Incentive conflicts and contractual restraints: Evidence from franchising

This study uses agency theory to develop testable implications about three provisions commonly observed in franchise contracts: (1) restrictions on pa ssive ownership, (2) area development plans, and (3) mandatory advertising expenditures. The primary hypothesis is that these provisions are most like ly when there are significant externalities among the units within the fran chise system. The evidence, based on a large sample of franchise contracts, is generally consistent with this hypothesis. The evidence also suggests t hat these incentive instruments are complements. In contrast to the theory, most of the results do not support the hypothesis that the percentage of c ompany-owned units is related to externalities within the system. Franchise e risk aversion and/or wealth constraints appear more important. While the study focuses on franchising, the results provide insights into related pro visions in other contracts.