After several weeks of the COVID-19 pandemic dominating news headlines around the world, upending the global economy, and changing how we interact with each other, it may be difficult to imagine what the world might look like after the worst of the crisis is over. We know that ‘business as usual’ will be different. But how?

There are few certainties, but what is clear is that the COVID-19 pandemic will result in catastrophic losses for many businesses. Indeed, a third of all businesses in certain sectors are unlikely to survive what is forecasted to be a recession more dire than the 2008 financial crisis and perhaps even worse than the Great Depression. Despite this, it is also true that certain businesses will thrive, new trends will emerge in the aftermath of the pandemic and consumer behaviour will change. Here’s how:

Consumer Behaviour Changes Following Major Life Events

Do you know why your customers do what they do? Or how people come to form habits – good and bad? Chances are your customers’ behaviour changed around the time of a major life event: living alone for the first time, marriage, a birth of a child, divorce.

In 2012, the New York Times Magazine interviewed Andrew Pole, a statistician employed by Target in the early 2000s. Pole’s assignment was to determine which of Target’s shoppers were pregnant so that the retailer could predictively market items commonly needed by new parents to them. Pole knew that if Target could effectively market its products to pregnant women, chances were excellent these women would shop at Target for a whole range of products from diapers and toys to lotions and cleaning products, rather than shop at a variety of stores for the same items. Pole’s research was so successful he was reported to have predicted one young woman’s pregnancy status, taking her family by surprise when they received Target’s advertisements in the mail.

Pole’s analysis fits with research performed by behavioural economists and psychologists which shows that once a person develops a habit or routine, their actions become automatic. In other words, once a person gets used to doing something a certain way, they will continue doing it the same way unless they bring a real intention to changing that behaviour.

The COVID-19 pandemic will qualify as a life-changing event for all of us and has already resulted in such a dramatic shift in daily routines, forcing the creation of new habits. These habits are likely to stick long after governments lift strict restrictions on citizens’ movement and activities. It will change everything from how consumers shop for groceries, where and how they dine, to how they move through the world.

Wither the Big-Box Grocery Experience

Perhaps one of the most significant routines to have been disrupted by the pandemic is the way Canadians shop for their groceries.

Grocery delivery app Instacart, which partners with grocery chains in Canada like Loblaws and Wal-Mart, reports that 5% of households currently buy their groceries online in the United States. Recent figures suggest that prior to the pandemic, only 1% of Canadian households brought their groceries online compared with 12% of households today. Certain grocery retailers have been so overwhelmed by demand for online orders that they have had to temporary suspend the service, while others are accepting orders several weeks in advance. Recent polls show that up to 22% of Canadians intend to include online grocery purchasing in the future.

Large groceries chains have benefited financially from the pandemic in the short-term, achieving 300-400% of their sales in the first weeks of March 2020, compared to the same weeks in 2019. These gains, while dropping, continue at 20-50% ahead of last year all across the country. While groceries chains would be well-advised to expand and invest in their online ordering platforms, competition for Canadians’ grocery dollars will only increase during and following the pandemic.

As Canadians move away from shopping in large supermarket chains, they will have a wealth of choice when it comes to purchasing food for themselves and their families.

Meal-kit delivery services like HelloFresh give consumers the choice to do virtually no traditional grocery shopping at all by sending subscribers refrigerated boxes with pre-measured ingredients matched to easy and quick dinner recipes.

The food delivery subscription model also includes services that link consumers directly to farmers, allowing them to choose which local food artisans they order from on a weekly basis while lowering the carbon footprint associated with purchasing their groceries. A silver lining of the pandemic has been a decrease in global carbon emissions, a trend some consumers will be eager to sustain by shopping locally.

Although convenient, subscription services are not without their challenges, including consumer complaints of overpackaging and concerns over refrigeration and potential tampering during the transportation and delivery process.

As a result of this and other factors, not all consumers will be ready to give up their trips to the grocery store. For Canadians looking to visit a bricks and mortar store, they will be turning away from big-box ‘superstores’ selling everything from milk to big screen TVs and instead will increasingly seek out stores that resemble local grocers or ones that take a different approach altogether.

For example, Amazon Go Grocery is a pilot project in Seattle which allows customers to shop in a grocery store without having to wait in line to check out at all. Instead, customers download the Amazon Go app which they scan on their way into the store. They then pick up whichever items they want and leave the store. A series of cameras and sensors automatically detect which items the customer has taken with them and charge it to their account on the app. Although a long way from widespread implementation,  this method and other forms of contactless payment is likely to appeal to many Canadians who are adjusting to stores of all varieties no longer accepting cash.

As consumer habits evolve, the grocery sector is likely to resemble home deliveries of the 1950s and 1960s with the added convenience of online shopping.

Food Supply Disruption and Price Adjustments

How and where consumers buy their groceries is just one part of the massive shift in the grocery sector. What consumers buy and how much they will pay for agricultural products will also be determined by disruptions to the food supply chain caused by the COVID-19 pandemic.

In Canada, scarcity and oversupply will likely co-exist for some time. Some farmers are expressing concerns that a lack of temporary foreign workers to pick local produce during the harvest months may result in shortages of and increased prices for certain produce in Canada. By contrast, dairy farmers have raised the alarm and some are now resorting to dumping milk as demand from restaurants and hotels has plummeted due to the pandemic.

Stories abound of consumers clearing grocery aisle shelves of pasta and jarred sauces, but there has been an uptick in the purchase of less obvious foods such as garlic, ginger, and orange juice – each speculated to have immune system boosting properties. Although such claims are not supported by scientific research, consumers are likely to buy these products in greater quantities at a time when supply from Asia and the United States is dwindling, resulting in higher prices.

Shelf-stable canned goods, dried legumes, and wheat flour are also increasing in popularity as consumers look to food products that can be stock-piled and provide nutritious and low cost meals for families. Shortages and an increase in price for these items should also be expected.

Fewer Restaurants, More Take-Out and Bigger Spaces

For those that relish the idea of returning to a busy local restaurant when the worst of the pandemic is over, they will have far fewer choices of where to dine. A recent report projects that up to 40% of all restaurants that have temporarily closed due to the pandemic will never reopen.

For overleveraged restaurants saddled with debt often taken on for pointless renovations or upgrades, major financial challenges are on the horizon. Throughout the COVID-19 pandemic, restaurants have seen plummeting sales and have been forced to provide a delivery and/or take-out only service, a requirement that is likely to become a new consumer habit. Permanently increased delivery sales with much higher costs of doing business will result in radical re-engineering of the foodservice economic model.

For the restaurants that do survive the pandemic, guests are likely to have different demands from their dine-in experience once strict social distancing orders are lifted. With fewer restaurants to compete with and lower rents (due to a glut of vacant space), a return to larger spaces that afford greater guest privacy and physical distance will be trends to watch for. Guests are unlikely to feel comfortable squeezing into small tables where they are seated close to their neighbours, and in the new climate there will be no need for them to do so.

For franchisors and franchisees in the foodservice sector, it is an unfortunate probability that those who were struggling financially before the crisis are unlikely to weather this economic storm. Franchisors that provide temporary relief or assistance to flagging franchisees may be doing so to no avail. FranData, a franchise information firm, projects a franchisee attrition rate of 25% following the COVID-19 pandemic, which may lead to a further weakened financial position for affected franchisors.

Restaurants that continue to operate should focus on streamlining and improving their take-out business by creating a guest experience that minimizes physical contact and makes pick-up easy. Although guests are likely to continue to feel reluctant to dine in, they will nevertheless be eager to take a break from cooking at home which presents an opportunity for restaurants that are able to adapt to this new reality quickly.

More Vehicles on the Road, Less Ride Sharing and Public Transit Use

In urban centres where public transit ridership is high and ride sharing apps proliferate, a fundamental shift in how people get from point A to B will take shape as a result of the COVID-19 pandemic.

Following a steep decline in sales throughout periods of lockdown, one of the key shifts is likely to be an increase in car ownership and a decrease in shared transportation of all kinds as a result of social distancing norms. Individuals are likely to feel more secure ensconced in their own vehicles rather than sharing public space with others as they make their way to work or travel.

As with all other services, consumers are likely to want to minimize the physical contact associated with purchasing vehicles or viewing them in showrooms. While most consumers remain unlikely to purchase vehicles sight unseen though digital sales, the leasing or purchasing process is likely to change and require dealership staff to perform multiple functions from test driving to financing so that consumers have a single point of contact with a dealership.

Smaller, fuel efficient vehicles suited to city life are likely to see the most growth as consumers look for vehicles that serve them well in commuting and completing daily chores.

Outside of routine transportation, those accustomed to air travel to North American destinations for business or leisure may turn to car rentals as an attractive alternative to flying. Rental companies are likely to see an increase in their business along with a demand for more stringent cleaning of vehicles once they are returned by customers.

Resilience and Patience is Key

Not a single business will emerge unaltered from the COVID-19 pandemic. Most consumers in businesses will be much more risk averse. While these are extremely challenging times, businesses that are resilient and able to focus on cash preservation are well suited to emerge on the other side of the crisis with their doors open for business.

With time, good management and a focus on opportunities, businesses that survive the COVID-19 pandemic will eventually find themselves in a climate with fewer competitors and a customer base with demands that have been shaped by our collective life-changing experience. In the post-COVID-19 world, opportunities to innovate and reinvent old ways of doing business await those who are there to rise to the occasion.

As Canada’s leading franchising and distribution law firm, our firm is working closely with industry leaders including specifically in the grocery, restaurant, automotive and retail sectors. We are available to discuss how to take your business through the crisis and to be poised for success as we emerge from it. If you would like to discuss how our firm can help your business in these times, please contact us.

John Sotos, Sotos LLP

John Sotos is the founding partner of Sotos LLP and a dean of the franchising, licensing and distribution bar. John has been recognized by Chambers Canada, Canadian Legal LEXPERT Directory, Who’s Who Legal, and Best Lawyers in Canada as a leading Canadian franchise law practitioner. John can be reached directly at 416.977.9806 or jsotos@sotosllp.com.

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In joint venture franchising, the franchisor, in addition to its traditional franchises, takes an equity interest in the franchisee, hence the term “joint venture franchising”.  The franchisee will be a corporation, limited partnership, or some other suitable investment vehicle.  The franchisor grants a standard franchise agreement to the joint venture franchise as it would with any other unit franchisee.  In addition, because the franchisor has an equity stake in the new joint venture, it also signs a joint venture agreement, unanimous shareholder’s agreement, partnership agreement, or some document that stipulates the respective parties’ rights and obligations.  Frequently, these franchisors also serve as the joint venture’s lenders, and there would be appropriate loan and security agreements.  The franchisor could also be the sublandlord pursuant to a sublease.

A small minority of franchisors have adopted, to significant economic advantage, the less-well known joint venture franchising model domestically as an alternative to traditional franchising in order to accelerate growth objectives.

ADVANTAGES OF DOMESTIC JOINT VENTURE FRANCHISING

Greater control

By virtue of the joint venture relationship, the franchisor has an actual seat at the franchisee’s board table.  As such, the franchisor has access to every detail of the franchisee’s business.  In fact, in most cases, the franchisor undertakes all of the franchisee’s back office functions because it is more efficient at such tasks than individual franchisees.

This greater level of control can allow franchisors to nurture new franchisees to minimize the risk of making avoidable mistakes. This is particularly helpful in fairly sophisticated businesses where the initial training does not come close to equipping the franchisee with the necessary know-how to build and run a business efficiently. Ultimately, the franchisor’s investment in the franchisee underscores its commitment to the success of the franchisee.  However, this comes at the cost of the franchisor having to expend far greater resources in joint venture franchises than it would under the traditional franchise model.

Perhaps the greatest advantage of joint venture franchising results from the high alignment of franchisor and franchisee economic interests.  Since the franchisor realizes most of its income from each joint venture franchisee’s bottom line, the sale of goods and services to the franchisee occur at true cost. This eliminates the economic inefficiencies resulting when franchisors gerrymander this function in order to shift income – an activity that is rarely efficient.

Another advantage of the joint venture franchise following its successful establishment is that the franchisor’s interest can be reduced or completely bought out all at fair market value. The relationship would then move closer towards the traditional franchisor-franchisee relationship. However, a future buy-out is not necessary to have a joint venture franchise, and a franchisor might want to have a higher level of control (and investment) on a long-term basis.

Undercapitalized individuals

Joint venture franchising works particularly well in fairly complex businesses heavy on capital investment with access to competent, trustworthy individuals who would make desirable franchisees but who otherwise would not have the finances to acquire a franchise.

Store managers at franchisor-owned locations (or those at direct competitors) with a proven track record of success in that role but without the financial resources to fund a new franchise make the joint venture franchise model an optimal vehicle for franchise expansion without the hit and miss results of traditional franchising.

Another common scenario for when a joint venture franchise would be desirable is where the employment of regulated professionals is a business requirement.  For example, a franchisor of pharmacies or medical clinics would have to recruit pharmacists and doctors.  Often recently graduated professionals in these fields will carry student debt and would otherwise not be able to raise the substantial capital for a franchise, no matter how promising they might be. Joint venture franchises present an opportunity for these franchisors to work with young, eager, and freshly trained professionals who would otherwise not be in the pool of franchisee candidates.

Tax advantages

Another advantage for joint venture franchises is potentially significant tax advantages for the franchisor. As long as the joint venture franchise is a Canadian-controlled private corporation (CCPC) and is eligible for the small business deduction, and is properly structured, then there is a substantial tax advantage for the franchisor to have some of its revenue come directly from its equity in the joint venture franchise. This assumes the nature of income does not include interest, dividends, or capital gains, as the joint venture is considered to be an active business Corporation. In cases where the franchisor is receiving income considered passive which does include interest dividends or capital gains, the Corporation is deemed to be considered a specified investment Corporation unless more than 5 employees work for the Corporation. This along with other tax planning can re-classify a specified investment Corporation to being active once again.

Income eligible for the small business deduction of up to $500,000 taxable income is subject to a federal rate of 9%, and if the Corporation is resident in Ontario, the combined total rate is 12.2% effective January 15^th 2020. By comparison, general income is taxed starting at a federal rate of 15%, increasing to 26.5% for Ontario corporate residents.

Since many franchisors will not meet the small business deduction requirements, they would normally pay the full corporate tax rate on income remitted to them from their franchisees.  On the other hand, franchisees would be more likely to qualify for the small business deduction. With joint venture franchises that qualify for the small business deduction, the amount that the franchisor earns through its ownership share of that franchisee could be taxed at the lower small business rates. This strategy can be repeated by the franchisor across its business, potentially owning equity in multiple joint venture franchises to gain access to the lower tax rate on dividends generated by the joint venture.  Of course, the income that the joint venture franchisee pays to the franchisor as part of the standard franchise agreement would be taxed at the normal corporate rates.

Ultimately it is the level and type of income combined that determine the assessment of tax. Optimizing such combinations could result in possible reduction of the tax burden.

POTENTIAL ISSUES WITH JOINT VENTURE FRANCHISES

While joint venture franchising offers substantial advantages, there are also potential risks, though many of them can be avoided with good legal and other professional advice.

For example, the franchisor should avoid blurring the lines between its role as a franchisor and as partner in the joint venture franchise.  If the franchisor gets too involved in decisions such as employee recruitment or dismissals for example, it could be exposing itself to liability for being a joint employer.  Franchise agreements and joint venture arrangements should be clearly and separately maintained with clear delineation of the franchisor’s function in both of its roles.

Similarly, the joint venture agreement should be well-drafted so that each party is clear on what each is contributing to the joint venture and what additional obligations each might have (e.g. non-disclosure, confidentiality). It should also set out what happens if there are irreconcilable differences between the joint venture partners and termination is necessary.

All in all, joint venture franchising is an underutilized business model for franchises in domestic markets. Depending on the context, it can have significant advantages over traditional franchisor-franchisee arrangements. The associated risks can be managed with proper legal and professional advice and can be outweighed by the benefits of properly used joint venture franchising.

Sotos LLP has over forty years of experience in advising on all aspects of franchise structuring, growth and expansion.

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Automotive dealerships often have millions of dollars in internally-generated goodwill. Changes announced in the recent federal budget could mean a much higher tax bill on the sale of this goodwill after January 1, 2017. If you are thinking of selling your dealership or have significant goodwill or “blue sky” in your dealership, time is running out to plan your affairs and reduce your tax bill on an eventual sale of the business.

Changes to Eligible Capital Property

The March 22, 2016 federal budget announced changes to the tax rules for the treatment of eligible capital property (“ECP”), resulting in higher taxes paid on the sale of ECP after January 1, 2017. ECP, generally, consists of the intangible assets of a business, and for automotive dealers could include such items as goodwill, customer lists, customer contracts, and all vehicle service and sales history data. Canadian business owners, especially those operating a Canadian Controlled Private Corporation (“CCPC”) (i.e., that are not controlled by a non-resident and are not public companies) will see significant tax leakage on the sale of their business starting next year.

Under the current rules, on a sale or disposition of ECP, 50% of the gain on the sale is taxed at the lower corporate income tax rate; the other 50% is added to the CCPC’s capital dividend account, which can be distributed to shareholders on a tax-free basis. For a CCPC operating in Ontario, this results in an effective tax rate of about 13%. Under the new rules, the gains on the sale or disposition of ECP will be taxed as ordinary capital gains, resulting in 50% of the gain being subject to the 50% tax rate, or an effective tax rate of about 25% – nearly double the rate the CCPC would pay if it completed the sale this year. Given that most of the value in the sale of a dealership typically stems from goodwill (which generally does not have a significant tax base because it was built over time, rather than acquired through an acquisition), the tax consequences of the rules change could be considerable.

How to Prepare for Changes and What You Can Do

Dealerships often trade based on a multiple of pre-tax earnings, or what is commonly referred to as “blue sky”. Dealer principals should determine the value of the blue sky and, more generally, the value of the dealership that would be attributable to ECP on a sale. In other words, the dealer should determine how much of the dealership’s value will be derived from built-in goodwill (and other eligible and intangible assets), and that will thus be subject to the higher tax rate beginning in 2017. Obviously in cases where that number would be low, the cost/benefit analysis may not make it worthwhile to do anything. On the other hand, if one were planning to sell in the next 18-24 months, an accelerated sale before December 31, 2016 may be an economically advantageous move to reduce the tax burden if the ECP-derived portion of the dealership’s value is substantial.

In addition, even dealer principals who are not planning to sell their business to another dealer in the short term should consider whether to undertake a corporate reorganization before the end of 2016 to recognize accrued gains where their lifetime capital gains exception is available; thus taking advantage of the one-time opportunity to boost their tax basis and reduce taxes on the ultimate sale of the business down the road. Whether such a move makes sense for any particular dealer will depend on individual circumstances, but all dealers should engage in proper planning now, in consultation with professional advisors, in order to have the best chance of avoiding a significant – and certainly unwelcome – tax hit in 2017.

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