Entrepreneurs, Contracts, and the Failure of Young Firms

Although economic theory has emphasized that moral hazard and hold-up problems influence the design of contracts, very little is known about the process by which explicit contracts are established and the effect of contractual arrangements on firm performance. This paper attempts to demonstrate that firms are selected for survival on the basis of contracting efficiency. Based on a statistical analysis of 170 new franchise contracts and interviews with the founders of 16 of these new franchise systems, we show that new franchise chains that adopt exclusive territories are more likely to survive over time than chains that do not. Moreover, successful and failed entrepreneurs possess different information about how to design contracts. These entrepreneurs undertake "contractual experiments" based on the information they possess. Those whose experiments prove to be more consistent with economic theory are rewarded for their superior information with survival.

[1]  Jean Tirole,et al.  Incomplete contracts: Where do we stand? , 1999 .

[2]  R. Nelson.  Recent Evolutionary Theorizing about Economic Change , 2005, Technology, Institutions, and Economic Growth.

[3]  O. Williamson.  Markets and Hierarchies , 1975 .

[4]  James A. Brickley.  Incentive Conflicts and Contractual Restraints: Evidence from Franchising* , 1999, The Journal of Law and Economics.

[5]  F. Hayek.  The economic nature of the firm: The use of knowledge in society , 1945 .

[6]  Edward L. Glaeser,et al.  Geographic Concentration in U.S. Manufacturing Industries: A Dartboard Approach , 1994, Journal of Political Economy.

[7]  Stewart Macaulay.  Non-contractual relations in business: a preliminary study , 1963 .

[8]  S. Winter,et al.  An evolutionary theory of economic change , 1983 .

[9]  Luigi Zingales.  Survival of the Fittest or the Fattest? Exit and Financing in the Trucking Industry , 1998 .

[10]  David B. Audretsch,et al.  Innovation, growth and survival , 1995 .

[11]  Scott Shane,et al.  New Firm Survival: Institutional Explanations for New Franchisor Mortality , 1999 .

[12]  Scott Shane,et al.  Organizational Incentives and Organizational Mortality , 2001 .

[13]  Mark J. Roberts,et al.  Patterns of Firm Entry and Exit in U.S. Manufacturing Industries , 1988 .

[14]  W. Dugger.  The Economic Institutions of Capitalism , 1987 .

[15]  Robert E. Martin.  Franchising and Risk Management , 1988 .

[16]  A. Alchian.  Uncertainty, Evolution, and Economic Theory , 1950, Journal of Political Economy.

[17]  G. Stigler.  The Economics of Information , 1961, Journal of Political Economy.

[18]  W. Vincent.  Encroachment: legal restrictions on retail franchise expansion , 1998 .

[19]  Elizabeth C. Hirschman,et al.  Judgment under Uncertainty: Heuristics and Biases , 1974, Science.

[20]  Ralph A. Winter,et al.  TERRITORIAL RESTRICTIONS IN FRANCHISE CONTRACTS , 1994 .

[21]  Carolyn Y. Woo,et al.  Entrepreneurs' perceived chances for success , 1988 .

[22]  D. Commerce.  Statistical abstract of the United States , 1978 .

[23]  M. Hannan,et al.  Structural Inertia and Organizational Change , 1984 .

[24]  Israel M. Kirzner.  Entrepreneurial Discovery and the Competitive Market Process: An Austrian Approach , 1997 .

[25]  R. Zeller,et al.  MARKET PENETRATION AND LOCATIONAL CONFLICT IN FRANCHISE SYSTEMS , 1980 .

[26]  John H. Freeman,et al.  PROFITABILITY, TRANSACTIONAL ALIGNMENT, AND ORGANIZATIONAL MORTALITY IN THE U.S. TRUCKING INDUSTRY , 1997 .

[27]  A. Tversky,et al.  Judgment under Uncertainty: Heuristics and Biases , 1974, Science.

[28]  O. Williamson.  / STRATEGIZING, ECONOMIZING, AND ECONOMIC ORGANIZATION , 1991 .

[29]  Daniel A. Levinthal,et al.  Innovation and Learning: The Two Faces of R&D , 1989 .

[30]  J. Heckman.  Sample selection bias as a specification error , 1979 .

[31]  Timothy Bates.  Entrepreneur Human Capital Inputs and Small Business Longevity , 1990 .

[32]  James A. Brickley,et al.  The Economic Effects of Franchise Termination Laws , 1991, The Journal of Law and Economics.

[33]  Paul H. Rubin.  The Theory of the Firm and the Structure of the Franchise Contract , 1978, Journal law and economy.

[34]  Sanford J. Grossman,et al.  The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration , 1986 .

[35]  Francine Lafontaine,et al.  Double-Sided Moral Hazard and the Nature of Share Contracts , 1995 .

[36]  K. Shaw,et al.  The Dynamics of Franchise Contracting: Evidence from Panel Data , 1996, Journal of Political Economy.

[37]  R. Caves,et al.  Franchising: Firms, Markets, and Intangible Assets , 1976 .

[38]  Steven C. Michael.  The Elasticity of Franchising , 1999 .

[39]  H. Simon,et al.  A Behavioral Model of Rational Choice , 1955 .

[40]  Francine Lafontaine.  Agency Theory and Franchising: Some Empirical Results , 1992 .

[41]  J. Hausman,et al.  Flexible parametric estimation of duration and competing risk models , 1990 .