Franchisor-Franchisee Relationship

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Theoretical Frame of Reference

This chapter of the thesis will look at the theoretical framework that will provide a guideline for the thesis. Previous research on the topics of franchises, innovation theory and entrepre-neurial activity will be brought together for better understanding of the franchise context and innovation within it.

 Structural Characteristics of the Franchise Form

Franchising is a complex organizational form consisting of two parties that form a business partnership: the franchisor and the franchisee (Spinelli & Birley, 1996; Davies, Lassar, Manolis, Prince & Winsor, 2011). Miller and Grossman (1990, cited in Spinelli & Birley, 1996, p. 330) describe franchising as “an organizational form structured by a long-term contract whereby the owner, producer, or distributor of a service or trademarked product (franchisor) grants the non-exclusive rights to a distributor for the local distribution of the product or service (franchisee).” Therefore a franchisee is a business owner that locally distributes the product or service provided by the franchisor, and the franchise is the business that the franchisee runs.
There are two main types of franchise arrangements – product, or trademark, franchising and business format franchising (Felstead, 1993). The first type refers to the situation where franchisors are either seeking outlets for their branded products or “seeking someone else to make-up the finished product and distribute the branded product to retailers” (Felstead, 1993, p. 47), while the latter refers to the licensing of rights to copy a unique retail system (Kaufmann & Eroglu, 1999). The thesis at hand focuses only on business format franchising.

 Franchise Agreement

A typical franchise agreement is characterized by the franchisee buying the rights to profits from a specific franchisor in exchange for an upfront fee and, throughout the period of the agreement, paying ongoing royalties to the franchisor (Brickley, Dark & Weisbach, 1991). This agreement usually allows the franchisee to use the franchise’s trademark and operating proce-dure in their local market while at the same time still being entitled to personal decision rights such as hiring personnel and choosing a local marketing strategy (Brickley et al., 1991).
The franchisee, however, has to agree to follow certain quality standards imposed by the fran-chisor (Justis & Judd, 1989, cited in Spinelli & Birley, 1996). The franchisor has the right to monitor the franchisee for quality and for the maintenance of the trademark’s value (Brickley et al., 1991).

 Franchisor-Franchisee Relationship

Although franchisors and franchisees are legally distinct parties (Mendelsohn, 1995), these parties are overall interdependent in the franchise system since the franchisee has responsibilities to the franchisor and the franchisor is economically dependent on the franchisee (Kumar, Scheer & Steenkamp, 1995). According to Spinelli and Birley (1996), both the franchisor and the franchisee strive for profits on their own ends, but due to the interrelated nature of the franchise system, the individual entrepreneurs owning a franchise contribute to the profits of the franchisor through the franchise fees, royalty payments, and sales of products and services. This makes the franchisor economically dependent on the franchisee.
However, the franchisor still has the more dominant role in this relationship. The franchisor sets the parameters of the relationship in the form of the franchise contract (Davies et al., 2011).
A franchisee is usually recruited on a “take-it-or-leave-it basis” (Felstead, 1993, p. 193) and the franchisee has very little room to negotiate the terms of the relationship, which will then last for five, 10, or 15 years (Felstead, 1993). That is why, according to Felstead (1993), the franchisee is relatively powerless in this relationship right from the beginning of the agreement and cannot “bargain with the franchisor as an equal” (p. 77).
There are three roles that the franchisor, who is “responsible for efficiently managing a complex system of independent business owners”, claims (Kaufmann & Eroglu, 1999). According to Kaufmann and Eroglu (1999), a franchisor must fulfil the role of the system creator, builder, and guardian to provide the favorable scale economies for the franchise. It is essential for the franchisor to find a good balance between trusting the franchisee with managerial decisions on a local scale and acting as the system creator. Some franchisors make decisions exclusively by themselves and act as the ultimate system creator – someone with an autocratic leadership style who ignores recommendations and solutions from franchisees. They do so because they are more concerned about earning their royalties than they are about finding new solutions and identifying new opportunities with the help of franchisees (Kaufmann & Eroglu, 1999).

Innovation

Innovativeness is considered to be one of the main instruments of growth strategies aimed at increasing existing market share and providing companies with a competitive edge (Gunday, Ulusoy, Kilic & Alpkan, 2011). Gunday et al. (2011) state that innovation is a crucial component of corporate strategies since it helps firms to become more productive, perform better in markets, increase customer satisfaction, and as a result achieve a sustainable competitive advantage.
The Oslo Manual is an international source of guidelines for defining and assessing innovation activities in different industries (Gunday et al., 2011). In the context of the thesis, the Oslo Manual (OECD, 2005) has been taken as the main source to describe, identify, and classify innovation. The definitions proposed in the Oslo Manual are derived from the work of Joseph Schumpeter, who was one of the pioneers of innovation theory, and proposed that entrepreneurs are the innovators who bring change to the market and this innovation is the driver of competitiveness and economic dynamics (Sundbo, 1998).
According to the Oslo Manual (OECD, 2005), innovation is the introduction of a new or drastically improved product (good or service), process, marketing method, or organizational method in the business. The minimum requirement for innovation to be considered as such is that it has to be either completely new or significantly improved in the firm. In the context of this thesis, innovation at the firm level means innovation undertaken by franchisees in their specific franchise stores that is new or drastically improved in the whole franchise chain. Therefore, an innovation in a franchise store is considered an innovation only, if it is the first franchise store to implement such an innovation in the chain. The main reason behind innovation is to improve performance, either by increasing demand or by reducing costs, which in turn will affect the rewards of the firm (OECD, 2005).

 Four Types of Innovation

The Oslo Manual (OECD, 2005), based on Schumpeter’s understanding of innovation, defines four types of innovation:
1. Product innovation – “the introduction of a good or service that is new or significantly improved with respect to its characteristics or intended uses” (OECD, 2005, p. 48).
Product innovation in services may include introducing completely new services by the firm, adding new functions and characteristics to an existing product, or implementing major im-provements in how products are provided to the customer (OECD, 2005). In the context of this thesis, product innovation covers the food and drinks that are the main service of the restaurant, as well as the environment where the customer consumes the food and drinks, including the opening hours of the restaurant that relate to the way in which the product is provided to the customer.
2. Process innovation – “the implementation of a new or significantly improved method for the creation and provision of services” (OECD, 2005, p. 49).
Process innovation may comprise of changes in techniques or equipment that are utilized in the production of goods or services. In the context of this thesis, it means a franchisee improving or developing a technique of providing a service, or the equipment utilized in the production of a service that does not yet exist in the chain.
3. Organizational innovation – “the implementation of a new organizational method in the firm’s business practices, workplace organization, or external relations” (OECD,
2005, p. 51).
If an improvement or a new practice in the above mentioned aspects is introduced in the fran-chises that is new in the franchise chain, this is considered an organizational innovation in the context of this thesis.
4. Marketing innovation – “the implementation of new marketing methods not previously used by the firm” (OECD, 2005, p. 49).
Marketing innovation includes changes in the marketing mix of a product – its price, packag-ing, promotion, and placement (OECD, 2005). In the context of this thesis, changes imple-mented by the franchisees in these areas are considered innovation when they are new in the whole franchise chain, or are improving an existing form of marketing in the chain.

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Service Sector Innovation

Link and Siegel (2007) state that a solid model of service innovation has yet to be proposed in the literature. Nevertheless, they state that empirical evidence proves that service industries do innovate, although measuring innovation in such sectors may be difficult since the nature of the output of service industry is abstract and intangible in nature. O’Sullivan and Dooley (2008) write that service innovation is concerned with making changes to products that cannot be touched or seen.
Service-sector innovations are typically based on both market-wide and consumer-specific needs (Link & Siegel, 2007). According to Sundbo, Johnston, Mattsson, and Millett (2001), innovation in the service industry is less technologically driven and more market and consumer driven. Service firm have few R&D activities, and innovation usually comes to the existence by unsystematic work of individuals in the firm. Pilat (2001, cited in Link & Siegel, 2007) states that service innovations are generally small or incremental leading to new applications of existing technologies or work systems.

Radical and Incremental Innovation

According to Norman and Verganti (2014) there are two categories of innovation for products and services – radical and incremental. Norman and Verganti (2014) state that radical innova-tion introduces a change of frame – “doing what we did not do before” (p. 5). Radical innova-tions usually result in a fundamental shift from previously existing system(s) since radical in-novations target needs that are not currently met or recognized in the existing systems (Singh, 2013). O’Sullivan and Dooley (2008) state that engaging in radical innovation can result in substantial benefits for the organization in terms of increased sales and profits, however, pur-suing such innovation is extremely risky and resource-consuming. Radical innovation is a rare phenomenon: it occurs infrequently, approximately one every 5-10 years (Norman & Verganti, 2014).
Incremental innovation encompasses improvements within a given frame of solutions – “doing better what we already do” (Norman & Verganti, 2014, p. 5) Singh (2013) states that incre-mental innovations satisfy companies’ needs of constant improvements of their business through progressive changes. Incremental innovation is less risky compared to radical innova-tion but growth achieved by incremental innovation is smaller in scale compared to radical innovation (O’Sullivan & Dooley, 2008).
In relation to the four different types of innovation discussed previously, Greenhalgh and Rog-ers (2010) state that incremental innovations are small improvements to an existing process, product, marketing, or organizational methods, while radical innovation introduces a comletely new type of service. In the context of this thesis, incremental innovation means an improvement within a franchise that is new to the chain, while radical innovation means the franchisee im-plementing a completely new element that did not exist in the chain before.

 Innovation and the Franchise System

Although franchises have a different organizational form from other firms, and the franchise contract can be limiting the actions of the franchisee, innovation can exist in this system as well.

Relation between Franchisees and Entrepreneurship

Traditionally, franchisors who start a new business model are considered to be entrepreneurs while franchisees implementing this business model are not (Falbe et al.., 1998; Weaven, 2004; Ketchen, Shorts & Combs, 2011; Dada, Watson & Kirby, 2015). Franchisees are rather referred to as the ‘controlled self-employed’ rather than true entrepreneurs (Felstead, 1991). In more recent research however, franchisees are increasingly being viewed as entrepreneurs and capa-ble of innovation. According to Davies et al. (2011), franchise organizations can be seen as a community of entrepreneurs, where each entrepreneur (franchisee) is aspiring for autonomy and innovation.
Arguments against seeing franchisees as entrepreneurs mostly concentrate on the fact that fran-chisees are not being highly innovative when establishing the business (Ketchen et al., 2011). They are not recognizing business opportunities and coming up with a business model of their own. Instead, the franchisor has already identified the opportunity and established the business, and the franchisee merely joins in the process of establishing an already-working business model (Ketchen et al., 2011). It is also said that franchisees are also not as risk-taking as true entrepreneurs (Ketchen et al., 2011).
However, more recent research states that franchisees are still taking a risk when starting up the franchise, although the risk may not be as great as if they were starting a new venture on their own (Ketchen et al., 2011; Dada et al., 2015). The franchisees risk their capital on the success or failure of the franchise and they are responsible for the business first-hand. Although they may lack in innovation in the start-up process since they are not coming up with a new business idea, franchisees are recognizing a business opportunity when starting the franchise, even if it may be limited to realizing that a certain location requires a certain type of store (Ketchen et al., 2011). In addition to that, Withane (1991, cited in Price, 1997) states that the entrepreneurship construct has three implicit dimensions – innovativeness, risk-taking, and proactiveness, and the first two are perceived as vital to the successful operation of the fran-chise.
Entrepreneurial activities are also not limited to the start-up process. Lumpkin and Dess (1996, cited in Falbe et al., 1998) differentiate entrepreneurship from entrepreneurial orientation, de-fining the first one as the creation of new ventures, and the latter as the managerial processes that include entrepreneurial strategies and activities. According to Dada et al. (2015), innova-tion is a part of entrepreneurial orientation, and their research concludes that some franchisees do pursue innovation in their activities.
Research conducted by Ketchen et al. (2011) also confirms that franchisees can remain entre-preneurial when developing their business as well. A popular opinion is that once the start-up phase is done, the franchisees are nothing but business owners, since their actions are limited by the franchisor’s rules when running the business (Ketchen et al., 2011). However, fran-chisees sometimes have a high degree of autonomy in running their franchise business, and therefore can participate in entrepreneurial innovations (Ketchen et al., 2011).

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 Franchisee Innovation

According to Stanworth and Curran (1999), several things affect franchise innovation, such as external environmental conditions, the organizational culture of the franchise system, and franchisee characteristics. Sundbo et al. (2001) state that all franchisees do not passively accept the business system but try to develop a partnership with their franchisor in which both can exercise influence on each other. Spinelli and Birley (1996) agree with this less hierarchical view on franchises, looking at the franchisor and the franchisee as two independently liable organizations. According to Sundbo et al. (2001), some franchisees put effort not toward accepting given conditions, but towards changing the conditions by making incremental adaptation innovations. However, Sundbo et al. (2001) note that franchisees have a narrow scope for innovation compared to regular entrepreneurs since they have limited control, and this is the main reason why change is usually incremental in nature. According to the view of Sundbo et al. (2001), franchisees innovate when the standard franchise concept is not functioning successfully in the local environment or because of the negative reactions of customers or employees.
Cox and Mason (2007) have discovered that franchisees are able to display autonomy in relation to adjusting product mix, prices, marketing elements, and recruitment procedures in response to local conditions. Price (1997) found that franchisees may be more oriented towards process innovation since, through such innovation, franchisees may be able to reduce operating costs. Weaven (2004) finds that franchisees are most interested in having control over local marketing, for example advertisements, coupons, and limited promotional activities. Stanworth and Curran (1999) agree by proposing that franchisees can substantially contribute to franchise system innovation through adaptation to local conditions. They also propose that developing new products and services can be another way to innovate in a franchise. According to Price (1997), in some cases franchisees will display innovative capability in new ideas for new products, working practices, and processes by using slack resources to further the objectives of the chain. However, Weaven (2004) has an opposing view on this and states that franchisees do not have enough control in the franchise system to instigate changes in new product or service development.
When examining U.K. fast food franchisees, Price (1997) found that the franchisor may be tolerant of franchisees’ incremental process innovations, which are sought to achieve higher profits, and can even expect franchisees to engage in such activities if these activities do not hurt the brand. However, Price (1997) states that the franchisor is less tolerant about franchisee-initiated product innovations or radical innovation of processes since these initiatives may hurt the brand value to a great extent.
The topic on the types of innovation pursued by franchises leads to the first research question of this thesis:
Research question 1: What type of innovation do franchises in the restaurant industry pursue, if any at all?

Positive Effects of Franchisee Innovation

With the current business environment constantly changing and the franchise environment becoming increasingly competitive, innovation, entrepreneurial activity, and the ability to adapt may be required from the franchises to stay competitive (Falbe et al., 1998). Dada and Watson (2013) found a positive correlation between entrepreneurial orientation, which encompasses the innovation aspect, and firm performance in franchises. With the standardization aspect of franchises, the result proves that franchises could benefit from more freedom.
Enabling franchisees to take part in franchise innovation and governance can not only improve efficiency of the whole franchise chain but also increase compliance to overall policies of the franchise system, which in turn decreases friction that can arise between the franchisor and the franchisee (Davies et al., 2011). This kind of increase in compliance can occur due to psychological reasoning; individuals are more likely to agree to external rules when they feel like their opinions and decisions play a role in creating these rules (Boje & Winsor, 1993, cited in Davies et al., 2011).
Price (1997) states that if the innovative capacity of the franchisees will not be heard and appreciated by the franchisor, some franchisees may engage in opportunistic behavior. Baucus, Baucus, and Human (1996) agree that blocking entrepreneurial interests of franchisees may lead to noncompliance, which will be exhibited in different ways such as misrepresentation of costs and revenues, delay of royalty payments, and opposing change required to maintain the competitiveness of the whole franchise. Franchisees may feel demotivated and disappointed when their innovative initiatives are opposed by the franchisor, since they enrolled in the franchise to become their own boss while benefiting financially from a proven business concept (Dant & Gundlach, 1999, cited in Pardo-del-Val, Martínez-Fuentes, López-Sánchez, & Minguela-Rata, 2014). Kaufmann and Eroglu (1999) agree that excluding franchisees from the process of innovation can damage the overall system and compromise the franchise’s ability to function in changing environments.

1 Introduction
1.1 Background
1.2 Problem discussion
1.3 Purpose
2 Theoretical Frame of Reference
2.1 Structural Characteristics of the Franchise Form
2.1.1 Franchise Agreement
2.1.2 Franchisor-Franchisee Relationship
2.2 Innovation
2.3 Innovation and the Franchise System
2.4 The Paradox of Entrepreneurial Activity in a Franchise
2.5 Franchisor Support for Entrepreneurial Activities
2.6 Overview
3 Method
3.1 Research Approach
3.2 Research Philosophy
3.3 Research Design
3.4 Literature Review
3.5 Case Selection
3.6 Data Collection
3.7 Data Analysis Approach
3.8 Research Trustworthiness
3.9 Ethical Considerations
4 Empirical Findings
4.1 O’Learys – Paul
4.2 Harrys – Jon
4.3 Coffeehouse A – Kai
4.4 Coffeehouse B – Eva
4.5 Naked Juicebar – Lisa and Oscar
5 Analysis
5.1 Innovation
5.2 Reasons behind Innovation in Franchises
5.3 Franchisor and Franchise Innovation
6 Conclusions
7 Discussion
7.1 Process and Organizational Innovation
7.2 Service Sector Innovation and Swedish Franchises
7.3 Franchisees as Entrepreneurs
7.4 Innovation in Different Types of Restaurant Businesses
7.5 Practical Implications
7.6 Limitations
7.7 Future Research
References
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