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LEARNING EFFECT AND CONTRACTUAL COMPLETENESS: THE CASE OF FRANCHISING

Vanesa Solis-Rodriguez

University of Oviedo

Manuel Gonzalez-Diaz

University of Oviedo

Contact Information:

Vanesa Solis-Rodriguez University of Oviedo Business Administration Department Avda. del Cristo, s/n Oviedo, 33071 SPAIN Tel: +34985103703 E-mail: solisvanesa@uniovi.es

Manuel Gonzalez-Diaz University of Oviedo Business Administration Department Avda. del Cristo, s/n Oviedo, 33071 SPAIN Tel. & Fax: +34985102807 E-mail: mgdiaz@uniovi.es

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LEARNING EFFECT AND CONTRACTUAL COMPLETENESS: THE CASE OF FRANCHISING

How firms design their contracts is a mayor theme in the literature on managing

outsourcing relationships because it can have strategic consequences for firms. Literature

has mainly focused in the importance of identifying potential contractual hazards and to

incorporate safeguards into their contracts to protect the relationship between parties.

However, a matter totally ignored has been the possibility that firm’s contract design

capabilities can also be an important factor in contractual design. In this study, we analyze

this phenomenon in the case of franchising using a sample of 74 Spanish contracts. Our

results support this idea, showing that those chains with enhanced knowledge about what to

specify in their contract (that is, those which have developed a learning effect) draw up

more complete contracts.

1. INTRODUCTION

Complex contracting is an important mode of formal governance, being observed in an

increasing range of exchange activities (Mayer and Argyres, 2004; Vanneste and Puraman,

2010). However, it is surprising that there has been little analysis of whether firms learn to

manage their interfirm relationships through the contract.

In recent times, several management scholars have begun to study how contractual

completeness, that is, the extend to which relevant contingencies are specified in contracts,

depends on the history of contracting parties working together (Parkhe, 1993; Luo, 2002;

Poppo and Zenger, 2002; Mayer and Argyres, 2004; Ryall and Sampson, 2009; Vanneste

and Puranam, 2010). All these studies reach the conclusion that both repeated interaction

among contracting parties or organizations interacting repeatedly on similar transactions

over time generates a learning effect about how to design the contract.

This paper explores whether firms learn to contract by studying 74 contracts belonging to

Spanish franchise chains with different degrees of experience in franchising world.

Franchising provides a natural framework for seeing whether contract completeness is

affected by the franchisor’s contract desing capabilities (Mayer and Argyres 2004; Argyres

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and Mayer 2007; Argyres et al. 2007). The reason is that, in comparison with other

contracts (JV, alliances, outsourcing), franchise contracts are usually more repetitive

relationships: each time a franchisor signs a new contract with a franchisee he has the

chance to improve the contract, that is, to complete the contract. So it is easier that

franchise chains accumulates new knowledge through these repeated interations and

therefore develop a learning effect than other contracts.

Our results support the idea that the chain’s franchising experience determines the degree

of contractual completeness. In other words, that those chains with a stronger learning

effect specify their contracts in greater detail. This gives empirical backing to the thesis of

Mayer and Argyres (2004) and Argyres and Mayer (2007) that firms differ in their contract

design capabilities and that they learn how to contract and manage their relationships over

time.

We therefore contribute to the inter-organizational relationship literature, particularly

franchising literature, by claiming that the development of franchise contracts does not

depend only on contractual hazards but also on the franchisor’s contract design capabilities.

Those organizations interacting repeatedly on similar transactions may learn from prior

experiences, allowing more complete contracts. Moreover, we have improved the

completeness measurement. Since we evaluated 74 contracts, we were able to identify all

the contingencies that a complete contract should contain and to measure the distance of

each real contract to that hypothetical situation so we have a measure of completeness that

is much more accurate than that used in previous studies, which only considered certain

clauses or contingencies for estimating this measure (Parkhe 1993; Saussier 2000; Luo

2002; Reuer and Ariño 2002, 2003, 2007; Reuer, Ariño, and Mellewigt 2006; Ryall and

Sampson 2006; Mesquita and Brush 2008).

The remainder of the article is structured as follows. After this introduction, the second

section focus on the importance of contract design, discussing the transaction cost theory of

contracting and literature on organizational learning. The third section describes the data

collection process and the sources and models used. The results are discussed in the fourth

section and some brief conclusions are given.

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2. THEORETICAL BACKGROUND AND HYPOTHESES

2.1. Contract design. The classical view.

A phenomenon widely observed nowadays is that an increasing range of exchange

activities is organized through interorganizational relationships in which complex

contracting plays an important role (Mayer and Argyres, 2004; Argyres and Mayer, 2007).

A contract is “an agreement which is legally enforceable or legally recognized as creating a

duty” (Atiyah 1989, p. 40). It outlines the roles and responsibilities of each party, the

allocation of decision and control rights, the planning for various contingencies, how the

parties will communicate and how to resolve disputes (Argyres and Mayer, 2007).

How firms design their contracts is a mayor theme in the literature on managing

outsourcing relationships because it can have strategic consequences for firms. The firms

will substantially improve the performance of their exchange relationships if they are able

to design the contract that better adapts to their characteristics (Ciborra, 1993; McFarlane

and Nolan, 1995; DiRomualdo and Gurbaxani, 1998; Barthelemy, 2001; Kern, Willcocks

and Van Heck, 2002).

Empirical research on contract design has been heavily influenced by transaction cost

economics (TCE). This theory argues that firms develop governance mechanisms in their

inter-firm relationships in order to reduce transaction costs and thus to become more

efficient (Williamson, 1985). A distinction is usually made between two types of

contractual governance for transactions that recur over time: the market and bilateral

contracts. Market governance is an efficient solution when transactions are standardized,

the parties are independent and their identities are irrelevant. This is the case when the

transaction does not require significant idiosyncratic investments by the parties, so that if

disagreement leads to cessation of the relationship both parties can easily contract with

alternative partners on similar terms, that is without any significant loss in value

(Williamson, 1985). Bilateral governace become efficient when the continuity value of a

relationship is significant, especially because at least one of the parties will be making

idiosyncratic investments, so would lose part of its value if the relationship were to cease.

The parties would therefore be in a situation of bilateral dependence.

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Focusing on the second one, when parties are bilaterally dependent on other parties’

behavior – what happens in most of the interorganizational relationships-, they will make

greater efforts to identify potential contractual hazards and to incorporate safeguards into

their contracts (Klein, Crawford and Alchian, 1978; Williamson, 1985) in order to

minimize the costs and performance losses arising from such hazards (Macneil, 1978;

Joskow, 1988; Heide, 1994). Therefore, we can conclude that the higher the likelihood of

contractual hazards, the higher the contractual completeness - the extent to which all the

relevant terms and clauses (contingencies) are specified in the contract (Luo, 2002;

Mesquita and Brush, 2008; Vanneste and Puraman, 2010). This is the case, for instance,

when the joint activity between firms is interrelated in ways that create asset specificity

(Goldberg and Erickson, 1987; Crocker and Masten, 1988; Joskow, 1988; Dyer, 1997;

Saussier, 2000; Poppo and Zenger, 2002; Reuer and Ariño, 2003, 2007; Reuer et al.,

2006)1. Their existence can generate a situation of high dependence that can lead to a hold-

up problem and potential conflict in the relationship, increasing the risk of opportunistic

behavior by the parties (Klein et al., 1978; Williamson, 1985).

Franchise contracts are not an exception, being the basic tool governing the business-to-

business relationship between franchisor and franchisee. Both parties share profits but their

incentives are not totally aligned because “the franchisor seeks standardization and control

of franchisees so as to maintain brand reputation whereas franchisees strive for autonomy

in operating their own entrepreneurial ventures” (Kidwell, Nygaard and Silkoset 2007, p.

523)2. Consequently, the literature sees them as an essential mechanism for regulating

methods of control and potential solutions for conflicts of interest, enabling them therefore

to reduce opportunistic behavior (Brickley and Dark, 1987; Shane, 1998; Combs and

Ketchen, 1999).

However, as stated by Argyres and Mayer (2007, p. 1065), “Economic theories of

contracting […] implicitly or explicitly assume that all firms know how to design contract

terms that specify roles and responsibilities of the parties […] when parties are bilaterally

dependent and then the contract involves complex technology or other kinds of task 1 Specific assets are understood as being those resources which cannot be readily deployed to other relationships or business, so that their current value is always above what it would be in alternative uses. 2 Rubin (1978), Brickely and Dark (1987), Lafontaine (1992), Combs and Ketchen (2003). A summary can be found in Blair and Lafontaine (2005).

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complexity, properly specifying roles and responsibilities is not always a trivial matter”. In

other words, a matter totally ignored by the literature on contract design has been the

possibility of heterogeneity in firm’s contract design capabilities. So it is necessary to

analyze if the development of franchise contracts depends not only on contractual hazards

but also on the franchisor’s contract design capabilities.

2.2. Contract design capabilities: The learning effect

Although there are not so much studies on the effect of learning on contract design

(exceptions are Mayer and Argyres, 2004; Argyres and Mayer, 2007; Argyres, Bercovitz

and Mayer, 2007; Cochet and Garg, 2008; or Vanneste and Puraman, 2010), there is a large

literature suggesting that learning in general within and between organizations is an

important phenomenon (Lieberman, 1984; Lyles, 1988; Darr, Argote and Epple, 1995;

Argote, 1999). This learning tends to occur through a relatively slow process of

environmental selection of faster learners (Alchian, 1950), or error detection and correction

in “theories-in-use” (Argyres and Schon, 1978), or both. In other words, firms tend to learn

through the repeated practice of routines, which gradually come to embody the fruits of

prior learning (Mayer and Argyres, 2004).

In this way, the literature on organizational learning (Lieberman, 1984; Argote, 1999;

Mayer and Argyres, 2004; Ryall and Sampson, 2006) and, to a lesser extent, transaction

cost theory (Williamson, 1985) maintains that learning affects contract design. More

specifically, as firms gain experience, they develop contract design capabilities, thus

learning to manage and solve the conflicts that are always present in channel relationships

and designing more complete contracts. They learn about potential conflicts and hazards

slowly and incrementally, introducing them in the contract as they experience these

contingencies (Cyert and March, 1963). That is, rather than anticipating such conflicts, the

parties have to actually experience an adverse situation before addressing it in a new

contract because attempts to address contracting hazards and incentive problems in

contracts are inadequate, requiring elaboration to be added in subsequent contracts (Mayer

and Argyres, 2004). Therefore, as firms gain experience, they not only become better at

understanding the kinds of conflicts and contingencies that might threaten the relationship

but they identify such conflicts and contingencies with greater accuracy and at lower cost

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and become better at understanding how to efficiently adapt if they occur (Argyres et al.,

2007).

In the field of franchising, this phenomenon is especially relevant because this learning

about how to specify the contract appears if organizations repeatedly interact on similar

transactions (Vanneste and Puranam, 2010), what happens in the case of franchising. The

main difference between franchise contracts and other contracts (JV, alliances, outsourcing)

is that they are usually more repetitive relationships: each time a franchisor signs a new

contract with a franchisee he has the chance to learn how to contract better, improving and

completing the contract. Therefore, this provides a natural framework for seeing whether

contract completeness is affected by the increase gained from experience in their

contracting capabilities (Mayer and Argyres, 2004; Argyres and Mayer, 2007; Argyres et

al., 2007; Ryall and Sampson, 2009).

There are not many studies on how contracts develop as chains gain experience in the

market, and no studies have considered the contract as a whole. What have been studied

most are the clauses relating to financial terms and the conclusion reached is that these

remain more or less unchanged over time (Lafontaine, 1992; Sen, 1993; Lafontaine and

Shaw, 1999; Seaton, 2003; Lafontaine and Oxley, 2004). Azoulay and Shane (2001), after

interviewing 16 founders of new franchises, note that some of those who initially had not

included clauses relating to territorial exclusiveness did so subsequently.

To our knowledge, the only study that directly analyzes the influence of learning is Cochet

and Garg (2008). These authors study the evolution of formal contracts used by three

German chains reaching the conclusion, amongst others, that a) it is over time when

franchisors introduce new elements in the contract or redesigned the existing ones in order

to adapt them to any problems arising3, being this phenomenon a result of the learning

process and b) these changes in contractual design clearly served the aim of improving

control over franchisee behavior, thus reducing costs for the franchisors. However,

although this study considers a large number of contractual clauses, it omits many others,

so much information on contractual design is missing (Argyres et al., 2007). In other fields,

3 These authors indicate that only one of the companies in the analysis dropped a clause, but this is described as a “minor change”.

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Ryall and Sampson (2006) note that the existence of prior relationships and, therefore, of

experience, increases the level of detail in contracts. Similar results were obtained by

Mayer and Argyres (2004) and Argyres et al. (2007).

We can therefore establish that the chain’s experience in franchising allows it to learn from

past mistakes, so that matters (or contingencies) leading to unanticipated problems and not

initially included in the contract can gradually be included in new contracts in order to

avoid such problems in the future (Argyres et al., 2007; Cochet and Garg, 2008). This

ability to make contract design more efficient means that the greater the experience of the

chain in franchising, the fuller the contracts (Baker, Gibbons and Murphy, 2002; Poppo and

Zenger, 2002; Ryall and Sampson, 2006), the more sophisticated and therefore the more

complete. Moreover, given the potential for more efficient design as well as the ongoing

framework value of contracts (Macneil, 1978), contracts may be expanded as a relationship

develops (Baker et al., 2002; Poppo and Zenger, 2002; Ryall and Sampson, 2006). This is

what Vanneste and Puranam (2010, p. 187) call the learning effect, that is, the tendency

toward using more detailed contracts as a consequence of enhanced knowledge about what

to specify in a contract that arises from repeated interactions.

The hypothesis is therefore as follows:

Hypotheses: The stronger the learning effect, the higher the contractual completeness of a

franchising relationship.

3. METHODOLOGY

3.1. Data collection

On the one hand, data to measure contractual completeness were drawn from contracts

between franchisors and franchisees. We contacted 805 Spanish franchise chains by

telephone and e-mail in March 2006 to ask them to collaborate in our study. We did not

include foreign franchisors in order to avoid a potential bias caused by the effect of the

national regulation on contract design. It is common practice for franchise chains in foreign

markets to use the same contract as in their domestic markets (Lafontaine and Oxley, 2004)

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so, if the sample includes both national and foreign franchisors, the differences in

completeness might be influenced by the law of the franchisor’s country of origin.

We requested information about the company and particularly about the franchise contract.

293 franchisors agreed to collaborate. We followed several standard recommendations in

the literature to increase the response rate4. Despite our efforts, many of them they did not

send the information requested on the contract. We doubled our efforts over the following

months and finally closed the request for information in December 2007, having received

74 contracts, which represents a response rate of 9.2 percent. All these contracts belong to

companies that are operating today in Spain in both the services and retail industries. Table

1 shows the sample distribution.

On the other hand, we complemented the contract information with secondary information

about the chains which we obtained from the dossier package sent by the franchisors and

from franchisors’ web sites or, when neither of these were available, from the Professional

Franchise Guides.

To test for a potential response bias in our sample, we followed the Armstrong and Overton

(1977) procedure. We compared several variables in early-returned questionnaires and late-

returned questionnaires. This comparison assumes that late respondents share similar

characteristics and response biases with non-respondents. Analyses indicated that no

significant mean differences existed between early and late respondents regarding

completeness. Furthermore, we compared the industries represented in the sample to the

population (Poppo and Zenger, 2002). The sample and population did not appear to differ

by industries.

4 See, for example, Fowler (1993) and Dillman (2000). These steps include calling key informants prior to asking for information, following up with repeated reminder mails or calls, promising a final survey report contingent upon their participation, signing confidentiality agreements and guaranteeing anonymous participation.

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TABLE 1: Sample distribution

Sector Number % of the sample Sector Number % of the sample

Real-state agencies 3 4 Hairdressing 2 2,7

Food 2 2,7 Advertising-Promotions-Communication

1 1,4

Clothing alterations and mending 2 2,7

Recycling-Consumables 4 5,4

Beauty and personal care 1 1,4 Insurance 2 2,7 Communication-Internet-Telephony 1 1,4 Automobile services 3 4

Consultancy 1 1,4 Specialized service 6 8,1

Dietetics store-Herbalist-Parapharmacy 2 2,7 Financial service 1 1,4

Teaching 1 1,4 Clothing 11 14,8 Hotel and catering 14 18,9 Specialist store 2 2,7 Photography 2 2,7 Vending 2 2,7 Printer’s-Sign-making 2 2,7 Travel agencies 5 6,7 IT 3 4 Total 74 100 Optician 1 1,4

3.2. Description of model and variables

Because our aim is to qualitatively analyze if those chains which have been able to develop

and exploit contract design capabilities (that is, a learning effect) tend toward using more

complete contracts, we have decided to use a cluster analysis and, more specifically, the

twostep cluster analysis, which automatically determines the optimal number of clusters

within a data set, using as the clustering criterion the Schwarz's Bayesian Criterion (BIC).

To that end, we used as grouping variable the franchisor’s experience, measured as the

number of years that the different chains have been working as franchises (EXPERIENCE).

We used this measure because it has been used in many studies as a proxy for experience,

both in franchising and in other fields (Caves and Murphy, 1976; Lafontaine and

Kaufmann, 1994; Minkler and Park, 1994; López and Ventura, 2002; Dant and Kaufmann,

2003; Perales and Vázquez, 2003; or Castrogiovanni et al., 2006). We consider this variable

is a good proxy for learning effect because companies learn to design more complete

contracts as they gain experience of problems over time (Klein et al., 1978; Williamson,

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1985; Mayer and Argyres, 2004; Ryall and Sampson, 2006). As Mayer and Argyres (2004)

point out on page 398, “when projects (in this case, outlets opening) occur almost

simultaneously, there is no real chance to incorporate lessons learned from the first”.

Moreover, an older system will generally have faced more different situations than new

systems, so as Mayer and Argyres (2004, p. 405) summarize: “[…] over time the contracts

between [the parties: franchisor and franchisee] come to serve as repositories of knowledge

about how to efficiently work with each other”. Finally, contractual learning studies have

compared contracts at different moments in time (Mayer and Argyres 2004; Cochet and

Garg, 2008).

In order to measure contractual completeness we use the CONTINGENCIES variable.

Taking into account the definition of completeness presented above, what we have to

measure is the degree to which all potential contingencies are covered (Luo, 2002;

Mesquita and Brush, 2008; Vanneste and Puranam, 2010). We therefore had to code all

these different contingencies included in our sample. To do this, the first step was to read

carefully the 74 contracts, in order to obtain a first draft of the list of contingencies or

contractual problems included in all of them. Some of these were obviously already known

to the authors, because the literature and empirical evidence on franchise contracts have

examined specific provisions appearing in contracts, such as payment structures (Blair and

Kaserman, 1982; Lal, 1990; Lafontaine, 1992, 1993), contract length (Brickley, Misra and

Van Horn, 2006), selling prices (Lafontaine, 1999), territorial exclusivity (Nair, Tikoo and

Liu, 2009) and tying (Michael, 2000). However, others were completely unknown as they

dealt with aspects that franchise chains do not make public.

Once we had the draft of the list of contingencies, the next step was to process all the literal

clauses included in the contracts in order to identify which contingencies were included in

each contract at least once5. For this purpose, the authors separately classified the

contingencies and agreed on any differences. Where there were discrepancies, a third-party

opinion was sought. Finally, 157 different potential contingencies to be solved in contracts

5 Any contingencies covered in a contract, even if they appeared only once, were considered because a) there are not many of them and b) the fact that they appear in just one contract does not mean they are specific to that contract; it may be that other chains that would also include such contingencies are not in our sample.

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were identified6. Obviously, the contracts did not all include either the same number or the

same kind of contingencies, so the reading of the different contracts involved a learning

process by which we progressively adjusted the number of contingencies. This was done

either by a) setting apart a new contingency for aspects that we had initially included under

other contingency, b) joining up contingencies that were initially separate in just a single

contingency or c) moving aspects that were initially under a specific contingency towards

another7.

It is important to note that the number of literal clauses does not have to tally with the

number of contingencies. A contingency can be detailed in several literal clauses or only in

part of one. Therefore, it is not the number of literal clauses formalized in the contract that

is relevant for analyzing contractual completeness, but the number of contingencies or

contractual problems which are considered in the contract. We believe this is the most

appropriate variable for measuring completeness. Each of these contingencies refers to a

specific aspect or contractual problem in the franchise relationship so, considering the

definition of completeness, the greater the number of contingencies in the franchise

contract, the more complete it will be. Therefore, our measure of completeness was

calculated as follows:

Contractual completeness = ∑=

157

1iiY

where iY equals 1 if the i th provision was used and zero otherwise. The summation term

therefore ranges from 0 to 157.

This measure of completeness improves previous measures of completeness because we

directly measure the number of contingencies and we consider all of them to compute the

level of completeness. Authors, such as Poppo and Zenger (2002) and Hendrikse and

Windsperger (2010), measure this concept indirectly because they ask managers to indicate

6 For instance, one contingency refers to franchisee’s obligations with regard to the franchisor’s method and know-how, another about how the franchisor has to promote the chain, etc. An average contract has 60 contingencies and over 6,000 words. 7 For instance, initially we had a specific contingency regarding the franchisee’s obligation to “Not alter the establishment decor” which was eventually included in a more general contingency relating to “Adaptation of the establishment”. Also, some aspects that were initially included in the “Compliance with the method” contingency were finally included in the “Brandname use” contingency.

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on a Likert scale to what extent the formal contract was highly customized or detailed.

Other works only consider certain clauses or contingencies for estimating this measure

(Parkhe, 1993; Saussier, 2000; Luo, 2002; Reuer and Ariño, 2002, 2003, 2007; Reuer et al.,

2006; Ryall and Sampson, 2006; Mesquita and Brush, 2008). The inclusion of all the

aspects covered in the contracts is important because, as stated by Goldberg and Erickson

(1987), the clauses inserted in a contract are chosen simultaneously and may interact, so

empirical studies should study all clauses together.

Along with this variable, we have introduced other 3 variables which are also proxies for

contractual completeness: number of pages (PAGES), number of words (WORDS) and a

variable we have called DETAIL8, the last one trying to capture the degree of detail of each

contract with regard to the rest of the contracts in the sample. To create this variable the

procedure was the following. First, we counted the number of words of each contingency

for each contract in our sample. Then, for each contingency, we identified the contract with

the highest number of words, so that contract, for that contingency, had a punctuation of 1.

This means that this contract, with regard to the rest of the contracts in the sample, is the

most detailed for this specific contingency9. Once we identified, for each contingency, the

most detailed contract we had to value the contracts which had not obtained the maximum

punctuation according to the previously established. In this case, for each contingency, we

divided the number of words in the contingency between the number of words in the

contract with the highest detail for that contingency (that is, the contract with punctuation

equal to 1)10.

8 Obviously, these variables are worse proxies for contractual completeness, but they serve as control variables. 9 We consider this can indicate a higher degree of detail, being the reason the following. Imagine we are analyzing for two different contracts one contingency, “franchisor’s obligations with regard to the establishment”. In the first contract, this contingency has 150 words and in the second one 500 words. The most likely is that in the first contract only a few aspects are included like, for instance, that the franchisee has to manage his establishment or that he has to obtain all the necessary licences to open the outlet. However, the second contract probably includes more aspects like, for instance, the decoration of the outlet, what to do if the franchisor modifies the image of the chain, if the establishment has to belong to the franchisee, etc. Therefore, the second contract includes the way to proceed in a higher number of situations than the first one, so we can conclude that it is the most detailed for this specific contingency. 10 In the previous example, the second contract would have a punctuation of 1, while the first one would obtain a punctuation of 0.3 (150 /500). This indicates that the first contract has a 70% less of detail than the second one.

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The descriptive statistics and correlations between variables are given in Tables 2 and 3,

respectively.

TABLE 2: Descriptive statistics

Variable Mean Std. Dev. Min. Max. N CONTINGENCIES 60.676 19.100 13.000 103.000 74 WORDS 6,032.510 3,782.406 920.000 19,099.000 74 PAGES 17.910 10.723 4.000 46.000 74 DETAIL 18.146 12.331 1.04 54.000 74 EXPERIENCE 9.410 6.523 1.000 31.000 74

TABLE 3: Correlations

CONTINGENCIES WORDS PAGES DETAIL EXPERIENCE CONTINGENCIES 1.000 WORDS 0.791*** 1.000 PAGES 0.719*** 0.897*** 1.000 DETAIL 0.867*** 0.891*** 0.789*** 1.000 EXPERIENCE 0.256** 0.119 0.050 0.154 1.000

***, **, * = Significant at 99%, 95% and 90%

4. RESULTS

Before presenting the cluster analysis results and with the aim of graphically checking if the

higher the franchisor’s experience the more complete the contract, Figure 1 shows, for each

franchise chain, its franchising experience (horizontal axis) and the number of

contingencies covered in its contract (vertical axis). It is clear from Figure 1 that, in general

terms, the franchise chains with more experience also have more detailed contracts.

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FIGURE 1: Franchisor’s experience and number of contingencies

Focusing on cluster analysis, Table 4 presents the results of our estimation, using the SPSS

statistical program. On the other hand, Table 5 shows the profiles of the groups obtained. TABLE 4: Clusters distribución

N % of combined

Cluster 1 39 52.70 2 25 33.80 3 10 13.50 Combined 74 100.00 Total 74 100.00

TABLE 5: Clusters profiles

Cluster

1 2 3 Combined

Experience Mean 4.62 11.72 22.30 9.41 Std. deviation 2.09 2.01 4.08 6.52

As we can observe, three groups of franchise chains have been identified through the

cluster analysis, which we have called “Inexperienced chains” (cluster 1), “Chains with

some experience” (cluster 2) and “Experienced chains” (cluster 3). The chains which

belong to the first cluster have, on average, an experience of 4.62 years in franchising

world; the second cluster has a mean of 11.72 years; and, finally, the third cluster has a

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mean of 22.30 years franchising the business. The differences among the clusters are

considerable11, so we can conclude that the higher the number of years franchising a

business, the higher the chain’s experience.

From this classification and with the aim of testing the hypothesis of this paper, we have

analyzed more deeply the three groups, focusing on the four variables which proxy

contractual completeness (Table 6). Firstly, focusing on CONTINGENCIES variable, we

can observe that the higher the years of franchising experience the higher the number of

contingencies in the contract. The chains which belong to the first cluster have a contract

with 55.48 different contingencies on average; the contract of the second cluster’s chains

have 63.96 contingencies on average; and chains in the third cluster have a contract with

72.70 contingencies, also on average.

The same trend is observed when the other 3 variables are analyzed. In this way, the

contract designed by the chains which belong to the third cluster is the one with the highest

number of words (8,079.90 words, as opposed to the 5,514.23 and 6,022.08 words of the

chains belonging to cluster 1 and 2, respectively), pages (20.90 on average, as opposed to

the 16.95 and 18.20 pages in the other two clusters) and degree of detail (24.22 as opposed

to 16.01 and 19.04, respectively). Therefore, we can conclude that the chains with the

highest experience franchising their businesses are the ones with the more complete

contracts. Because the chain’s experience proxies contract design capabilities, the

hypothesis in this paper seems to be supported, that is, the stronger the learning effect, the

higher the contractual completeness of a franchising relationship. TABLE 6. Cluster’s general comparative

CLUSTERS 1 2 3 CONTINGENCIES 55.48 63.96 72.70

WORDS 5514.23 6022.08 8079.90

PAGES 16.95 18.20 20.90

DETAIL 16.01 19.04 24.22

11 Moreover, this analysis allows us to identify if grouping variables are really important to create the clusters. In our case, the variable “years of franchising experience” contributes to the formation of the three clusters. See Appendix I.

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If we focus on analyzing the type of contingencies included in the contracts, we also

observe important differences among the clusters. On the one hand, regarding the

contingencies concerning franchisee’s and franchisor’s obligations, we can conclude that

franchisee’s obligations are the contingencies which make a difference (Table 7). In this

way, the contracts designed by the chains which belong to the first cluster have on average

8.18 contingencies regarding franchisor’s obligations and 17.72 contingencies regarding

franchisee’s obligations; the chains belonging to the second cluster have on average 8.92

contingencies about franchisor’s obligations and 20.36 contingencies about franchisee’s

obligations; and, finally, the contracts of the chains which belong to the third cluster have

on average 10.60 and 22.00 contingencies, respectively. Therefore, taking into account

these results, we can extract two main conclusions. The first one is that experience in

franchising allows the chains design the contract in greater detail both from the point of

view of franchisor and franchisee. The second one is that, despite the former, the

contingencies including franchisee’s obligations grow in higher proportion. This result

supports the idea that most of the contingencies included in franchise contracts refer to

franchisee’s obligations. In other words, there is an asymmetry in discretion in franchise

contracts: the franchisor enjoys higher levels of discretion and power than the franchisee

(Klein, 1980; Al-Najjar, 1995; Spencer, 2008). TABLE 7. Use of contingencies with franchising experience

EXPERIENCE

CONTINGENCIES CLUSTER 1 CLUSTER 2 CLUSTER 3

Frachisor’s obligations 8.18 8.92 10.60

Franchisees’ obligations 17.72 20.36 22.00

Grounds for termination 19.69 23.20 25.00

Grounds for termination in favour of the franchisor 14.95 17.12 18.80

Grounds for termination in favour of the franchisee 4.44 5.72 5.70

Focusing on the contingencies establishing franchisee’s obligations during the term of the

agreement (Table 8), we can observe that the ones regarding to a) the transfer of the

franchise contract, b) the use of the trademark, c) the establishment, d) the method, e) the

geographical exclusivity, f) the offering or g) the inspections are, as minimum, in

approximately 85% of the contracts designed by the chains belonging to the first cluster,

while these contingencies are practically in 100% of the contracts designed by the chains in

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clusters 2 and 3. Other contingencies like, for instance, a) maintain confidentiality, b) non

competition, c) have accounting books, d) payments up to date or e) supply only through

official providers appear, on average, in 69% of the contracts developed by the

inexperienced chains (cluster 1), being in practically 100% of the contracts developed by

most experienced chains (cluster 3) and in most of the contracts designed by the chains in

cluster 2.

However, the biggest differences are observed with regard to contingencies hardly studied

in previous literature like, for instance, a) the indication of legal independence between

franchisor and franchisee, b) the beneficial use of the franchisor’s training, c) the

observance of rules, d) the diligence in running the business, e) to inform the franchisor any

improvement for the franchisor’s know how or f) the start up of the franchisee’s

establishment.

Of all of them, the franchisee’s obligation of informing the franchisor about any

improvement he has done in the chain’s know how deserves a special attention. This

contingency shows that all the innovations developed by franchisees does not own to them,

but the franchisor, not receiving any compensation for the innovation. An example of how

this specific contingency is designed is the following:

“[…] All suggestions to improve franchisor’s system […] will be always well

received by the franchisor, who will take them into account when new rules are

included or when the existing ones are modified. Franchisees expressly recognize

and accept that if these suggestions are incorporated to the system for all the

chain benefit, automatically they will be property of the franchisor without rights

in favour of franchisee, having the franchisee the obligation to inform about any

improvement over the franchisor’s know how or new knowledge applicable to

the system […] (the franchisee can not use these improvements in his

establishment without expressed and written permission from the franchisor).”

With regard to post-contractual obligations, we also observe important differences among

the clusters. In this way, contingencies practically not included in the contracts designed by

the inexperienced chains (cluster 1) like, for instance, a) giving the franchisor a preference

option over the establishment and/or the other elements of the chain, b) stopping the

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franchising business and inform all the affected people about it or c) deleting his identity as

franchisee in telephonic lines or advertising, are included in a lot of the contracts designed

by the most experienced chains (cluster 3). TABLE 8: Franchisee’s obligations: cluster’s comparison

CONTINGENCIES CLUSTER 1 (%) CLUSTER 2 (%) CLUSTER 3 (%) Indication of legal independence 56.41 56.00 70.00 Transfer 92.31 96.00 100.00 Royalty 71.79 72.00 40.00 Advertising fee 51.28 32.00 20.00 Fee 76.92 80.00 60.00 Initial investment 17.95 24.00 00.00 Beneficial use of franchisor’s training 53.85 56.00 70.00 Inspections 89.74 80.00 100.00 Accounting books 61.54 88.00 100.00 Non-competition 69.23 72.00 90.00 Confidentiality 76.92 72.00 100.00 Trademark 87.18 92.00 100.00 Policies and insurance 58.97 76.00 90.00 Prices 51.28 44.00 60.00 Exclusivity 89.74 84.00 90.00 Establishment 89.74 100.00 100.00 Diligence in running the business 35.90 52.00 50.00 Method 87.18 96.00 100.00 Supply 71.79 96.00 100.00 Minimum level of purchases from central office 2.56 12.00 40.00 Data protection 15.38 16.00 40.00 Informs to the franchisor 20.51 36.00 80.00 Offering 84.62 92.00 100.00 Achieve trade objectives 12.82 24.00 00.00 Opening hours 43.59 40.00 40.00 Managing the outlet 2.56 24.00 10.00 Observance of rules 17.95 44.00 50.00 Hiring employees 43.59 56.00 60.00 Payments 82.05 84.00 90.00 Start up the business 48.72 64.00 70.00

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TABLE 8: Franchisee’s obligations: cluster’s comparison (Cont.) Post-contractual obligations Non competition 56.41 48.00 50.00 Confidentiality 48.72 40.00 60.00 Not use of method and elimination of chain’s elements 84.62 88.00 100.00 Give the franchisor all chain’s elements 76.92 64.00 80.00 Franchisor’s right over the establishment 20.51 36.00 60.00 Activity cessation / Communication 30.77 40.00 60.00 Payments 53.85 52.00 70.00 Telephonic lines / Advertising 20.51 28.00 50.00

Focusing now on the contingencies establishing franchisor’s obligations (Table 9), we can

observe that the most used contingencies, independently of chain’s experience, are the ones

regarding to training, assistance, supply and method, typical franchisor’s obligations. On

the other hand, the biggest differences among the three clusters are observed in the

contingencies regarding to establishment’s advising, hiring of employees and advertising of

the chain. TABLE 9: Franchisor’s obligations: cluster’s comparison

CONTINGENCIES CLUSTER 1 (%) CLUSTER 2 (%) CLUSTER 3 (%) Transfer 35.90 24.00 40.00 Training 76.92 92.00 80.00 Assistance 79.49 76.00 90.00 Supply 82.05 96.00 100.00 Confidentiality 2.56 12.00 10.00 Trademark 69.23 80.00 70.00 Advertising 58.97 56.00 90.00 Exclusivity 87.18 72.00 70.00 Establishment’s advising 35.90 56.00 70.00 Diligence in running the business 15.38 36.00 40.00 Method 89.74 88.00 100.00 Data protection 7.69 12.00 30.00 Hiring employees 15.38 16.00 40.00

Finally, if we analyze more general contingencies (Table 10) we also observe significant

differences. Contingencies like, for instance, a) that the contract replaces any previous

agreement, b) the chance to modify the contract, c) the nullity of the clauses, d) record the

franchise contract into a public document or e) deciding the applicable law are in few of the

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contracts developed by the inexperienced chains. However, these contingencies are

included in a lot of the contracts designed by the most experienced chains.

In short, we can conclude that the main difference among the different groups of franchise

chains is that the contracts designed by the most experienced franchise chains include, on

the one hand, a wider range of franchisee’s obligations, the aim being to try to avoid

opportunistic behaviours’ which put the chain’s image and reputation at serious risk, and,

on the other hand, contingencies regarding more general aspects for the franchising

relationship. TABLE 10: Other contingencies: cluster’s comparison

CONTINGENCIES CLUSTER 1 (%) CLUSTER 2 (%) CLUSTER 3 (%) Contract duration 100.00 100.00 100.00 Aim of the contract 92.31 88.00 90.00 Independence of the parties 79.49 88.00 100.00 Arbitration / Jurisdiction 100.00 88.00 100.00 No right to indemnity for goodwill 17.95 24.00 30.00 Contract replaces any previous agreement 38.46 36.00 50.00 Contract modification 28.21 40.00 60.00 Communication between the parties 58.97 52.00 70.00 Travel and accommodation expenses, etc. 5.13 16.00 30.00 Personal guarantees 7.69 8.00 30.00 Nullity of the clauses 30.77 40.00 70.00 Record the franchise contract into a public document 5.13 20.00 40.00 Applicable law 25.64 52.00 60.00

All these results support our hypothesis suggesting that the longer a chain has been using

the franchise formula as a means of expanding its business, the more complete the contracts

it draws up will be. This seems logical because, as stated in the literature on organizational

learning and, to a lesser extent, TCE, firms learn to design contracts over time as they gain

experience (Klein et al., 1978; Williamson, 1985; Mayer and Argyres, 2004; Ryall and

Sampson, 2006). The reason is that experience allows franchisors to a) become better at

understanding the kinds of contingencies that might threaten the relationship, b) identify

such contingencies with more accuracy and at lower cost and c) learn to adapt efficiently if

such contingencies occur (Argyres et al., 2007). We can therefore establish that the chain’s

experience franchising allows it to learn from past mistakes, so contingencies leading to

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unanticipated problems can gradually be included in new contracts in order to avoid such

problems in the future (Argyres et al., 2007; Cochet and Garg, 2008).

5. CONCLUSIONS

This paper analyzes the importance of learning effect on contract design and, more

specifically, on the degree of contractual completeness in franchise chains. In this way, we

claim that, along with contractual hazards, franchisor’s contract design capabilities are an

important factor, a consideration that has often been disregarded (Argyres and Mayer,

2007). Firms learn over time how to design their contracts and how to make them more

effective.

Instead of carrying out a survey on different contractual provisions or drawing up a

checklist of contractual safeguards based on public information, as in previous studies, we

asked the chains for the whole contract, obtaining 74 different contracts. In this way, we

were able to identify all the different contingencies included in the contracts, thus

overcoming many of the problems identified in the measures of completeness used in

previous studies, which only considered certain contingencies.

Our results support the hypothesis that the stronger the learning effect (measured as chain’s

experience franchising) the higher the contractual completeness of a franchising

relationship. More specifically, we observe that the contracts designed by the most

experienced franchise chains include, on the one hand, a wider range of franchisee’s

obligations, the aim being to try to avoid opportunistic behaviours’ which put the chain’s

image and reputation at serious risk, and, on the other hand, contingencies regarding more

general aspects for the franchising relationship. This indicates that the franchisor enjoys

higher levels of discretion and power than the franchisee (Klein, 1980; Al-Najjar, 1995;

Spencer, 2008). Therefore, we can conclude that the chain’s experience determines the

degree of contractual completeness. These results support the theses of Mayer and Argyres

(2004), Argyres and Mayer (2007) and Argyres et al. (2007). The fact that experience leads

to the use of more complete contracts suggests that firms’ contract design capabilities are

relevant and that those individuals who wish to franchise their business have to find out

how to design balanced contracts. They have to learn how to translate their experiences and

23

knowledge about day-to-day problems into new provisions and safeguards which attenuate

the conflicts.

This study is not without limitations, being a first qualitative attempt to describe the

franchise contract from the point of view of literature on learning. A more qualitative

research is necessary. In this way, we are interested in analyzing in a greater detail how this

learning effect is accumulated in the franchise contract, i.e. how the design of particular

clauses evolves (that is, what particular situations are incorporated in the contingencies)

and how their effectiveness in solving contractual problems improve.

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APPENDIX I: IMPORTANCE OF GROUPING VARIABLE

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31