Royalty Rates and Upfront Fees in Share Contracts: Evidence from Franchising

Abstract

This article provides evidence on the determinants of royalties and upfront fees in share contracts by examining how state franchise termination laws affect franchise contracts. The results are consistent with the joint hypothesis that the two‐sided moral hazard model explains the terms in franchise contracts and that termination laws increase the relative importance of franchisor effort (due to the extra effort that is required to control system quality). I find that franchise companies that are headquartered in termination‐law states charge significantly higher royalty rates than companies headquartered in other states (around 1% higher). Correspondingly, the initial franchise fees are lower for companies headquartered in termination states. Overall, franchisees appear to pay a higher price for franchises in states with protection laws. Consistent with a basic tenet of law and economics, price adjustments appear to offset at least some of the transfers that would otherwise be implied by the laws.