The recent collapse of debt financing has also greatly affected the franchising industry. In fact, the issue of franchisees obtaining financing to invest in a franchise outlet has always been a major concern for participants in the industry. For example, being highly leveraged may considerably undermine the incentives for franchisees that are at the core of the franchising idea. This is even explicitly acknowledged in many franchise chains where the franchisor puts explicit lower bounds on the capital that a franchisee must have. At the same time, the inability of franchisees to raise their own capital may also considerably constrain the ability of franchise chains to expand in times of tight credit. Despite the central nature of financing arrangements in franchising, this issue has not been studied either in the theoretical or empirical literature.
In this paper, we develop a simple theoretical model with financially constrained franchisees where franchisee effort and the profitability of franchised outlets will depend on how much collateral a franchisee is able to put up. If the franchisor is not able to find a potential franchisee with sufficient collateralizable assets so that the franchisee will exert more effort than a manager, a company owned outlet will generate higher profits. Based on this theory, we can test the hypothesis that financial constraints have a significant impact on the franchising decision on the basis of macroeconomic data.
To this end, we set up an empirical model of entry and expansion into franchising that explicitly takes into account financial constraints of potential franchisees in the franchising decision. In the model, chain stores are randomly and continuously presented with opportunities to expand by establishing new outlets. Every period these chains have to decide whether to pay a sunk cost to become a franchise chain and thus create the possibility of opening either franchisee owned or company owned outlets if they take advantage of the opportunity.
We estimate the determinants of the sunk cost of entry into franchising and the determinants of the relative profitability a company owned outlet and a franchised outlet. In particular, we are interested in examining how financial constraints influence a chain’s decision. We use “Gross Equity Extraction”, which is obtained from Greenspan and Kennedy (2007) and adjusted for local conditions using a local housing price index, as a measure of average collateralizable housing wealth. If this measure declines, it is harder to find a franchisee with sufficient collateralizable wealth so that it is optimal to open a franchised outlet. In this sense, the probability of opening such an outlet conditional on a marginal expansion should go down if financial constraints are important for such decisions.
The empirical model is estimated using data on more than 2000 chain stores in the U.S. In our data, we observe only the net change in the number company owned and franchisee owned outlets, which can be positive or negative. We therefore expand the standard count data approach to estimate both rates at which new outlets are opened and existing outlets are closed. This extension leads to computational challenges as a net change can be consistent with a large number of combinations of new outlets and exits. This combinatorial problem is exacerbated when the data is not on a yearly basis and there is a gap two consecutive observations. We develop an algorithm to deal with this complication.
While our results are of interest for the study of entry into and growth of franchising, they are also of interest to the general literature on the relevance of financial constraints for entrepreneurship. There is a substantial macroeconomic literature that has attempted to identify the presence of financial constraints from the decision of entry into self-employment. However, there is an important issue of endogeneity in this literature. It is not clear whether a positive correlation between self-employment and financial constraints is explained by the hypothesis that self-employed individuals are less financially constrained or they are more likely to accumulate wealth. Our paper avoids such problems because it makes inferences not from a franchisee’s decision itself, but from the fact that the marginal choice between opening a company owned outlet and a franchised outlet by the franchisor should depend on the collaterlizable wealth distribution in a region if financial constraints matter and not otherwise. We are therefore providing a novel way of testing for the role of financial constraints for the transition to self-employment.
The rest of the paper is organized as follows. Section 2 presents the theoretical model that relates financial constraints to a franchisor’s decisions. Section 3 presents the empirical model for estimation. Section 4 describes the data. The estimation results will be presented in Section 5. Finally, Section 6 concludes.
