Franchising Strategy: Theoretical Development

In this section I discuss theoretical development in the area of franchising strategy and real estate franchising specifically. At a generalised level, theoretical support for franchising rests on two classic positions: the agency and the resource scarcity view, but in order to fully understand the propensity to franchise in the realm of real estate agency, I believe a more diverse theoretical perspective is required. For this reason in section 2.4, I discuss the additional notions of upper echelon; resource based, and institutional theory within the distinctive context of real estate agency franchising.

2.3. 1 Agency Theory

The first traditional explanation for adopting a franchising strategy rests on agency theory. An agency relationship exists in any joint effort in which one party must hand over authority to another party (see the principal/agent; Eisenhardt, 1 989b) and it is necessary in such relationships for resources to be expended to overcome potential conflicts of interest. The franchisor as principal requires assurance that the agent, or franchisee, is working in his best interest (Jensen & Meckling, 1 976). There are two basic tools available to achieve this end: monitoring and performance incentives. As outlined in the extant literature, the agency view suggests that franchising overcomes the need for close monitoring of the work and standards in a chain of dispersed business units. Thus, lower monitoring costs explain franchising across industries (Rubin, 1 978).

Although franchising does not totally remove the moral hazard dilemma, quality and standardisation can be controlled by the franchise contract. Hoy and Stanworth (2003, p. 66) discuss post contractual opportunism and claim that both parties are potentially at risk. The franchisee risks the franchisor not adequately promoting the brand and where this is the case, recruitment of owners into the system is problematic. Conversely, the franchisor risks the franchisee cutting corners or letting the name down in some way. Shane ( 1 998b) discusses imperfect alignment of interest. When customers patronise offices in a system because of the brand, the benefits are shared, but if there is sub-optimal service experienced, customers are likely to change allegiance, so free riding can dilute overall perception of quality. The weakest link can be a measure of overall chain strength. Franchising enables better alignment of the needs of both parties, to the point where the relationship has been likened metaphorically to a symbiotic alliance (Dana et aI. , 2001 ) where entrepreneurs work together in a parallel fashion for mutual benefit. The profit stream anticipated by the franchisor depends on the performance of the franchisee and vice versa. The links between entrepreneurship and real estate agency are discussed in the following chapter.

In real estate franchising imperfect alignment of interests is controlled by strong franchisor support systems and vigorous efforts to maintain the relationship with franchisee owners. Real estate franchises have reward systems linked to all aspects of business performance from citations for top performing offices to individual salespeople and administrative staff, ranging from amongst other things, annual conferences to formally arranged networking. Jensen and Meckling ( 1 976) point out that the moral hazards of shirking and prerequisite taking are more likely to occur amongst company owned units as managers have less to lose. Bradach' s ( 1 997) study of restaurant franchisors shows that franchisors typically inspected firm-owned restaurants once monthly, whereas franchisee-owned outlets were only inspected by franchisors on an annual basis (Castrogiovanni et al., 2006b, p. 24). Real estate franchisors have regional development teams available on a call out basis to help any franchisee with any problematic issue, rather than to

act as monitors of standards. Since franchisees invest their own capital and are owners of the business with the ability to profit from the reversionary sale and the continued income stream, their business effort is better assured and monitoring is probably unnecessary (Rubin, 1 978; Norton, 1 988; Klein, 1 995). Franchisors benefit from having less monitoring costs and from regular royalty payment revenues (Hoy & Stanworth, 2003).

In industry sectors where there is wide geographical spread into unfamiliar markets and where evaluation of local decision making presents a problem for the franchisor, researchers have sought an answer to the cost effect of monitoring (Carney & Gedajloviv, 1 99 1 ; Minkler, 1 990), suggesting that franchising is an ideal solution (Sorenson & Sorenson, 200 1 ). Both situations have relevance in the real estate context as systems spread widely. It has also been claimed that in industries where there is a heavy reliance on repeat business there is an increased incidence of a propensity to franchise (Brickley & Dark, 1 987; Fladmoe-Lindquist & Jacque, 1 995; Castrogiovanni et al., 2006a). It is difficult to accurately assess a manager's performance in diverse regional settings and unfamiliar markets (Minkler, 1 990, 1 992) thus as franchise networks expand, saturating the domestic market and flowing into international markets, as larger real estate networks in this thesis demonstrate, the firm's proportion of franchised units increases, or the imperative to franchise increases (Castrogiovanni et al., 2006a). In the case of the real estate industry, agencies will only remain in company control as long as it takes to either install a suitably qualified franchisee owner or fully integrate a newly acquired or merged agency into the system. Combs and Ketchen (1 999) also raise the issue of specific knowledge that is often required to operate effectively in a particular location. This aspect is fundamental in real estate agency where the credibility of agents is based on their local market knowledge and standing in the local community.

Another issue considered in the agency approach is the possibility that the selection of non-owner managers could be sub optimal in terms of managerial talent and business acumen. In the NZ real estate agency sector, legislative

constraints9 ensure agency owners must be hold managerial and technical proficiency and in 2007 the Real Estate Licensing Board (R.E.A.L.B.) moved to eradicate unlicensed people being on the boards of real estate companies 10, so technically lack of managerial talent should not be a problem. Furthermore, the talents and skills of franchisees are enhanced by the support services offered by the franchisor corporate team, whereas company managers or independents may be lacking support.

Where there are problems between the parties, delays in contract renegotiation could impair profitability in some contexts. Franchising serves to ease these possible problems because franchisee ownership is an incentive to work hard (Norton, 1 988; Rubin, 1 978). When the franchisee risks losing invested capital, he/she may be less cavalier in taking on the role in the first place, thus the quality of the management will be higher. Hold-up problems are reduced because the franchisee risks loosing a major investment if hislher contract is revoked for reasons of non compliance. This especially applies to more recent real estate franchisee owners who must expend considerable financial resources to take over ownership of an agency. Franchisees who have been owners since the system inception tend to have entered under invitation and in most cases only invested minor amounts of their own capital. However it is also important to note, that real estate franchisees are able to switch franchisor allegiances fairly easily.

Agency theory assists with an overall understanding of franchising strategy as it acknowledges both the costs and benefits and recognises the trade offs that occur. On balance the theory suggests that franchising is an optimal strategy for growth and in terms of profit maximisation Sorenson and Sorenson (200 1 ) find that expanding firms that cover large geographic areas should franchise, as monitoring costs are reduced and interests better aligned. Thus it is understandable how agency issues play a part in real estate franchise decisions. However, the other traditional theory also has a part to play.

9 The Real Estate Agents Act 1 976. 10

In February 2007, the R.E.A.L.B served letters to all licensees to remove unlicensed people from positions on real estate company boards.

2.3.2 Resource Scarcity Theory

The resource scarcity view maintains franchising overcomes resource constraints to growth even though initially the company owned route may provide greater returns (Brown, 1 998; Oxenfeldt & Kelly, 1 969). These constraints include human, financial and organisational capital. The latter may comprise management talent or trained management. Accessing resources, therefore, may be an antecedent to franchising (Oxenfeldt & Kelly, 1 969). Dant et al., ( 1 992) suggest that success of an organisation is dependent on human, intellectual, informational and financial resources but that these are hard to gather at an early stage when firms are young and small (Caves & Murphy, 1 976). Franchising provides a ready and relatively quick means of obtaining these critical resources in the early growth stages. Financial capital is required for a successful launch campaign and for underpinning start up costs and providing working capital. To compete with more established firms, rapid expansion may be essential to build economies of scale in purchasing and marketing (Combs & Castrogiovanni, 1 994; earney & Gedajlovic, 1 99 1 ). The organisation also requires knowledge of specific desirable locations for the franchise businesses to be established, as well as access to labour. Finally the franchisor needs a source of franchisees able to implement the proven business format in separate geographic locations. Real estate franchisors have access to a pool of people who are willing to become franchisee owners and who have experience in the industry, mostly in sales roles. It is merely a matter of choosing the right people to be added to the chain. Real estate sector franchisees provide specialist, local knowledge to assist customers and enhance system effectiveness. In this way their businesses are the local arm to the global brand and develop as parallel and co-dependent businesses.

The resource scarcity model finds favour in some empirical evidence showing that immature franchisors (those less than 1 0 years old) are affected by commercial credit market conditions in establishing franchisee units (Martin & Justis, 1 993). Combs and Ketchen ( 1 999) suggest that financially strong franchise organisations are more likely to have company owned units. Thus

the argument that financial resource scarcity underpins the move to franchise is not without contention. A life cycle model suggests that as firms mature and acquire appropriate resources, rapid expansion is no longer needed and there is a trailing off of franchising and a return to company owned units (Oxenfeldt & Kelly, 1 969). Overall results are equivocal, with some early research supporting this trend (Hunt, 1 973; Caves & Murphy, 1 976, Dant, 1 995) and yet other studies are contradictory (Martin, 1 988). Factors related to age, system size and the desire to grow rapidly find no support in a recent meta- analysis of Combs and Ketchen (2003), and refuting the life cycle link with franchising a view that firms emphasise franchised or company owned units according to shifting imperatives has been advanced by Castrogiovanni

et al. , (2006a; 2006b). Furthermore, Hoy and Stanworth (2003) disagree with capital resources scarcity and emphasise agency issues in support of the earlier work of Rubin ( 1 978). The conclusion negating the lack of capital resources as an antecedent to franchising and the life cycle model concurs with information gleaned from the real estate franchisors discussed in chapter five of this thesis.

It is now suggested that the reason for the inconclusive nature of resource scarcity research to date is because many of the tests have focused on the relationship between the availability of resources and a franchisor's proportion of franchised outlets, without considering the mix at any given time (Castrogiovanni et al., 2006a). It seems that an emphasis on resource competency rather than resource scarcity will shed better light on the franchising decision. Indeed, tests on the life cycle idea tend to support this model. An examination of franchisors in three industries showed that after an initial rush to franchise, a tailing off in franchising activity was not succeeded by a return to company owned units (Hunt, 1 973), so today, fluctuations in the rate of franchise conversions seem to be better explained by the changing imperatives notion (Castrogiovanni et al., 2006b). Where multinational franchise expansion occurs franchisors have to develop support systems that can sustain a large number of franchisees, and where this happens, as in real estate agency, franchising remains a strong strategy. In the real estate sector

franchisors do not buy back regional agencies because they would be too difficult to manage, too costly and legally constrained (Brickley, Dark & Weisbach, 1 991) and there are always plenty of recruits waiting to take over as franchisees or as in most cases, a succession plan is already in operation. Brickley and Dark (1 987) broached the issue of informational resource scarcity amongst franchisors and found that where there was uncertainty about locations, franchisee units were more likely to be established. In the real estate industry this can be seen when franchisors expanding nationally and internationally, take over outside agency groups. In this way local knowledge and locally trusted companies are added to the system 1 1 . It has also been

suggested that franchising enables managerial growth (Thompson, 1994; Shane, 1 996) and that where there is a steady stream of entrepreneurial people who are ready to become managers and potential franchisees once professionally qualified as there are in the real estate industry, franchising will flourish.

In summarising these sections on the traditional views of franchising, both agency risks and resource scarcities appear to play a part in franchising strategy and in ways specific to the industry context. What appears most informative, and likely to add to a better understanding of franchising, is an investigation how certain franchise models develop and as they reach maturity learn how to manage franchisees more effectively by developing a set of skills that form at least a partial basis for competitive advantage (Castrogiovanni et al. , 2006a, pg. 40). An earlier study of four older franchises supported the idea of learned capabilities. Bradach (1 997), for example, showed that over time franchisors developed systems for effectively persuading franchisees to adopt company initiatives while also learning from innovations developed by franchisees.

11 Harcourts International merged with locally identifiable agency groups in Western Australia, Tasmania and New South Wales, in recent international expansionary moves.

2.4

Real Estate Agency Franchising : A Diverse Theoretical