What Drives Royalty Rates in International Franchising?

by | Feb 17, 2023


Franchising – a business arrangement in which a firm (the franchisor) permits another firm (the franchisee) to use its brand name and business format to market goods and services – is big business. Today, the franchising industry contributes more than $2 trillion per year to the global economy and provides work to more than 19 million people worldwide. Because of its outstanding economic importance and inherent intricacies as an inter-organizational business structure, franchising has received much research attention across various disciplines. Most studies are set in a domestic context. But in practice, franchising across borders is the rule, not the exception: Four of five franchisors operate internationally.

“Franchising is an attractive business concept that enables franchisors to expand internationally quickly and with few resources, and it allows franchisees to benefit from the franchise’s brand name value and proven operational procedures.”

Compared to other foreign market entry modes, such as wholly owned subsidiaries and joint ventures, international franchising has received much less attention – causing scholars to call it a “Cinderella topic”. This research adds to our limited knowledge of international franchising by shifting the focus from the pre-contracting (e.g., partner selection) and post-contracting stages (e.g., conflict management) to the contracting stage.

The contracting stage is essential to international franchising agreements for two reasons. First, formal contracts are generally considered a pivotal instrument to govern interfirm relationships effectively. Contracts help address the risk of opportunistic behavior, such that one party acts in its own self-interest at the other party’s expense. For example, the franchisor may shirk investments in the franchise brand, or the franchisee may harm the franchisor’s brand by lowering its service level to cut costs. Second, the cross-national nature of such business arrangements aggravates the risk of opportunistic behavior due to larger information asymmetries and increased difficulty predicting foreign business partners’ behavior. Conventional measures to ensure compliance in such situations, such as monitoring protocols, tend to be more difficult and costly to implement internationally. This highlights the role of contractually agreed upon (financial) incentives to align both parties’ interests and actions.

A critical incentive to achieve compliance in franchising agreements is the royalty rate. The royalty rate represents the percentage of gross sales a franchisor receives from the franchisee on an ongoing basis as payment for the granted rights. To effectively reduce the risk of opportunism, royalty rates need to provide both partners with a sufficiently large incentive not to take advantage of each other. Therefore, franchisors and franchisees are naturally inclined to accept only royalty rates both perceive as “fair,” keeping in mind their individual goals and risk perceptions.

“Royalty rates are an essential contractual provision to reduce the risk of opportunism in franchising partnerships, many of which are international.”

While some research has shed light on the determinants of royalty rates in domestic contexts, little is known about the factors that drive royalty rates in international franchising agreements. We propose that several country characteristics might affect the perceived risk of opportunistic behavior and, in turn, lead to different royalty rates: the host market’s economic potential, the level of legal rights protection, and the cultural distance from the franchise’s country of origin. Furthermore, with the trademark and territory specified, we focus on the two remaining key contract elements that may affect both parties’ risk perceptions: territorial exclusivity and contract duration.

The analysis of a unique data set comprising 125 international franchising contracts between franchisors and franchisees from 19 countries reveals that economic potential (but not territorial exclusivity) is associated with higher royalty rates, whereas legal rights protection, cultural distance, and contract duration are associated with lower royalty rates. By contrast, territorial exclusivity appears to have no significant impact on royalty rates. These relationships are robust across business-to-consumer and business-to-business markets.

In summary, our research sheds the first light on the determinants of royalty rates in international franchising agreements. It extends current knowledge by exploring the contracting stage of international franchising and provides insights that inform franchisors’ and franchisees’ decisions about the design of such contracts.

Full reference: Zeißler, Jennifer, Timo Mandler, and Jeeyeon Kim (2022), “What Drives Royalty Rates in International Franchising,” Journal of International Marketing, 31 (2), 103–123. https://doi.org/10.1177/1069031X221123265

Cite for: Franchising, international franchising, royalty rates, incentivization, contracting, moral hazard, opportunism, interfirm relationships, market attractiveness, cultural (geometrical) distance

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