Financial Constraints and Moral Hazard: The Case of Franchising

Abstract

Financial constraints are an important impediment for the growth of small businesses. We study theoretically and empirically how collateral availability for a particular type of small entrepreneur, namely potential franchisees, affects the moral hazard problem of franchisees exerting effort and hence the entry and expansion decisions of franchised chains. We find that a 30 percent decrease in average collateralizable housing wealth in a region -- a measure of financial resources of potential franchisees -- leads to a 10 percent reduction in franchised chain employment because of delayed entry into franchising and slower franchise chain growth.