Investment Requirements in Franchise Contracts as a Self-Enforcing Device: Theory and Evidence

In a setting in which franchisees that operate under a common brand name have incentives to free-ride on each other’s sales e¤ort, we examine how a franchisor uses investment requirements as a tool to reduce franchisees’underprovision of sales e¤ort. Theoretically, we show that if the franchisor’s reputation is highly important the franchisor asks for higher investment requirements when penalizing a misbehaving franchise is more di¢ cult (weaker law enforcement) and when directly monitoring franchisees is more costly. We empirically test the theoretical predictions using two datasets at the franchisor level. We measure weak law enforcement using the passing of state level goodcause termination/nonrenewal laws for franchise contracts and we measure monitoring costs using the number of states in which a franchisor operates. Using a database that contains information for 279 franchisors, before and after the laws were passed in some states, we …nd that the passing of the laws implied an incremental 2% increase in investment requirements for franchisors located in states where the laws were passed. Using a large database (10,047 franchisor-year observations), posterior to the passing of the laws, we …nd that franchisors located in states where good-cause termination/nonrenewal laws were passed ask for investment requirements 4.8% higher than franchisors located in states without such laws, and that when a franchisor expands its operations to an additional state it increases investment requirements by 0.64%.