A typical retail lease often provides for percentage rent, in which one aspect of rental payments is based upon a percentage of gross sales made from the premises. In calculating percentage rent, a landlord needs to account for the ever-increasing revenue source of online sales. Depending on the relative size of the tenant, landlords often find themselves negotiating when those sales are to be included or excluded from the calculations of gross sales for percentage rent. There are several considerations that the parties need to think about when crafting their percentage rent and gross sales provisions to account for such online sales.
One of many deal terms landlords and tenants use to make the economic terms of a lease work for both parties in retail leases is percentage rent, whereby the parties agree to have one aspect of the rental payments be based upon a percentage of the gross sales made from the premises. Depending on the base gross sales threshold amount and how high the percentage rate may be, percentage rent allows the landlord to reduce or eliminate the fixed monthly rental payments. The use of percentage rent causes the landlord to have a vested interest in the performance of its tenants and incentivizes them to make sure tenants are performing well. It also allows the tenant a bit of a reprieve in rent costs during those periods when the shopping center is not doing well and they are not making money at their site.
When using percentage rent, a significant portion of the rent is now derived from the gross sales made from the premises. Therefore, it becomes extremely important to clearly define what is included and, just as importantly, what is excluded from the definition of “Gross Sales”. Gross sales typically include the gross amount received by the tenant from all sales, both for cash and on credit, by check, debit card, or any similar method, made in, upon, or from the premises, and all moneys or other things of value received by the tenant from its operations at, in, on, or from the premises. However, this definition does not make clear whether internet sales are included.
Landlords will want to make sure this definition is expanded to expressly include the additional methods of receiving orders, such as catalog orders, telephone orders, and computer, internet, and other electronic orders of merchandise. Landlords should begin from the starting point of drafting the definition of gross sales as inclusively as possible: essentially, “all sales are included, unless expressly excluded.”
This obviously brings the parties to one of the most heavily negotiated parts of defining gross sales: the exclusions. Tenants do not want to pay percentage rent on revenue that is never actually realized, so they often try to carve out items such as refunds, employee discounts, returns to manufacturers, tips, etc. Tenants will often try to exclude internet sales also, on the grounds that they do not constitute revenue generated from the brick-and-mortar premises. This has validity for a retailer with thousands of locations, because online sales cannot readily be attributed to any one location. In that case, some metrics must be employed to try to equitably apportion some level of internet sales to a specific location. It is much easier to attribute all internet sales to the premises if the tenant is small and has only its one retail location.
It is common to attribute internet sales to a specific location if the sale “originates” from the premises, if the customer actually makes its payment at the store, or if an order is physically filled at the premises. In such cases there is a stronger argument to be made that such sale should be attributed to the premises and included in the amount of Gross Sales generated from that store. However, even with these guidelines, you may find yourself wrestling with certain terms and logistical issues. For example, what does it mean to “originate” a sale from the premises? Many retailers install computer terminals with internet access directly within the premises and direct their customers to fill an order directly from their corporate website if a particular size or color is unavailable in the premises. Does that sale count as a sale that “originated” from the premises? The ultimate resolution of such issues often turns on the relative bargaining power of the parties. The smaller the tenant, the more leverage a landlord will have to keep the definition as broad as possible; the bigger the tenant, the more leverage the tenant will have in limiting this definition. All of that being said, some fairly clear guideposts are cash coming in the door or merchandise going out the door and are good starting points for evaluating any particular situation.
Whatever your ultimate definition of gross sales and your treatment of internet sales, the more detailed the definition becomes, the more important it will be for the tenant to have a very good record keeping system and for the landlord to have broad audit rights. The good news for landlords is that although the bigger tenants will be more successful in achieving carve outs from the definition of gross sales, they normally have more sophisticated procedures and systems in place to track and account for internet sales, a logistical burden that should always remain the tenant’s responsibility.
Finally, no one can foresee new technologies or what new and ingenious ways retailers will dream up to fill their customers’ orders. Therefore, a well-drafted gross sales provision will contain a catchall to capture any potential future technological advances. It will define gross sales to include technological extensions, advances, refinements, substitutions, and innovations that enhance, supplant, augment, or replace those that may be referred to in the lease.
Landlords that want to capture as many sales as possible for purposes of calculating percentage rent in an ever-increasing online world need to be mindful of such sales and draft gross sales definitions as inclusively as possible while simultaneously limiting the exclusions that a savvy, experienced retailer will inevitably try to carve out.
For any questions, please contact the Hinckley Allen attorney with whom you regularly work, or one of our Retail Real Estate attorneys. Follow Hinckley Allen on Twitter and LinkedIn for the latest news and updates.