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 passive ownership, (2) area development plans, and (3) mandatory advertising expenditures. The primary hypothesis is that these provisions are most likely when there are significant externalities among the units within the franchise system. The evidence, based on a large sample of franchise contracts, is generally consistent with this hypothesis. The evidence also suggests that these incentive instruments are complements. In contrast to the theory, most of the results do not support the hypothesis that the percentage of company‐owned units is related to externalities within the system. Franchisee risk aversion and/or wealth constraints appear more important. While the study focuses on franchising, the results provide insights into related provisions in other contracts.

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