ANN ARBOR—When the average housing wealth of homeowners in a particular area falls as much as it did during the Great Recession, a chain’s entry into franchising could be delayed by roughly four months and its employment growth reduced by 9 percent, say University of Michigan researchers.

Franchises that provide “turn-key” operations to franchisees, in exchange for royalties on revenues and a fixed upfront franchise fee, have played an important role in the growth of chains in the U.S. economy, say Ying Fan, U-M assistant professor of economics; Francine Lafontaine, U-M professor of business economics and public policy; and Kai-Uwe Kuhn, a former U-M economics professor now at the University of East Anglia.

Such franchised chains, also known as business-format franchisors, operated more than 387,000 establishments in 2007, with 6.4 million employees, according to U.S. Census data. The majority of these establishments are owned and operated by small business owners.

Fan, Lafontaine and Kuhn found that when average housing wealth decreases in an area, it delays franchise expansion and associated small business creation and employment.

The researchers describe how the recent Great Recession has “led to a sizable deterioration in households’ balance sheets.” They also note that this decline “has been suggested as a major factor adversely affecting the viability and growth of small businesses.”

To examine the extent to which small business growth may be affected by financial constraints, the researchers honed in on how changes in the household wealth of potential franchisees affected how long it takes for a chain to start franchising, and how chains grow through a combination of opening company-owned and franchised outlets.

They used data from 934 chains that started franchising some time between 1984 and 2006. Combining chain-level data with information about economic conditions in the expected expansion areas of the chains such as average combined housing wealth, they captured the financial resources of this chain’s potential franchisees.

“We find that when the average housing wealth decreases, chains enter into franchising later and open fewer franchised outlets,” Lafontaine said. “More importantly, from a job creation perspective, they also open fewer total outlets.”

The authors used simulation methods to predict how the number of total outlets of chains five years after they start their businesses would change if the average housing wealth in the chain’s expansion area were decreased by 30 percent. They found that, on average, chains would open 9.4 percent fewer total outlets.

In addition to the financial resources, franchisors look to partner with potential franchisees who will invest their time and effort in measures far beyond what a manager might contribute.

“They don’t just want to give them a manager job. They want them to be invested in the franchise,” Lafontaine said.

The results suggest that franchisees’ investments in their businesses are an important component of the way franchisors organize their relationships with their franchisees. So when collateral values decrease in a chain’s expansion area, franchising as a mode of organization becomes less efficient and franchisors’ organizational choices become more constrained. That can reduce the growth and total employment of these chains.

The research will be published in an upcoming issue of the Journal of Political Economy.

More information:

• Ying Fan
• Francine Lafontaine