Jason Gherke

Franchising’s moral hazard

Moral hazard is a term used by economists to describe the greater likelihood that someone will take risks if they are subsequently not liable for those risks.

The term has been used by the insurance industry since the 17th century, but took on new life during the Global Financial Crisis (GFC) as governments in major economies such as the United States and the United Kingdom bailed-out banks and large corporations who were at risk of collapse.

The GFC demonstrated that moral hazard exists when banks engaged in high-risk lending to uncreditworthy borrowers, then packaged-up and sold these risky loan portfolios as investments, which subsequently proved to be worthless. The government bailouts in the US and UK then transferred the consequences of the banks’ risky lending behaviours to the taxpayers of those countries. Insurers have historically used the concept of moral hazard to mitigate risk. By increasing premiums according to risk, and by requiring the payment of an excess whenever a claim is made, the insurer moves some of the risk back to the insured party. Without this partial assignment of risk, an insured party could behave with outright abandon in the knowledge that any consequences of their actions or neglect will be borne by the insurer.

So does moral hazard exist in franchising?

The answer is yes, and in more ways than one.

Franchisors are faced with moral hazard as their businesses depend on growth provided by the human and financial capital of franchisees. Start-up franchisors and those without any company-operated outlets are more prone to moral hazard as the consequences of their actions pose a greater risk to their franchisees, rather than themselves.

Such actions could involve the franchisor’s method of selecting franchisees, training and supporting them. Other actions involve the franchisor’s choice of location for a franchisee to operate, the business model itself, as well as marketing and supply chain economics.

On an individual and isolated basis, franchisees bear the primary risk of decisions made by franchisors.

However the risk is eventually transferred to the franchisor if the franchisor’s decisions result in the failure of the majority of franchisees or even entire network, resulting in such loss royalty income to make the franchisor unviable.

Unlike the banks during the GFC, governments don’t bail out franchisors in financial distress. The moral hazard for franchisors whose behaviours transfer all risk to franchisees is that the widespread failure of franchisees will ultimately have consequences for the franchisor.

Mature franchisors who see value in fewer but happier franchisees understand this better than enthusiastic newcomers whose sole focus is on building outlet numbers, regardless of individual outlet performance.

However despite the obvious perspective of moral hazard applying to franchisors, it also applies to franchisees.

Franchisees invest in franchises rather than starting their own independent

Jason Gehrke is a director of the Franchise Advisory Center and has been involved in franchising for more than 30 years at franchisee, franchisor and advisor level. He provides training and professional development services to franchisor teams and regularly conducts franchise education programs. For details of upcoming education events for franchisors click here

small business in order to mitigate risk. The moral hazard is that the business model in a franchise is fully developed, comprehensively proven and has such substantial market demand that the franchisee need only open their doors to commence trading and the customers will come pouring in. The moral hazard here is the free-riding of the franchisee on the franchisor’s brand name and reputation, without additional local effort by the franchisee to ensure the success of their business. In other words, the franchisee contributes only their financial capital, but applies little or none of their human capital to the success of their business.

So if the business doesn’t work, the moral hazard of the franchisee is to attribute the failure to the franchisor, and seek redress accordingly.

A mutual form of moral hazard applies for multiple unit franchisees

A franchisor who grants additional outlets to an existing franchisee faces little risk themselves initially in doing so. The risk of the additional outlets is all borne by the franchisee as an increase of their capital invested in the franchise (usually through additional borrowings). The franchisee’s own human capital is already fully invested in the franchise at this stage anyway.

But moral hazard applies to the franchisee too. For each additional outlet granted to them by the franchisor, the franchisee transfers the risk of that decision to the franchisor as the franchisee becomes larger and dominates a particular market or region. Franchisors can’t afford for multiunit franchisees of major size and market dominance to fail, for reasons of market share, prestige and so on.

(The franchisee can thus exert a level of influence over the franchisor akin to the tail wagging the dog, rather than the other way around.)

Moral hazard is poorly understood by non-economists outside banking and insurance industries, but is relevant to help understand the perspectives of both franchisors and franchisees. The idea that someone else bears the consequences of risks undertaken by one party is the basis of moral hazard. This article has identified how moral hazard can apply to both franchisors and franchisees.

However the key difference between the moral hazards of the banking sector in the US and UK during the GFC and the franchise sector today is that governments are unlikely to ever offer bailouts to the franchise sector in the same way that bailouts have been offered in the banking sector.

Furthermore, governments have sought to reduce moral hazard in franchising through reducing information asymmetry (ie. the extent to which one party has more information compared to another) to help potential franchisees better assess the risk of joining a franchise. One way of addressing this information asymmetry was the introduction of the Franchise Rule which requires franchisors to produce a Franchise Disclosure Document (FDD) to a potential franchisee before a franchise sale can occur.

While a FDD reduces information asymmetry prior to a franchisee entering a franchise, it does not change the power dynamics in the franchise relationship thereafter, and so moral hazard still applies.