Revenue versus incentive: Theory and empirical analysis of franchise royalties

• We explore why royalty rates are higher for service-type franchises than for others.
• We propose a new variant of the revenue hypothesis about royalty rates.
• We use OLS to explore data on 118 Japanese franchise chains from Shogyokai in 2001.
• We find evidence supporting our new variant of the revenue hypothesis.

This paper analyzes royalty rates in franchise contracts, focusing on the two leading hypotheses. We consider whether royalty payments are simply the means for franchisors to acquire revenue from franchisees (revenue hypothesis), or are to preserve incentives for the franchisors to exert appropriate efforts (incentive hypothesis). We propose a new variant of the revenue hypothesis, which is derived from an elementary model of franchise contracts with input sales. We hypothesize that the royalty rate is higher when the total margin ratio of the franchise chain is higher (when the sales revenue ratio is lower). We use OLS to explore data on 118 Japanese franchise chains in 2001 and find evidence supporting this hypothesis, which provides an explanation for higher royalty rates for service-type franchises.