction of the franchisee will be positively impacted when the strategy of the franchisor and franchisees are compatible. The five factors of strategic compatibility and their influence on overall franchisee satisfaction will be discussed in the next sections.

Strategic compatibility regarding positioning

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Target scope

Advantage

Low cost Product uniqueness Broad (industry wide) Cost leadership strategy Differentiated strategy

Narrow (market segment) Focus strategy (low cost) Focus strategy (differentiation)

Table 2: Generic strategies (Porter, 1980).

The chosen strategy has important consequences for the composition of the assortment, service level, pricing, promotion, appearance of the store and others. It is expected to have strong influence on franchisee satisfaction.

Strategic compatibility regarding formula hardness

This second factor of strategic compatibility has everything to do with the challenge of finding the right balance between system uniformity and the advantages of local adaptation. The franchisor has to make certain choices with regard to this issue and adapt the degree of formula hardness accordingly. Kneppers-Heijnert (1988) argues that the intensity of cooperation between franchising partners can vary from hard/full to soft/free. Croonen (2006) explains that the first form means that cooperation is established by a large number of rules (hard) and entails almost all fields of business (full). This form is used when the franchisor requires full control over the franchisees to ensure uniformity of the formula. In order to maintain uniformity in business format franchising, in general, virtually every aspect of a unit’s operations is formulated in operating manuals and procedures that the franchisee is obliged to follow (Croonen, 2006). However, considering the cost of control, this form is very expensive and reaps no advantages of local adaptation.

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Strategic compatibility regarding innovation

The third factor of strategic compatibility is related to the increasing importance of innovation management due to rapid technological and market changes, shortening product and concept life cycles and changing consumer tastes (Croonen, 2006). These changes result in threats and opportunities, which, from the perspective of the franchisor, may require a system wide adaptation. The franchisor has to make choices concerning the innovation paradox of exploration versus exploitation, because it is impossible to allocate unlimited resources to both areas. Exploration involves risk taking, experimentation and innovation, while exploitation concerns the improvement of existing processes, standardization and cost reduction (Koza & Lewin, 1998).

The rate of innovation refers to if and how quickly both partners are willing to adopt innovations. From the franchisor’s point of view this applies to the system as a whole, while as far as the franchisee is concerned it applies to the franchised unit (Croonen, 2006). When the franchisor and the franchisee have divided their tasks clearly, both will focus on the same form of innovation at the same time. This consistency will result in higher achievements and as a result, these strategic choices are expected to influence franchisee satisfaction.

Strategic compatibility regarding franchisee participation

The fourth factor of strategic compatibility involves the participation of franchisees in (strategic) decision making processes. The franchisor’s choice to authorize franchisee participation results in loss of power by the franchisor, but has the advantage that franchisees perceive to have influence and are listened to. Franchisee participation leads to a higher level of trust in the franchisor, which on its turn leads to increased franchisee satisfaction.

A common organizational form of franchisee participation is a franchise board, consisting of franchisees, which is intended to represent the interests of all the franchisees within the system. The need for a franchise board increases when the system becomes larger and harder (Croonen, 2006). The franchise board may be consulted by the franchisor before certain changes are made, or for the franchisor to learn about developments at store level. A properly functioning franchise board can provide better handling of conflicts, better communication and clear agreements between franchisor and franchisees, which are beneficial for the continuity and success of the formula (Croonen, 2006).

Strategic compatibility regarding growth objectives

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Through quantitative growth, the franchisor aims at growing by means of adding more units to the franchise system, showing relatively less concern for the performance of the individual units (Croonen, 2006). Quantitative growth is disadvantageous for existing franchisees, because the franchisor’s focus is on acquisition. Also, the franchisee might be confronted with the entry of another franchised unit in its local market (unless the franchisee has contractual exclusivity rights).

Through qualitative growth, the franchisor mainly aims at growing by means of improving the performance of the existing units, for example by means of renovating the store or by moving to another store location (Croonen, 2006). Qualitative growth might also be harmful to the franchisee in case the franchisee does not agree with this. Moreover, any expansion, refurbishment or relocation is generally financed by the franchisee.

The franchisor must determine what type of growth the system should pursue, so that an unambiguous strategy can be employed. This choice might have important consequences for franchisee satisfaction. The result of this strategic choice will either consist of an increase in the number of units or an improvement in the quality of the entire system.

Related areas of conflict

Table 1 provided an overview of the fundamental areas of conflict, translated into the most important areas of conflict as found by Frazer et al (2012). The next table supplements these areas of conflict with the relationship aspects that are discussed in the previous sections. The related aspects are considered the potential causes of conflict and should therefore be addressed in order to prevent conflict and opportunistic behavior. For example, the degree of formula hardness results in permitted levels of autonomy, which on its turn influences the balance between formula uniformity and franchisee autonomy.

Fundamental area of conflict Area of conflict (Frazer et al, 2012) Related construct of model Formula standardization versus

franchisee autonomy

Compliance with the system Permitted levels of autonomy Misrepresentation issues

Formula hardness Positioning Innovation Distribution of assets and economic

rewards between partners

Profitability

Pricing and sourcing of goods

Trust and fair dealing Profitability Franchisee expectations versus

reality

Quality of provided training Site suitability Territorial issues Communication problems Franchisor capabilities Growth objectives Franchisee participation

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2.5 Relationship dynamics

This thesis considers the franchising relationship as a dynamic rather than a static relationship and argues that its dynamic character has important consequences for managing the franchising relationship. Taking the relationship dynamics into account is believed to be crucial in maintaining a successful relationship during all phases of the life-cycle.

In general, researchers have devoted relatively little attention to studying the developmental processes or dynamics of alliances (Croonen, 2006). Instead, researchers generally seem to view the franchising relationship as a fixed relationship that does not develop over time (Elango & Fried, 1997). In contrast, as discussed before, many studies have proven that franchising relationships are in fact instable and have high failure rates.

Meek et al (2011) argue that little research has yet addressed the dynamics of the franchising relationship, despite the multidisciplinary nature of franchising research. Similarly, Frazer and Winzar (2005) suggest that researchers need to focus more on how relationship dynamics affect franchising. With knowledge of the dynamics of franchising relationships, franchisors can determine which phase of the relationship is most critical for the long-term success of the franchising system. In some phases, franchisees may be more likely to engage in negative behaviors such as opportunism, reducing investments, or lowering operational inputs (Oxenfeldt & Kelly, 1969).

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franchising relationship (Windsperger, 2001). Having made significant financial investments in their franchising systems and being inexperienced regarding the operation of their own outlets, franchisees initially are heavily dependent on their franchisors’ guidance and welcome their advice (Frazer, 2001). The relationship is therefore expected to follow a U-shaped curve instead of an inverted U-shaped curve.

In a recent attempt to answer this call for more focus on the dynamic nature of the franchising relationship, Blut et al (2011) have collected primary data from 2,668 franchisees in order to develop a lifecycle model of franchising relationships. They have divided the franchising relationship into four different phases; honeymoon, routine, crossroad and stabilization. It is suggested that conventional lifecycle theory cannot be applied in the franchising context, because in franchising, the relationship is most intense during the honeymoon phase. Ties between the franchisor and the franchisee become less strong during the routine phase and reach bottom at the crossroad phase, from which intensity and valuation of the relationship rise once again during the stabilization phase. A number of academics within current literature have used a marriage analogy, emphasizing the longevity of the relationship (Watson & Johnson, 2009). The franchising relationship has also been compared to a parent–child relationship (Mendelsohn, 2004). It is suggested that franchisees are like small children when they first join the system; eager to learn and requiring hand holding. Over time, they become like teenagers, resentful of parental interference (Watson & Johnson, 2009).

Figure 1 presents a graphical representation of the life-cycle model developed by Blut et al (2011). The relationship phases are expected to have effect on operational satisfaction and strategic compatibility. The next sections provide a description of the four life-cycle phases.

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2.5.1 The honeymoon phase

During the initial honeymoon phase, franchisees are fascinated and excited about the first experiences in their new surroundings. Franchisees entering a franchising system are enthusiastic to become a part of it, as they stand on the threshold of a new phase in their professional lives (Oxenfeldt & Kelly, 1969).

Fichman and Levinthal (1991) argue that this honeymoon phase is the result of high initial commitment to the relationship, which is triggered by four mechanisms; high initial investments, prior favorable beliefs, goodwill and psychological justification. Blut et al (2011) argue that the high level of commitment in the honeymoon phase is mainly due to the first two mechanisms (initial investments and prior favorable beliefs) and that that the phases after the honeymoon phase are mainly shaped by goodwill and psychological justification.

As discussed before, the initial investments a franchisee typically has to make when entering a franchising system has important consequences for the development of the franchising relationship. The required initial investments function as entry barriers and have motivational effects (Lewis & Lambert, 1991). As a result of the initial dependency on the franchisor, franchisees show high levels of cooperation and willingness to participate in the development of the franchising system (Frazer, 2001).

High commitment in the honeymoon phase is also triggered by the franchisees’ prior favorable beliefs. Franchisors tend to make considerable promises in order to convince franchisees to enter their system (Grünhagen & Dorsch, 2003). Consequently, new franchisees are highly motivated and show positive attitudes toward their franchisor. As a result of both mechanisms, franchisees show higher levels of commitment during the first phase of the relationship than do parties in conventional buyer–supplier relationships (Blut et al, 2011).

2.5.2 The routine phase

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evaluation of the franchising relationship (Blut et al, 2011). Grünhagen and Dorsch (2003) also found evidence that, with the duration of the relationship, the level of franchisee self-interest and conflict will increase.

2.5.3 The crossroad phase

During the subsequent crossroad phase, franchisees increasingly understand how the system works and begin to adjust accordingly. Although one would expect that during this phase, the adjustment of the franchisee result in less conflict, Blut et al (2011) argue that this phase is characterized by further decrease in evaluation of the franchising relationship. Due to training by the franchisor and experience with the franchising system, the franchisee has gained some degree of expertise. Once the franchisee is able to operate the business independently, the need for self-determination and independence will increase (Peterson & Dant, 1990). As a result, it becomes more difficult for the franchisor to justify continuing fees. Therefore, the initial stock of goodwill is further reduced during this phase. Because franchisees invested financial and other personal resources and signed a long-term contract, they might experience their situation as being locked-in (Windsperger & Dant, 2006).

2.5.4 The stabilization phase

During the fourth phase, the franchising relationship shows only small incremental changes in terms of behavior and performance. The improvements that are brought about by adjustments of the franchisee during the crossroad phase become evident in the stabilization phase. Learning and relationship building efforts by both the franchisor and the franchisee contribute to an overall recovery of the relationship as well (Blut et al, 2011).

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2.6 Conceptual model

The previous section has explained the various life-cycle phases as proposed by Blut et al (2011). This concludes the development of the conceptual model. Figure 2 provides a graphical representation of the constructs that have been examined in the previous sections, including the relations between them. The harmony of the franchising relationship is the central concept of this study. The most important variable positively influencing the central concept is franchisee satisfaction, which on its turn is positively influenced by both strategic compatibility and operational satisfaction. Finally, this study proposes that strategic compatibility and operational satisfaction largely depend on the life-cycle phase in which the relationship resides.

Figure 2: Conceptual model of dynamic franchising relationship management.

The arrows represent the relations between the variables, which correspond with findings in existing literature, as discussed in previous sections.

The next chapter will discuss the research methodology. It will explain why the researcher has chosen for a qualitative approach, how the research was designed and provide information about the selected case franchising systems.

Franchising relationship harmony Phase of franchising relationship life-cycle Overall franchisee satisfaction + Franchisor capabilities Profitability Trust and fair dealing

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Chapter 3 – Methodology

This thesis is written on behalf of Flavors of Spain and its main goal is to provide recommendations, based on existing literature and verified at two relevant franchising systems in the Netherlands, through several in-depth interviews. In this chapter the research methodology of this study’s empirical part is described.

According to Watson and Johnson (2009), given the scarcity of research on franchising relationships, a qualitative approach is appropriate. In a similar vein, Gauzente (2005) argues that there is a need for more qualitative approaches in franchising research. So far, the franchising literature has mainly been based on quantitative approaches (Elango & Fried, 1997). However, franchising literature calls for more in-depth process research that helps to understand organizational phenomena at more levels and to gain insight into developments over time (Croonen, 2006). Also, according to Ring & Van de Ven (1994) relatively little scholarly attention has been devoted to studying developmental processes of cooperative inter-organizational relationships. Most of the research focuses on antecedent conditions or structural properties of relationships (Croonen, 2006). As argued before in section 2.5, this is also the case in the area of franchising.

This thesis intends to contribute accordingly by taking a qualitative research approach at gaining insight into the dynamic relationship between franchising partners. There are still relatively few guidelines and procedures for conducting research on such dynamic phenomena (Croonen, 2006). Section 3.1 will deal with the research design by providing an explanation of the methodological choices made in this case study. Next, section 3.2 will present a description of the selected case studies.

3.1 Research design

This research aims to answer the main research question and provide Flavors of Spain with recommendations on how to manage the relationship with its future franchisees. Therefore, various sub-questions and a research model concerning dynamic franchising relationship management have been developed. The development of the research model should be attributed to extensive literature research on the topic of franchising. The next step is to explore the model empirically at two relevant franchising systems in the Netherlands. This section describes the research methodology of these exploratory case studies.