Describe in brief the structure of a franchise contract

Answer 1

A franchise contract must reward sales efforts by the franchisee while acknowledging that any relationship between effort and results is inexact. The parent company can obtain sales figures but may be unable to evaluate the franchisee's actual efforts. Poor figures can reflect extraordinary effort in a bad location or weak effort in a good one. The contract must thus be structured to motivate the franchisee. Effort can also entail costs that the franchisee must have some expectation of recovering. An auto dealer with a sizable sales staff and a full inventory of parts has higher costs than one with few salespeople and no parts department. Franchise agreements often require that certain services be offered. In return the parent auto company can protect a dealer against free riding competitors by including contract terms stating that it will not open another dealership within a certain distance of this one.
Franchisor and franchisee are in a principal-agent relationship with the same types of monitoring problems and risks of opportunism we previously encountered. To lessen them, many franchise contracts have similar structures. First, the franchisee pays a fixed annual fee for the right to operate. Second, the franchisee pays a royalty, usually a monthly payment that averaged 5.1 percent of gross revenue in 2001 (the latest data available). Approximately 70 percent of franchisees also pay their parents a percentage of gross income for advertising, on average 1.7 percent for those with such an obligation. Problems in measurement and monitoring may explain why the figures are percentages of gross rather than net revenue. A franchisee can understate profit by incurring costs (a company Cadillac) that do not improve the competitive position of either the outlet or its parent. A few home-based franchise systems charge a flat royalty per month regardless of the franchisee's revenue or profit.