Bonding Through Investments: Evidence from Franchising

sertsios, giorgo;

This article studies whether producers� up-front investments can help sustain
relations with business partners. The initial investment combined with
the business partner�s threat to terminate the contract before it expires can
generate a bonding mechanism that precludes the producer from behaving
opportunistically. I test this view using franchise contract data and a natural
experiment. In practice, the franchisor (business partner) determines
how much a franchisee (producer) needs to invest up-front. I show that franchisors
affected by the passing of a law that restricts their ability to terminate
misbehaving franchisees ask their franchisees for higher up-front investments.
This result is particularly large for small franchise systems, as franchisees� investments are less redeployable in case of contract termination. The data suggest
that contractual up-front investments can be used to sustain business
relations