FINDING THE RIGHT MIX: FRANCHISING, ORGANIZATIONAL LEARNING, AND CHAIN PERFORMANCE *

Transcription

1 FINDING THE RIGHT MIX: FRANCHISING, ORGANIZATIONAL LEARNING, AND CHAIN PERFORMANCE * Olav Sorenson Anderson Graduate School of Management University of California, Los Angeles 110 Westwood Plaza, Suite 420 P.O. Box Los Angeles, California olav.sorenson@anderson.ucla.edu Jesper B. Sørensen Graduate School of Business University of Chicago 1101 E. 58 th Street Chicago, Illinois jesper.sorensen@gsb.uchicago.edu Word count: 9,200 Draft: June 5, 2000 * Both authors participated equally in this research. Grants to both authors from the Center for Entrepreneurial Leadership at the Ewing Marion Kauffman Foundation, Kansas City, MO supported this work. Sørensen also received support from the James S. Kemper Foundation Faculty Research Fund at the University of Chicago Graduate School of Business. We would like to thank Jonathan Press for his assistance in assembling the data. The usual disclaimers apply. 1

2 FINDING THE RIGHT MIX: FRANCHISING, ORGANIZATIONAL LEARNING, AND CHAIN PERFORMANCE ABSTRACT Franchising provides an increasingly important vehicle for entrepreneurship and accounts for a large and growing share of business in the retail and service sectors. Chain organizations, which must manage units dispersed across large geographic regions, most frequently use this form of governance. These chains must balance the centralization and standardization required for efficiency and consistency with the adaptation necessary for success in local markets. By adopting an organizational learning perspective, we argue that the mix of company-owned and franchised units affects this balance, thereby influencing a chain s performance. In particular, the different incentives facing company managers and the entrepreneurs that manage franchises encourage distinct patterns of organizational learning and knowledge transfer across units. Franchised establishments provide better opportunities for the firm to learn through experimentation; however, companies find it easier to diffuse this information and enforce standards through their company-owned units. Analyses of franchised restaurant chains in the U.S. provide empirical evidence of this tradeoff. 2

3 Franchising occupies a prominent position in contemporary American business and provides a common vehicle for entrepreneurship. Although franchised enterprises, which typically operate in low-technology sectors of the economy, receive less attention than entrepreneurial ventures in high-tech industries, such as the Internet or biotechnology, entrepreneurship through franchising accounts for a large, and growing, share of business in both retail sales and the provision of services. For example, estimates suggest that 40 percent of all U.S. retail sales in 1996 passed through organizations that engaged in franchising some or all of their units (Bradach 1998). This practice appears particularly common among chain organizations, where franchising takes the form of business-format franchising. Under this type of franchising, entrepreneurs purchase a license to the chain s business concept, including the right to use the chain s brand name and access to it s marketing strategies, organizational routines and operating manuals (Caves and Murphy 1976). 1 In return for these resources, the franchisee typically pays the franchiser both initial franchising fees and on-going royalties, but retains the rights to the establishment s earnings (Hunt 1972; Rubin 1978). Examples of this organizational form include restaurants such as McDonald s, hotel and motel chains (e.g., Holiday Inn), and small business services like Mailboxes Etc. Given the growing importance of franchising as a means of entrepreneurship, both entrepreneurs interested in purchasing these licenses and potential franchisers need to understand the performance implications of this governance structure. To explain their performance, a substantial body of research from an economics perspective focuses on the incentives created by assigning residual claims on profits to the entrepreneurs that manage franchised units. This literature suggests that firms might wish to franchise units to alleviate agency problems that stem from hiring employees to manage geographically dispersed operations. Monitoring the actions of distant establishment managers can prove costly and difficult for the corporate office (Rubin 1978; Norton 1988). Therefore, firms may limit the intensity of their observation of these distant units. Without close supervision, these managers 1 In traditional, or product name, franchising, franchisees simply distribute a branded product produced by the franchiser, without any assistance in developing operating procedures. 3

4 might decide to allocate their effort to activities that detract from the performance of the unit they manage (Jensen and Meckling 1976). Researchers often label this possibility as the risk of moral hazard. Franchising can alleviate this problem by aligning incentives (Alchian and Demsetz 1972; Brickley and Dark 1987). The entrepreneurs that manage franchised establishments operate with clear incentives to maximize the performance of these units as they receive any net profits and they stand to lose their investment capital should the unit perform poorly. Therefore, firms that choose to franchise should perform better than those that retain ownership and hire managers when conditions create a high risk of moral hazard (Fama and Jensen 1983; Shane 1996). Indeed, empirical studies find that franchising allows chains to perform better, presumably due to the better alignment of incentives (Lafontaine 1992; Shane 1996; Shane and Foo 1999). Although mitigating moral hazard plays an important role in firm performance, this focus on identifying the optimal governance structure (i.e., hierarchical governance vs. franchising) for individual establishments remains relatively silent regarding the optimal portfolio of governance structures. Nevertheless, each establishment operates within a community of operational units, and the performance of each unit might depend to some extent on the activities of the other units. Extending the agency perspective to the chain level generally implies that one governance structure should dominate and that firms that employ that structure exclusively should perform best (Lafontaine 1991; Lafontaine and Kaufman 1994; Shane 1996). 2 However, chains usually mix governance structures (Bradach 1998). 3 Consider the restaurant industry as an example. Only about 11% of restaurant chains in 1998 pursued a pure governance strategy (10% operated only through franchised units and 1% operated only through corporate-owned units). Moreover, as seen in Figure 1, chains exhibit substantial heterogeneity in their mix of companyowned and franchised units. Although these mixed forms might represent artifacts of the chains paths in moving toward the appropriate governance structure (Oxenfeldt and Kelley, 1969; 2 See Shane (1998a) for a notable exception. He suggests that intermediate strategies might best allow firms to balance moral hazard concerns with the problems associated with franchising (e.g., free-riding). 4

5 Shane 1998b), the optimal choice of governance for a new unit might depend on the composition of the chain as a whole. For example, Bradach (1998) argues that the presence of company-owned units can enhance the performance of franchised operations, and vice-versa. Understanding the performance implications of the portfolio of governance structures requires an explicit consideration of the interactions between units within a chain. The literature on organizational learning provides a framework for just such an explicit consideration of the interactions among the constituent units in these chains. Organizational learning refers to the modification of existing organizational routines in response to signals and information from the firm s past experiences and the environment (Cyert and March 1963; Levitt and March 1988). According to this perspective, the constituent units of a chain can benefit by sharing the routines and knowledge they develop, thereby spreading the costs of generating that knowledge (Argote, Beckman and Epple 1990; Bradach 1997). For example, Baum and Ingram (1998) find that each hotel in a chain benefits from the operating experience of other hotels belonging to the same chain. Likewise, Darr, Argote and Epple (1995) find that pizza franchisees diffuse the routines that they develop to other chain members, increasing the efficiency of all franchise members over time. Nonetheless, although this research considers seriously the interactions among chain members, it fails to take into account how governance structures might influence this learning process. Thus, this literature cannot inform us as to how the choice of governance structures might influence chain performance. However, by infusing the organizational learning perspective with an explicit consideration of incentives, we hope to gain an enriched understanding of how the mix of company-owned and franchised units affects chain performance. Chain managers must choose between two types of organizational learning: exploitation and exploration. This key strategic decision stems from the fact that the chain s units operate in dispersed geographic locations. This exposes the chain to varied local market conditions that 3 Bradach (1998) calls this mixing of governance structures a plural form. 5

6 require local adaptation to maximize performance, since a common set of operating procedures cannot optimize performance across these diverse locations (Bradach 1998; Kaufmann and Eroglu 1999). Simultaneously, a chain s competitive advantage over independently owned units depends crucially on the benefits of the stronger brand names and more efficient operational procedures generated through the application of common procedures throughout the organization (Norton 1988; Jain 1989; Lafontaine 1999). Both system-wide efficiencies and local adaptation create imperatives for organizational learning within chains, yet each demands a different type of learning. Exploitation the incremental improvement of existing organizational routines to improve operational efficiency helps the chain realize economies of scale, and consistency through the application of standardized practices across all its units. On the other hand, exploration the development of new routines to capitalize on novel environmental conditions allows the chain to adapt to varied markets. March (1991) argues that the longterm performance and survival of organizations depends on their ability to balance these two forms of learning. We contend that the mix of company-owned and franchised units importantly affects the balance between exploitation and exploration in chain organizations through the incentives that these governance structures create. Specifically, we argue that incentives lead the managers of company-owned units to lean toward the exploitation of existing organizational routines at the expense of exploratory learning that would better adapt the establishment to local conditions. By contrast, the entrepreneurs that manage franchised units have better incentives to engage in exploratory learning. Although these entrepreneurs might also ably engage in the refinement of existing organizational routines, chains might still wish to maintain company-owned units because organizational learning involves not only the generation of knowledge, but also the diffusion of that knowledge across units. Transferring knowledge between franchised units might prove difficult because of the potential for free-riding by franchisees. Chains pursuing a pure franchising strategy might therefore encounter impediments to the development of system-wide efficiencies. 6

7 The paper proceeds in the following order. First, the theory section delineates the relationship between each ownership structure and organizational learning processes. We then discuss the implications of the mix of governance structure for chain performance, and offer hypotheses about chain performance. The next section describes the data a longitudinal sample of restaurant chains in the United States used to investigate these ideas. The methods section presents a model capable of evaluating both the mean and variance implications of a strategic choice. After presenting the results of our analyses, we discuss their implications, paying particular attention to the ramifications for both franchisers and entrepreneurs considering becoming franchisees. Hierarchy, Franchising and Organizational Learning Organizations make choices explicit and implicit about how to respond to their environments in their selection of organizational practices and structures. This paper focuses on how differences in governance structure influence the type of learning that firms use. Following March (1991) and others, we classify organizational learning into two ideal types: exploitation and exploration. Exploitation involves the incremental improvement of existing organizational routines to enhance operational efficiency. Firms learn from experience with their existing resources and technologies and use that knowledge to improve upon them. Exploratory organizational learning, by contrast, seeks to discover the potential usefulness of untapped resources and new technologies. The general manager faces the difficult challenge of balancing these two types of learning. An organization engaged in a pure exploration strategy will develop insufficient experience with any one technology to operate efficiently or to exhibit any distinctive capability. Meanwhile, an organization devoted to exploitation can fail to observe changes in the world around it, and hence find itself executing sub-optimal routines. Differences in the risks and rewards associated with these two types of learning complicates the task of balancing them. Compared to exploration, the returns to refining an existing technology lie closer in time, provide clearer 7

8 feedback, and offer less risky payoffs, which creates a decision-making bias in favor of exploitation (March 1991; March and Levinthal 1999 [1993]). Two factors suggest that the managers of company-owned units will direct their attention toward the refinement of existing routines rather than to the exploration of new resources and the invention of novel routines. First, the nature of monitoring within organizational hierarchies creates incentives that encourage managers to focus on the incremental improvement of operations as opposed to the development of new procedures. Second, the rewards offered to managers of corporate units rarely encourage innovation. We consider each of these factors in detail. Monitoring generates negative incentives that deter managers from innovating. While franchising relationships transfer claims on the residual profits to the entrepreneur that manages a franchise as a means of aligning interests, hierarchies use monitoring to avoid self-interested behavior on the part of unit managers. Monitoring works by allowing owners to sanction managers (at the extreme, through firing) when they fail to act in the interests of owners. This observation typically takes one of two forms: either owners observe managers actions often called behavioral control or they base their evaluations on the outcomes that they observe, such as unit sales or detailed operational statistics (e.g., Anderson and Oliver 1987). Both generate incentives for exploitation. Under behavioral control, monitors will generally interpret deviations from accepted practices as outside the interests of the firm. Thus, managers know that they can best avoid unfavorable evaluations by operating efficiently using well-honed procedures. Although owners who base their evaluations on outcomes leave more room for experimentation, the firm typically develops its benchmarks based on the past performance of established procedures. Since failing to meet these standards can result in sanctions, risk-averse managers in a company-owned unit will generally choose to improve existing operations because exploration carries with it more variable returns and hence a greater probability that the expectations of superiors will not be met. 8

9 Bradach s (1998: 83-91) examination of restaurant chains suggests that these chains rely extensively on behavioral controls to monitor the activity of company managers. First, chains regularly conducted QSC (quality, service, and cleanliness) field audits of company-owned units. The audits involve highly detailed examinations of all aspects of a units operations, including products, service times, bathroom cleanliness and employee behavior. Second, chains used mystery shoppers, whose unannounced visits similarly examined the units performance from a customer s perspective. Finally, chains employ extensive management information systems to track labor-to-revenue ratios, waste-to-revenue ratios, food and labor costs, inventory levels, and so on. These systems allow chains to compare performance to established budgets and identify under-performing units. At the same time, Bradach (1998) found that the performance evaluations of chain managers emphasized maintaining established practices over financial measures. Chains also monitor the behavior of franchisees, but less stringently and systematically. Bradach found that both field audits and mystery shoppers were used to monitor franchisees, but less frequently. Moreover, the field audits placed less emphasis on detailed measurement of operations than on conversations between the franchisee and the corporate representative about local market conditions and issues facing the franchisee (Bradach 1998: ). Chains did not require franchisees to integrate their management information systems with headquarters, and were therefore unable to engage in the detailed, quantitative monitoring that they used in company-owned units (Bradach 1998: 99). In addition to facing negative incentives that deter innovation, managers of company-owned establishments have only weak positive incentives to engage in exploration. Since these managers have little if any claim on the profits generated by their innovations, they will not reap the full benefits of any successful innovations. As March and Levinthal (1999: 214) argue, organizational arrangements seem to be more effective in removing downside risks than in providing extremely rich rewards for great success. Although chains can try to address this problem by tying bonuses to unit performance or profitability, this solution creates its own 9

10 problems. Managers who receive these rewards (e.g., a percentage of profits) essentially secure a call option. Since the value of this option increases with variance, this compensation scheme gives managers an incentive to engage in risky behavior even when those activities lead to a decrease in expected unit performance. Evidence on the compensation structure for managers of corporate units fits this argument. A manager s compensation in the chains Bradach (1998) studied consisted largely of a fixed salary with a small bonus. Only a small portion of this bonus depended on unit profitability. Instead, the incentives tied rewards to maintaining specific cost/revenue ratios (food, labor, waste, etc.), minimizing food and labor variances, and customer service. Consistent with this, company managers perceived that their evaluations depended on their ability to maintain standards (Bradach 1998: 37-38). Moreover, chain operators explicitly voiced their reluctance to emphasize financial performance too heavily: As one executive put it: We would have chaos if people were given too much of an incentive to maximize financial results. They would screw up the business concept in their attempt to get the bonus (Bradach 1998: 37). The incentive system for corporate managers therefore emphasized the maintenance of established standards and discouraged innovation. 4 While managers of company units receive incentives to refine existing routines, entrepreneurs who run franchises appear more likely to engage in exploratory learning for at least three reasons. First, entrepreneurs that purchase franchise licenses may exhibit a higher propensity to engage in risky behavior than the managers of company-owned units (Knight 1921; Leibenstein 1968). Exploration requires a willingness to accept the uncertain returns to innovation. To the extent that franchise opportunities attract individuals that can tolerate higher degrees of risk than 4 We do not wis h to imply that no innovation occurs in corporate units, or that chains consisting of corporate units alone will fail to innovate. However, as Bradach (1998: 118) notes, innovation among corporate units tends to originate at headquarters (in corporate R&D centers) and implementation typically occurs at a market level, as opposed to at a unit level. 10

11 people drawn to managerial opportunities in company-owned units, one might expect these entrepreneurs to engage in more exploratory learning. Second, entrepreneurs that manage franchised units should exhibit a greater willingness to invest in innovations whose returns may take time to materialize. The returns to exploration not only vary more, but also lie more distant in time than the returns to exploitation (March 1991). Since the payoff to innovation can take longer to realize, the propensity to engage in exploration depends on a decision-maker s time horizon. Entrepreneurs probably operate under longer time horizons than the managers of company owned stores. While entrepreneurs interests align with the long-term performance of the unit they own, the managers of company-owned units might worry that their employment would not survive a short-term performance decline to realize a long-term gain, or might wish to maximize short-term performance to enhance their promotion chances. Consistent, Bradach (1998: 38) found that corporate managers were primarily oriented toward promotion as an incentive and had a short-term orientation. Finally, entrepreneurs will more likely engage in exploration because they enjoy rights to the profits generated by any innovations that benefit their units. Essentially, this assignment of rewards encourages entrepreneurs to take risks that they believe might benefit the performance of their establishment. Nevertheless, the risk of losing their capital investment should limit their innovation to those ideas that they believe justify the risk. No strong reasons lead us to expect that entrepreneurs should engage less than the managers of company-owned units in the refinement of existing routines. Entrepreneurs strong incentives to maximize the performance of their units should also encourage them to devote energy to exploitation. Nevertheless, the increased tendency to engage in exploration might come at the expense of lowered exploitation. If entrepreneurs face a budget constraint in the resources they can devote to organizational learning, devoting energy to exploration will necessarily reduce the amount allocated to exploitation. Still, to conclude that entrepreneurs engage in less exploitation than managers, one must further assume that both sets of actors expend the same amount of 11

12 total effort, but the stronger incentives for entrepreneurs suggest that this assumption may not hold. Thus, the entrepreneurs that run franchised units might easily devote as much energy to exploitation as the managers of company-owned units. As we discuss below, however, the transfer of accumulated knowledge between franchised units may be difficult. The differences in the learning behavior across governance structures suggest the following conclusions. First, a chain consisting exclusively of company-owned units will likely generate fewer innovations than chains that franchise some of their operations. Second, the innovations produced by company-owned units will exploit existing procedures as the incentives facing the managers of these units encourage the refinement of existing organizational routines, but fail to promote experimentation with fundamental operating procedures. As the heterogeneity of markets served by a chain increases, this failure to explore becomes increasingly problematic because it implies a failure to adapt to local conditions. The managers of company-owned units may direct their energies toward refining activities ill-suited to the local environments in which they operate. Does this imply that chains should pursue a pure franchising strategy, with no company owned units? No. Two primary factors indicate that chains might still perform better by maintaining a mix of company-owned and franchised units. Both reflect the difficulties of maintaining operational standards and common processes across franchised units (Bradach 1998). Chain organizations need to preserve these standards because the efficiencies generated through centralization and standardization form the basis for their competitive advantage over standalone competitors (Norton, 1988). The development and maintenance of these standards requires knowledge transfer across the constituent units in the chain, and the willingness of unit managers to contribute to system-wide process improvements. An exclusive reliance on franchising impedes both of these tasks. In particular, the variability in operations generated by exploratory learning limits the transferability of information across units. As argued above, the entrepreneurs running 12

13 franchised units have strong incentives to develop procedures that meet the demands of their local environments. This local adaptation carries an inherent risk that units will generate idiosyncratic knowledge of little value to units operating in different environments. If the chain cannot usefully apply the knowledge gained at one unit to its other constituent units, it loses the ability to benefit by spreading the costs of learning across its multiple operating units. Even if the learning generated by franchisees could benefit other units within the chain, the transfer of knowledge between units in different locations can prove difficult. Theories of the absorptive capacity of organizations suggest that the likelihood that an organization can acquire a new piece of knowledge depends on the extent to which this new knowledge relates to the organization s existing base of knowledge (Cohen and Levinthal 1990). Extending this idea to intra-organizational learning suggests that units in a chain organization will most successfully transfer knowledge when they operate from the same knowledge base (for a similar argument in the context of strategic alliances, see Lane and Lubatkin 1998; Hitt et al. 2000). When the entrepreneurs that manage franchised units adapt to local conditions, they decrease the degree to which they operate from the same knowledge base as units operating in different locations, thereby limiting the likelihood of successful knowledge transfer within the chain. Free-riding behavior among franchisees can also hamper the development of common standards and knowledge transfer. Although franchising arrangements effectively minimize shirking behavior by unit managers, they also create incentives for free riding (Shane 1998a). The entrepreneurs running franchises have little incentive to contribute to the development of chainwide public goods (e.g., a consistent brand image). Faced with a choice between investing resources in developing chain-wide standards and investing in improvements to a local unit, entrepreneurs will likely invest in their own units. Therefore, entrepreneurs running franchised units will more likely develop routines that do not apply to other units within the chain. Moreover, even when they do refine existing routines in a manner that could benefit other units, they might fail to pass this information on to the rest of the chain, an activity which undoubtedly 13

14 entails expense, to minimize costs. Thus, the benefits of exploitation more likely accrue to the chain if they occur among company-owned units than if they originate among franchisees. The presence of company owned units within a chain can facilitate knowledge transfer between units. For example, they can provide a setting for demonstrating the value of innovations to skeptical franchisees. Bradach (1998) shows that chains typically test and evaluate new ideas in company-owned units, in part because the integrated management information systems allow headquarters to gauge precisely the success of new products or procedures. Also, performing tests in company-owned units gives the chain greater control over the conditions under which the test occurs (Bradach 1998: 144). The results of these tests can then help the company persuade the entrepreneurs in charge of franchised units to adopt the innovations. Moreover, chain management has a stronger incentive to diffuse the knowledge generated at franchised establishments than the entrepreneurs running those franchises do themselves. Since the company reaps the benefits of these innovations in both the company-owned establishments and the franchised units (through royalties), they have stronger incentives to educate and inform all their constituent units about the value of new practices. Implications for Chain Performance Measuring organizational learning processes can prove extraordinarily difficult. Though some studies impressively document the accumulation and movement of knowledge within organizations (for a review, see Argote 1999), the intensity of data required typically precludes the researcher from considering the performance implications of such learning at the level of the firm because the collection costs dictate small samples. Nevertheless, we wish to investigate the performance implications of the portfolio of governance structures for the chain as a whole. Thus, we focus on specifying observable implications of exploration and exploitation for organizational performance, in this case revenue growth rates of chains. This empirical strategy allows us to generate testable hypotheses about how the mix of company and franchisee ownership affects chain performance. 14

15 To summarize, our basic argument is that company-owned units tend to engage in exploitation while franchised units are more likely to engage in exploration. This suggests that in a chain dominated by company-owned units, the refinement of existing routines will dominate organizational learning. Conversely, in chains dominated by franchised units, exploration will dominate organizational learning. As the balance of company-owned and franchised units changes, so does the balance between exploitation and exploration. What are the implications of this for chain performance? Organizational learning affects performance in two measurable ways. First, learning patterns act upon the mean, or expected, levels of performance. Firms that interpret and respond to their environments poorly will, on average, exhibit mediocre fit with their environments and perform badly. Second, learning patterns also impact the variability of firm performance over time or space (Sørensen 1999). The variability of performance tends to increase when firms have difficulty adapting to changes in their environment or to differences in environmental conditions across locations. Exploitation represents the dominant organizational learning strategy for an organization facing a constant set of environmental conditions,. The successful refinement of established organizational routines will generate both higher mean levels of performance and lower levels of variability about this mean performance level. As experience with established routines increases, individuals perform those routines more efficiently, raising the mean level of performance. Furthermore, as experience increases, behavior becomes more routine and fewer surprises or unexpected situations occur, leading to less variable performance (March and Levinthal 1999). In this type of situation, we would expect the chains that rely exclusively on company-owned units to exhibit the highest mean performance levels and the lowest variance in their performance. 15

16 However, chain organizations typically do not face a constant set of environmental conditions because of the geographic dispersion of their units. Any single set of operational procedures is unlikely to fit all competitive conditions equally well. Therefore, a chain that relies exclusively on company-owned units will mal-adapt to at least some locations. So, the consequences of pursuing a strategy with no franchised units depends on the heterogeneity of the locations faced by the units. As this heterogeneity increases, the fit of the common operating model should decline on average, leading to poorer performance. Similarly, as the heterogeneity of locations increases, attempts at refining common operating procedures will yield less consistent results, producing greater variability in performance. Thus, the effects of relying exclusively on company-owned units should depend on the heterogeneity of locations served by the chain s units. Hypothesis 1a: When facing relatively homogeneous locations, chains consisting of company owned units alone should experience the highest rates of growth in total revenue. Hypothesis 1b: As the heterogeneity of their locations increases, chains consisting of company owned units alone should experience declining rates of growth in total revenue. Hypothesis 2a: When facing relatively homogeneous locations, chains consisting of company owned units alone should exhibit less variance in their growth rates than chains that franchise. Hypothesis 2b: As the heterogeneity of their locations increases, chains consisting of company owned units alone should exhibit increasing variance in their growth rates. Now consider the opposite extreme: a chain pursuing a pure franchising strategy, with no company owned units. Again, the heterogeneity of locations served by the chain plays an important role. As noted, the entrepreneurs running franchises are more likely to adapt their operations to their local market conditions, which should increase growth rates. At the same time, chains pursuing a pure franchising strategy will find it difficult to develop and maintain common standards that generate chain-wide operational efficiencies and economies of scale, 16

17 which weakens their competitive position relative to independent competitors and to other chains that can achieve these economies of scale. To the extent that the chain operates in a homogeneous set of locations, a pure franchising strategy should therefore hurt chain performance. At the same time, the attempts at innovation undertaken by franchisees produce more variable returns than the steady returns generated by refining existing processes. Therefore, chains without company owned units should exhibit more variable performance when they face a homogeneous set of locations. As the heterogeneity of locations increases, however, a pure franchising strategy can result in less variable performance. Hypothesis 3a: When facing relatively homogeneous locations, chains pursuing a pure franchising strategy should experience lower growth rates than those pursuing pure corporate ownership. Hypothesis 3b: As the heterogeneity of their locations increases, chains pursuing a pure franchising strategy should experience increasing growth rates. Hypothesis 4a: When facing relatively homogeneous locations, chains pursuing a pure franchising strategy should exhibit more variable growth rates than firms that do not franchise. Hypothesis 4b: As the heterogeneity of their locations increases, chains pursuing a pure franchising strategy should exhibit increasingly variable growth rates. As Figure 1 shows, most chains maintain a mix of company-owned and franchised units. For chains that do not pursue either pure strategy, we expect a non-monotonic relationship between firm performance and the chain s unit mix. As the mix of units becomes more even, the mix between exploration and exploitation in the chain as a whole also becomes more balanced. To the extent that organizations perform best when they maintain a balance of exploration and exploitation (March and Levinthal 1999), chains with intermediate mixes should exhibit superior 17

18 performance, both in terms of their mean performance levels and the variability of their performance. 5 Hypothesis 5: The mix of company-owned and franchised units should exhibit an inverted-u shaped relationship with chains growth rates. Hypothesis 6: The mix of company-owned and franchised units should exhibit a U-shaped relationship with the variability of a chain s growth rates. Finally, we consider how the presence of units of one type affects the growth of units of the other type. In other words, how does the number of franchised units affect the growth rates of company-owned units, and vice-versa? Consider first how the number of company-owned units impacts the growth rates of franchised units. Holding constant the number of franchised units in the chain, increases in the number of company-owned units should improve performance by facilitating the consistency and efficiency that give chain units a competitive advantage over stand-alone firms. This should result in higher growth rates and more stable performance. Hypothesis 7: Holding constant the number of franchised units, increases in the number of corporate units should increase the revenue growth of franchised units. Hypothesis 8: Holding constant the number of franchised units, increases in the number of corporate units should decrease the variance in the revenue growth of franchised units. We turn now to revenue growth among company-owned units. If we hold constant the number of company-owned units, then a larger number of franchised units in a chain should expose the chain to a larger number of new innovations as a result of franchisees exploration. Nevertheless, these innovations may not apply to the market conditions in which the corporateowned units operate. Moreover, the variability in the operations of franchisees may degrade 5 Our hypotheses with respect to the effects of unit mix address the shape of the relationship between unit mix and performance. Though we expect a non-monotonic relationship, we do not attempt to predict where 18

19 public goods, such as the chain s brand name (Jain 1989; Lafontaine 1999). Since the degradation of public goods impacts corporate units but those same units do not receive the benefits of tailoring their operations to local conditions, increases in the number of franchisees may hurt the performance of corporate units. Hypothesis 9: Holding constant the number of company-owned units, increases in the number of franchised units should decrease growth among companyowned units. Data To investigate the importance of learning in franchising, we collected data on restaurant chains in the United States. Data from Technomic (1999), a consulting and research firm specializing in the restaurant industry, provided the sampling frame and allowed us to decompose total sales into sales at corporate-owned restaurants and sales of franchisees. We supplemented these data with corporate-level information from the franchisers annual reports. Our analyses are based on 116 chains observed for a total 635 chain-years. Most chains (92) are observed for seven years, although chains that enter or exit the sample during the sampling period contribute fewer chain-years of data. Table 1 provides descriptive statistics for the variables used in the models. Revenue: Sales in constant 1992 dollars 6 provides the dependent variable for the growth models. Although one could also investigate other performance measures (e.g., profits), no source compiles systematic cost data for the franchisees. Moreover, sales growth provides a particularly good measure in this case because the structure of the franchising agreement typically means that franchisers maximize earnings when their franchisees maximize sales. Of course, franchisees might prefer to maximize the the inflection point should lie, which will depend on the heterogeneity of locations faced by the firm. 6 We adjusted the data to real dollars using the Consumer Price Index (CPI) because restaurant receipts represent a consumer good subject to inflation. 19

20 profitability, rather than the sales, of their establishments since they receive residual rights to the profits (Battacharryya and Lafontaine, 1995). Nevertheless, a variety of existing research argues that sales growth might provide the best performance measure for investigating entrepreneurial performance (Flamholtz 1986; Hoy, et al. 1992; Barkham et al. 1996; Sexton and Smilor 1997). Number of units: The number of units simply counts the number of establishments of a particular type in operation during a given year. Thus, the number of corporate units tallies the number of restaurants owned and operated by the franchiser and the number of franchise units counts the restaurants run by independent owner-operators. Including counts of both allows us to differentiate between scale and mix effects. We log both variables to account for decreasing returns to scale. Since the number of units provides some information regarding the likely variation in the environments encountered by the chain, we also interact the number of units with governance structure to test H1b, H2b, H3b and H4b. To test these hypotheses, we ideally would have measures of the degree of heterogeneity of the local markets faced by a chain. Lacking such a measure, we believe that the number of units is a reasonable proxy. Mix: This variable simply calculates what proportion of the chain s restaurants are franchised. It allows us to estimate whether interaction effects occur in the management of chains. Although previous research often constrains mix to having a linear relation to performance (e.g., Shane, 1996), we include both mix and its square since we have hypothesized non-monotonic relationships between the unit mix and performance. For chains that exclusively use one or the other governance structures, we include dummy variables to capture any qualitative differences that this focus entails. Age: Previous studies find that growth rates often vary with organizational age. As they mature, firms may lose flexibility or fall out of touch with the market. For example, Barron, West and Hannan (1994) find that younger organizations grow more rapidly 20