O.R. study shows 91% of successful franchises have defined territory

April 10, 2001

If you're thinking of opening a new burger franchise, make sure your contract gives franchisees an exclusive territory, according to a study published in a journal of the Institute for Operations Research and the Management Sciences (INFORMS®).

In a study sampling franchise systems, the authors found that 91% of successful new franchises granted exclusive territory in their contracts. For the same period, a revealing 31% of failed franchises had no contractual exclusivity.

"There is a pre-conceived notion that a franchise is a guaranteed form of entrepreneurship," explains Scott Shane, Smith School of Business, University of Maryland at College Park. "In fact, lots of things contribute to the failure of franchises. One is territory. If you're thinking of opening a franchise outlet, be on guard for the danger of encroachment. Those purchasing a franchise outlet often stay away from franchisors who won't protect their territory in writing."

New franchise chains that adopt exclusive territories are more likely to survive over time than chains that do not, say the authors, based on statistical analysis of 170 new franchise contracts and interviews with the founders of 16 new franchise systems.

The study, "Entrepreneurs, Contracts, and the Failure of Young Firms," is by Pierre Azoulay, the Sloan School of Management, MIT, and Prof. Shane. It appears in the current issue of Management Science, an INFORMS® publication.

Mistakes Learned from Subway and McDonald's

Despite the benefits of exclusive territories, say the authors, some entrepreneurs fail to adopt this policy because their limited knowledge of contracting leads them to overlook the importance of the franchisor encroachment problem when designing their contracts.

In conversations with the authors, entrepreneurs who adopted exclusive territory were highly cognizant of franchisees' fears of encroachment. While non-adopters were no less informed about the importance of exclusive territories to franchisees, they considered franchisees' hostility unreasonable. Their main anxiety was that exclusivity would allow franchisees to hold up growth of the new franchise.

The authors conclude that exclusive territories do not slow the growth of new chains, as nonadopters claim. Instead, the absence of an exclusivity clause in the contract makes it difficult to attract franchisees to a new system. The authors also interviewed franchisors who did not provide exclusive territory but nevertheless survived. To the authors' surprise, among the four such franchisors interviewed, three had switched from not having exclusive territory to providing franchisees with a protected territory. One told the authors, "I recall my reaction many times when I was a franchisee and the franchisor said 'trust me' and I would think, 'not with my money.'"

The interviews revealed the frequently haphazard way the entrepreneurs decide contract terms. Because most franchisors in the sample couldn't afford to pay a lawyer to write a fully customized contract, these franchisors often identified a small set of important policies and allowed attorneys to fill in the remainder of the contract using a boilerplate. Entrepreneurs identify contract provisions on the basis of a small number of simple routines, the authors confirmed. Sometimes, the routines follow a franchisors' formal business school training. At other times, they found, franchisors adopt policies by imitating other franchises, in the process making errors.

One interview subject said he copied McDonald's policy of not extending exclusive territory. But the franchisor had not done his homework; in its start-up years, McDonald's in fact had followed an industry standard of granting exclusive territory.

Similarly, another franchisor in the sample declared it was following the Subway franchise's lead when denying exclusive territories to franchisees, apparently not realizing that Subway faces chronic litigation from franchisees because of encroachment-related disputes.

Data

The model relies on three distinct sources of data: an original sample of 170 franchise contracts, matched data from two franchise guides (Bond's Franchise Guide and Entrepreneur Magazine's Franchise 500 annual survey), and telephone interviews. The authors obtained Uniform Franchise Offering Circulars from a representative sample of new franchise systems established in the United States between 1992 and 1995. The authors used the exit from franchising as a performance measure. The industry sectors examined included restaurants, retail stores, business services, and other services.
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The Institute for Operations Research and the Management Sciences (INFORMS®) is an international scientific society with over 10,000 members, including Nobel Prize laureates, dedicated to applying scientific methods to help improve decision-making, management, and operations. Members of INFORMS® work in business, government, and academia. They are represented in fields as diverse as airlines, health care, law enforcement, the military, the stock market, and telecommunications. The INFORMS® website is at http://www.informs.org

Institute for Operations Research and the Management Sciences

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