Richard L Rosen, The Richard L Rosen Law Firm PLLC
Some 20 years ago, while delivering a presentation on “The State of Franchising”, I communicated my belief that the internet, then in its infancy, would have a profound impact on both retail franchising generally, and on shopping centre development and the real estate market. That prediction has proven accurate.
Today, many products and even services, previously purchased or obtained in retail brick-and-mortar locations, can now be acquired online. Folks who had travelled to their local (or not-so-local) “widget shop” can now acquire their widgets with the stroke of a finger, online. Many customers, or prospective customers, have traded the personal service, attention and the “touch and feel” shopping experience for the convenience and time-saving aspects of purchasing by means of the internet.
Of course, since retail success is driven by customers, anything that reduces “traffic” will almost surely have a negative impact on the likelihood of retail success. Clearly, the internet reduces traffic at the retail level. Not coincidentally, as customer traffic has been reduced and retail sales have fallen, stores have failed. Many of these failing stores have been, and will likely continue to be, franchised retail locations.
A recent study by Aaron Smith and Monica Anderson points out that, though two-thirds of online shoppers generally prefer high-street shopping to online shopping, by 2015 approximately 10 per cent of annual retail purchases – worth almost $350 billion – were nonetheless purchased online. Almost 80 per cent of Americans make purchases via the internet. This trend is certain to continue having a negative impact on retail purchases generally, and this is inevitable for franchised retail outlets. On 24 August 2017, The New York Times reported on the shopfronts sitting vacant in SoHo – one of Manhattan’s retail hubs, and where, as recently as 2014, the annual rental cost for a 5,000 square foot storefront averaged $4.3 million. Why? Because retailers (not only in SoHo, but across the country) have been “wounded” by competition from internet shops. A report issued by Credit Suisse on 31 May 2017 predicts that between 20 per cent and 25 per cent of shopping centres in the United States – about 275 in total – will close within the next five years. This staggering (potential) occurrence could have a cataclysmic effect on franchising at the retail level.
Irrespective of whether this prediction proves accurate or not, its psychological impact alone is certain to affect both retail franchising and the real estate industry. Anticipating a downturn in the real estate market place, it is likely that real estate developers will be less prepared to commit the resources necessary to develop shopping centres than they have been in the past. Lenders may be reluctant to commit funds to projects that, in the past, they had fought over; or if they do lend, interest rates may increase and loan to equity ratios will become less favourable for developers. Tenants will become more conservative in committing to costly locations calling for exorbitant rents. Rents, therefore, will fall. All of these factors will, inevitably, have an impact on retail franchising – which will, of course, include the enthusiasm with which prospective franchisees view the franchise opportunities available to them.
Does the proliferation of online purchasing point to a death knell for franchising? Not likely – but it may call for some modification to the typical franchise model. Even before the advent of the internet, I contended, on behalf of franchisee clients, that it would be reasonable for them to receive some participation in revenues generated by the franchisor from the sale of the products sold by said franchisor in retail outlets (supermarkets, for example), within the franchisee’s “protected territory”. It had always seemed reasonable to me that if the franchisee’s prospective customers were making purchases (of products sold by the franchisee) in venues other than the franchisee’s retail location, and if the franchisor was receiving a primary benefit (eg, the price received by the franchisor for the sale of the product to the supermarket), then the franchisee should receive some portion of that benefit. Over time, I extended my argument to include internet sales.
Most franchise agreements, then and now, have a “carve-out” clause which gives the franchisor the right to sell its goods or services at certain types of venues within the franchisee’s territory. Today, franchise agreements almost universally include the internet within that carve-out. There are two reasons for franchisors allowing their franchisees to participate in the revenues generated by such sales, either to retail outlets located within the franchisee’s protected territory, or to online customers located within the territory. Firstly, it is reasonable; but secondly, it is becoming necessary for the franchisee’s economic survival. If the retail franchise model requires support to survive, and if internet sales are the culprit, why not make internet sales a part of the solution? Why not provide the franchisee with a participation in the revenue generated as a result of internet sales by the franchisor of products or services (ordinarily sold or provided by a franchisee) to customers located (residing or working) within the franchisee’s protected territory?
The theory behind this approach is, of course, the fact that the internet has become, in significant part, responsible for a reduction in the revenues generated by the franchisee’s retail location. This may vary from system to system and product to product, but the trend seems clear. If internet sales are the culprit, they can be part of the solution. After taking into account factors that would include the nature of the products, price points, profit margins, etc, for both the franchisor and the franchisee, a relatively small percentage of gross online sales revenues could be paid (or perhaps credited) to the franchisee. “Gross sales” in this context, is a far more practical tool than “net profits” in that it is easily determined and involves no complex calculations or formulas. In an ideal world, the formula would take into account the profit that the franchisee would have generated in its retail store from the “lost sale”, as well as the fact that the franchisee would incur virtually no overhead expenses with respect to the income received.
Intrinsic in the fairness and reasonability of this approach is that the franchisee’s participation should be in revenues that might have been generated by its retail location, rather than via the internet. Therefore an approach might be that the customer purchasing the franchisor’s products online would reside or work within the franchisee’s protected territory. Since the franchisor would be in possession of (or have access to) the billing and shipping data with respect to the online purchase, this determination should be relatively easy to accomplish.
Of course, franchise agreements would need to address the rights of the parties to have access to applicable information – perhaps by having the franchisor, for example, provide sales and customer location information to the franchisee, along with the applicable monetary calculations. How this information can be confirmed or reviewed would, inevitably, be subject to the usual challenges and negotiations.
While the above-proposed arrangement between the franchisor and the franchisee addresses the means by which the franchisee can survive the encroachment upon its sales due to online purchases, and the likelihood of his happening, it does not address the issue of how real estate developers, generally, can keep customers in their shopping centres or lure them back. While we may recognise that the type of purchase is likely to have a meaningful impact on whether or not a customer will purchase online (eg, a book) or in a store (eg, a wedding dress) it will be necessary, in any event, for real estate developers to enhance the overall “mall experience” so as to bring more customers to shopping centres. It is probable that the “mall experience”, which is already changing, will continue to evolve. What we are seeing, and what we will continue to see, is a more interactive shopping environment for retail customers. The traditional emphasis on retail shopping may give way to more participation activities, for both individuals and families. Sports activities may play a greater part of what is offered, along with entertainment venues and restaurants that offer a different level of dining experience than that frequently found at shopping centres. Of course, as the retail mix changes, this will affect franchising as well. Many of the new venues and activities will inevitably become franchises.
And now, in what may be the ultimate irony, online retailers have discovered that a brick-and-mortar presence may actually enhance their market visibility, and are opening retail outlets in shopping centres. A growing number of e-commerce sellers have developed “web rooms” containing large TV screens on their walls, where social media posts from satisfied customers are frequently displayed. Online catalogues can be accessed from tablets located throughout the retail location and orders can be placed. Online retailers recognise that a physical presence improves brand awareness, but they also recognise the cost savings and other efficiencies resulting from utilising ecommerce. Of course, I’m waiting to see the first “online, web-based retail store franchise”, which is certain to come.
As a result, while these changes may help the shopping centres (and the franchised retail locations they contain) to survive, other changes are also likely. The explosive growth that shopping centres have experienced since the 1950s will almost certainly come to a halt. Yet entrepreneurs, being who they are, will surely find ways to continue to develop. Shopping centres may become smaller in order to accommodate greater risk and the realities of the market place. Rents may have to come down so as to induce retailers to make the long-term commitments that landlords and lenders alike will both desire and require. All of this will have an impact on franchisors and franchisees. The one thing that is certain is that there will be change.
Who knows? We may even witness the reappearance of the small-town, main-street retailer. As for me, I hope so.