BUSI 423 Week 4 Essay 2 Example

Territory, Encroachment and Trust: How the Franchise Agreement Shapes the Relationship

Introduction

Few issues strain franchise relationships as much as territory. A franchisee who has built a profitable unit may wake up to find a new outlet of the same brand opening down the road, or the franchisor selling the same products online to the franchisee's customers. Grossman and Katz (2017) advise prospective franchisees to study the territory provisions of the franchise agreement carefully because they define what the franchisee is protected from. This essay argues that territorial conflict grows out of a genuine difference in the parties' economic interests, that research confirms the harm encroachment can do, and that the best protection combines well-drafted contract terms with a relationship of trust.

The Root of the Conflict

The franchisor and the franchisee measure success differently. The franchisor earns royalties as a percentage of the system's total sales, so a new unit that adds sales to the system increases its income even if some of those sales come from existing units. The franchisee earns the profit of one unit, so any customer taken by a new unit is a direct loss.

A simple example shows the gap. Suppose a bakery franchisee sells $900,000 a year and pays a 6 percent royalty. The franchisor opens a new unit two miles away that sells $700,000, of which $150,000 comes from the existing unit's customers. System sales rise by $550,000, and the franchisor's royalties rise by $33,000. The existing franchisee's sales fall by $150,000, and since rent, labor and other costs do not fall proportionally, profit may fall by $40,000 or more. The same decision is rational for the franchisor and damaging for the franchisee, which is why territory cannot be left to goodwill alone.

Evidence That Encroachment Hurts

Franchisees' complaints about encroachment might be dismissed as fear of competition, but research suggests they have a basis. Kalnins (2004) studied hotels in Texas and examined how the opening of new hotels of the same brand affected the revenue of nearby existing hotels. He found evidence that new same-brand units reduced the revenue of nearby incumbent franchised hotels, consistent with franchisors expanding in ways that benefited the system's royalties at some cost to existing franchisees. The finding does not mean that every new unit is unfair; brand presence can attract customers to an area. It does mean that a franchisee's territory has real economic value.

How Agreements Handle Territory

Franchise agreements address territory in several ways, each with trade-offs. An exclusive territory promises that the franchisor will not open or license another unit of the brand within a defined area. It gives the franchisee the strongest protection, but franchisors often limit it with exceptions for airports, stadiums, grocery stores and online sales, and they may require the franchisee to meet sales targets to keep it. A protected territory without exclusivity may forbid new traditional units but allow other channels. A right of first refusal lets the existing franchisee open any new unit planned in its area, which turns potential encroachment into an opportunity for growth. Some franchisors adopt impact policies, under which a franchisee who can show a loss of sales from a new unit may receive compensation or a royalty reduction.

From the franchisor's side, broad exclusive territories carry costs. A territory that is too large may leave a growing market underserved, inviting competitors to fill the gap. The best agreements therefore tie the size of the territory to the market's population and growth, and they explain how online and nontraditional sales will be treated, since these channels are now where many disputes begin.

Trust and Compliance

No contract can anticipate every situation, so the relationship depends on how the franchisor uses the discretion it keeps. Davies et al. (2011) developed and tested a model of trust and compliance in franchise relationships and found that franchisees' trust in their franchisor was linked to their willingness to comply with system standards. A franchisor that encroaches aggressively may gain royalties in the short term but lose the trust that keeps franchisees following procedures, investing in remodels and supporting system changes. Seen this way, restraint in placing new units is not generosity but an investment in the system's health, one that pays off in franchisees' cooperation.

Recommendations for the Prospective Franchisee

A prospective franchisee should read the territory item of the disclosure document and the agreement itself with the following questions in mind: Is the territory exclusive, and how is it defined? What exceptions apply, especially for online sales and nontraditional locations? Is the protection conditional on meeting sales quotas? Does the franchisee have a right of first refusal on new units nearby? Does the franchisor have an impact policy, and has it ever been used? Talking with current franchisees about how the franchisor has handled new units in the past reveals whether the written protections are honored in practice.

The answers should be weighed together rather than one at a time. A modest territory may be acceptable if the franchisee holds a right of first refusal, because growth in the area then becomes the franchisee's opportunity. A large exclusive territory may be worth less than it seems if it carries sales quotas the franchisee is unlikely to meet in the early years, since missing a quota can shrink or cancel the protection. And an impact policy that has never been applied is a promise without a track record, so a buyer should ask the franchisor for examples of its use. The best combination for most buyers is a clearly mapped territory, explicit treatment of online and nontraditional sales, a right of first refusal on new units and a franchisor whose history shows restraint.

Conclusion

Territorial conflict is built into franchising because the franchisor profits from system sales and the franchisee from one unit's profit. Research confirms that encroachment can reduce existing franchisees' revenue, and agreements offer a range of protections, from exclusive territories to rights of first refusal and impact policies. Yet the contract alone is not enough. Trust, earned through how the franchisor uses its rights, keeps franchisees committed to the system. A careful franchisee seeks clear terms and evidence of fair dealing, and a wise franchisor provides both.

References

Davies, M. A. P., Lassar, W., Manolis, C., Prince, M., & Winsor, R. D. (2011). A model of trust and compliance in franchise relationships. Journal of Business Venturing, 26(3), 321-340. https://doi.org/10.1016/j.jbusvent.2009.09.005

Grossman, R., & Katz, M. J. (2017). Franchise bible: How to buy a franchise or franchise your own business (8th ed.). Entrepreneur Press.

Kalnins, A. (2004). An empirical analysis of territorial encroachment within franchised and company-owned branded chains. Marketing Science, 23(4), 476-489. https://doi.org/10.1287/mksc.1040.0082