Restaurants Are Facing Mass Extinction, But Local Governments Can Save Them
The economic case for government regulation of third-party delivery fees well-beyond the aftermath of COVID-19
by Zach Goldstein, CEO and Founder of Thanx, Nation’s Restaurant News 2020 Power List
Since publishing “The Four Horsemen of the Restaurant Apocalypse?” last September, a lot of people have asked me “So you really hate third-party delivery companies, huh?” In short: no, absolutely not. Consumers increasingly demand convenience, so delivery is critical to the future of how we consume food. But: I am passionate about the vibrancy and longevity of the restaurant industry. I remain legitimately fearful that the third-party delivery (3PD) trajectory could eradicate restaurants as we know them — a concern only amplified by the acceleration of digital purchasing amid COVID-19. Seeking the safety of interaction-free ordering, many consumers are (often-unknowingly) massively shifting (already-slim) profit margins from the restaurants they love to technology behemoths.
This article is more optimistic than the last (and shorter!); a wave of recent government regulations have the potential to play a critical role in establishing an equilibrium that may sustain restaurants (and the 3PD companies which offer a valuable service to their communities). Cities such as San Francisco, D.C., Los Angeles, Seattle, and New York City have implemented temporary caps on 3PD fees charged to restaurants (generally capped at ~15% vs >30% normally) during the COVID-19 crisis.
I am generally a proponent of free-market economics; unnecessary government regulation often creates suboptimal outcomes (read: added cost) for businesses and consumers alike. The Bloomberg Editorial Board advanced this argument in responding to recent interventions:
“Price controls won’t improve this model. To the contrary, they’ll induce apps to pass along the added costs to customers, thereby reducing demand for the very restaurants they’re intended to help. More customers will order food for pickup to avoid the fees, increasing the risk to public health. And investors may tire all the sooner of subsidizing loss-making services whose potential revenue is artificially capped.”
But in this case, they are wrong. Restaurants, consumers, and even the 3PDs themselves, should welcome permanent and widespread regulation. Without it, restaurants face a mass-extinction event. Instead of rolling back “fee caps” once COVID-19 restrictions on indoor dining lapse, these regulations should be made permanent (and more cities should adopt the protocol), with one simple change: If third-party delivery companies share customer data (e.g. email address) with the restaurant who fulfills the order, they would no longer be subject to any fee caps.
Want to lend your support to lobbying mayors and Congress to help #SaveRestaurants? Sign your name here. Read the press release here.
(Re)Setting the Stage
In “Four Horsemen of the Restaurant Apocalypse ”, I argued that third-party delivery fees resulted in unsustainable economics for all but the largest restaurants which, when combined with the loss of a direct relationship with the consumer (disaggregation), will cripple restaurants as we know them. It’s an evolution supported by Aggregation Theory and which played out as predicted in the hotel industry. Recent consolidation has reduced the Four Horsemen down to three (Uber acquiring Postmates) and drastically strengthened the balance sheet and long-term resolve of another (global delivery powerhouse Just Eat Takeaway acquiring GrubHub). This is more bad news for restaurants; concentration drastically increases an already-lopsided power balance (see my LinkedIn rant on this subject).
Since that article was published, we’ve seen countless examples of restaurants struggling under the burdensome (and simply unfair) economics of 3PDs, nonetheless too dependent on the revenue stream to turn them off. The inevitable result: a slow death. In one well-circulated image, Chicago Pizza Boss grossed a paltry 36% of revenue from Grubhub orders in March (before any actual costs of producing the food are taken into account). Los Angeles-based Marinate reported Doordash charging 51% in fees after the nickel-and-diming was complete. Some have resorted to publicly begging customers to cut out 3PDs.
Beyond unsustainable fees, the 3PDs are starting to flex the power afforded to them by capturing the end-consumer relationship. Uber Eats recently announced a new advertising product that effectively requires restaurants to pay up in order to remain well-ranked in search results. The news headlines were generous to the 3PDs on this announcement, but could have very-well read “Uber Eats takes restaurants’ customers and sells them to the highest bidder” — it’s mutually assured destruction.
It’s not all bad news; we’ve also seen examples of restaurants successfully building “owned” or “first-party” digital platforms to win back share from the 3PD marketplaces. The result — especially amid the massive shift to digital initiated by COVID-19 — has been outsized sales performance over the last six months for those who were ahead of the curve. Below are two good examples: an in-depth review of Oath Pizza’s successful digital strategy and an email from Curry Up Now seeking to educate their own consumers on the benefits of direct ordering. But most restaurants simply won’t get there in time.
And the issue is finally gaining national recognition. Just last week, three members of the US House of Representatives sent a letter to the Federal Trade Commission calling for an investigation into market consolidation and unfair and deceptive practices of food delivery platforms. As they wrote: “COVID-19 has made restaurants increasingly reliant on food delivery platforms as measures to reduce the spread of the virus continue to limit in-person dining. While restaurants struggle to survive, these delivery platforms’ fee structures and questionable practices have made it hard or impossible for restaurants to remain profitable, prompting multiple cities to cap these fees as an emergency measure to support local restaurants.”
A Power Imbalance
The driving force in this rapidly-escalating power imbalance is access to capital — the 3PDs are swimming in it, the restaurant well is dry. Doordash and Uber (now public) raised some of the largest private capital war chests in history, valuing each business in the double-digit billions (expect a Doordash IPO in the next 6–12 months to give them even deeper pockets). As Ranjan Roy wrote in May:
“Raise a ton of money, lose a ton of money, and just obliterate the basic economics of an industry… Third-party delivery platforms, as they’ve been built, just seem like the wrong model, but instead of testing, failing, and evolving, they’ve been subsidized into market dominance.”
This claim was all-but-confirmed by a comment on the same article by Collin Wallace, former Head of Innovation at Grubhub (and now starting a business to help restaurants gain direct access to online customer data, including from 3PDs):
“COVID-19 is exposing the fact that delivery platforms are not actually in the business of delivery. They are in the business of finance. In many ways, they are like payday lenders for restaurants and drivers. They give you the sensation of cash-flow, but at the expense of your long term future and financial stability. Once you “take out this loan” you will never pay it back and it will ultimately kill your business…”
Artificially-low delivery costs to supercharge growth
The problem actually starts with mis-set consumer expectations. With nearly-unlimited access to capital, 3PDs have heavily subsidized deliveries, creating an artificial expectation from consumers that delivery should be priced below the actual cost of the logistics of bringing someone food. In China, Meituan and others have been able to deliver profitable per-delivery unit economics, in-part enabled by a cost of labor that is impossible in the US (rightfully, from a moral standpoint) due to labor protection laws such as minimum wage; in the US, most deliveries are unprofitable for 3PDs. Without such unrestricted access to capital, this would otherwise be an industry deal-breaker.
The 3PDs have effectively commandeered the demand curve — a great recipe for burning huge amounts of capital (which they are). But 3PDs make their investment case over a longer-term window; they present the (very likely accurate) calculation (in spite of collateral damage) that these near-term losses will be made up for over the long-term by customer lifetime value (e.g. future purchasing on their platform). To be clear, this is not a “pennies and cents” argument where massive volume at very low margins wins the day (e.g. Amazon); the 3PDs (like their ride-share counterparts Uber and Lyft) need the fundamental economics of the industry to change for them to ultimately turn a profit. Drones and self-driving cars could ultimately greatly improve these economics, but there’s no reason to believe 3PDs would return recaptured costs to restaurants in the form of lower fees.
“If you were to artificially lower the price for one audience, that is going to come at a cost in a different part of the system.” — Tony Xu, Doordash CEO
Put differently, 3PDs are knowingly “subsidizing” the cost of delivery below the “market clearing” rate, driving up near-term demand with the assumption that they can extract profit from these same consumers in the future. It further complicates this already-messy incentive structure when (private equity and venture) capital rewards growth rates over profitability, as the private markets have for the last decade.
In a recent interview with Axios, Doordash CEO Tony Xu suggested that fee caps will directly increase costs to consumers: “If you were to artificially lower the price for one audience [via fee caps], that is going to come at a cost in a different part of the system (consumers).” But isn’t that exactly what the 3PDs are already doing — driving increased consumer demand with subsidized delivery fees, but at the cost of long-term viability for restaurants?
Rent-taking on “supply side” to reduce unprofitability
Delivery companies are offsetting their unprofitable enterprise by clawing back some of their losses from the restaurants themselves — a fee structure that’s entirely opaque to the consumer.
The 3PDs seek to assert that any limits on what they can charge restaurants must be directly passed on to consumers. In their campaigns against “fee caps”, Grubhub purposefully muddies the message, claiming that local government regulation will “increase your fees by $5–10”.
It’s one thing to grow unprofitably at the expense of your shareholders who have a future expectation of profitability; this is the venture capital model. Companies and their investors bet on their own long-term economics to offset near-term losses; that CAC:LTV (customer acquisition cost to lifetime value) formula is one that investors are comfortable evaluating and the capital markets would, theoretically, stop rewarding a 3PD with new capital if they no longer believed the formula worked.But it’s another thing entirely to do so on the backs of small businesses already-struggling to thrive — and who share none of the long-term upside if the bet pays off.
Restaurants “pick their poison”: die quickly or die slowly
So if the costs are so detrimental to restaurants, then why do they participate in third-party marketplaces at all? Surely they are free, rational actors in this market who can make their own calculus. So the argument goes. But the 3PD aggregators have undue market power (consistent with Aggregation Theory) which creates an impossible decision for restaurants: a) don’t participate in third-party marketplaces and die quickly or b) do participate and die slowly. Damned if you do, and damned if you don’t.
This — once again — comes down to access to capital; restaurants simply cannot compete for enough capital to combat the aggressive customer acquisition of the 3PD marketplaces; by not participating, restaurants immediately lose revenue to a competitor who does participate because the 3PDs are increasingly the “first stop” for a consumer wanting food. Damned if you don’t. But those restaurants who do participate in 3PD marketplaces risk becoming disaggregated from their customers, a future which will ultimately doom them with unsustainable economics and new competitors with structural cost advantages (see “ghost kitchens”). Damned if you do.
The question for governments and society at large: do we want a restaurant ecosystem with only noodles, pizza, and wings restaurants built for lowest-cost delivery? Is the diversity of restaurants indeed a “public good” worth protecting?
Local Governments to the Rescue?
Government intervention has the potential to even out the imbalance created by asymmetric access to capital (this is similar to the argument for monopolistic regulation in order to prevent select businesses from having market-shaping power that unreasonably harms challengers). While 3PDs argue that regulation creates a painful negative externality — higher delivery fees for consumers — the alternative is far worse: the permanent death of many restaurants. By some estimates, as many as 60% of restaurant locations are at risk of going out of business; some will be replaced. Others will not and the loss of entry-level jobs and years of equity invested by these business owners will be crippling to the economy.
For many of us in the business world, it can be deeply unsettling to see “point solution” public policy that disrupts free markets. And even in this category we have seen many of the complications and unintended consequences of government intervention with AB5, a California law designed to protect so-called “gig workers” such as delivery drivers. But for restaurants who (as an industry) cannot mount a coordinated enough effort to fight back against these fees and are as a result being disintermediated from their customer, government regulation may be their last hope. At Thanx, we offer a suite of tools to empower restaurants (and retailers, malls, etc) to embrace the digitization of their industry and build lasting relationships with their customers (including the very powerful data that comes with it) — but even our “A+ students” are seeing third-party’s stranglehold on their revenue increase each year.
The caps give restaurants a little more heft in their corner, a “thumb on the scale” to balance out the disproportionate access to capital at the root of this issue. Is 15% the right cap? Are caps even the optimal form of regulation? I’ll leave that to the policy experts to debate; but we have to start somewhere and even many economists would advocate the important role government regulation can play in solving for the public good when the markets cannot. The longevity of the local restaurant community is an unequivocal public good.
As a result of this policy, delivery costs will more closely align with consumers’ actual willingness to pay — and those delivery costs will come down over time through the evolution of technology (a standard “experience curve”, but also deliveries will eventually be enabled without humans) instead of being driven artificially lower. But while local governments can play an influential role in rebalancing this runaway train, permanent government regulation simply cannot be the long-term solution. We still need to encourage innovation (even from the restaurants who are under fire), not create conditions for complacency (though, the restaurant industry was already competitive enough before 3PDs that already only the strong survived). This is the rationale for excluding 3PDs from the fee cap if they share customer data with the restaurant.
With access to the contact information (e.g. email) of every consumer who places an order (just as Amazon and Doordash gets from every digital purchase), restaurants will be able to build long-term relationships with their customers, regardless of the channel through which a purchase was made. With complete data, it’s up to the restaurants to successfully lock-in lifetime value; many will still fail and lose customers to the 3PDs because they are ineffective in building long-term customer loyalty. But it will no longer be due to structurally-unbalanced dynamics; the free markets will be working again.
Why Care About Restaurants
Skeptics and free market fundamentalists would argue the positive externality generated by restaurants in a community is no greater than that of hardware stores and clothing retailers. Should we have intervened to protect the now-bankrupt local booksellers from Amazon? Some might argue “yes” in retrospect; I would not. But I do contend that access to the rich diversity of food that only small and mid-size restaurants can provide to their local communities is indeed far different than buying a commodity (like a book) through a new channel. Cities still have books. Without local restaurants, they may be left merely with “food”. And that could rock the very foundational value proposition of the city itself: a density of interesting cultural experiences with the tradeoff of higher personal expenses and less space. Cities would undoubtedly lose significant cultural appeal without a broad array of dining options, perhaps permanently shifting their attractiveness to residents. This provides a very clear economic case for local governments to take action.
There is also a macro and moral case: restaurants give so much to their communities — as first jobs for those just getting started, as attractive career paths for those who can’t afford post-secondary education but are willing to work their asses off, as entrepreneurial success stories where anyone, especially new immigrants, can fulfill the American dream, and as stewards of their local populations when crises/natural disasters hit. For one deeply-personal story of a restaurant operator in Baton Rouge struggling with these decisions amid COVID-19, listen to this heart-wrenching New York Times The Daily podcast recorded in the height of the crisis. It’s for these operators that we fight.
While local governments can play the much-needed white knight in giving restaurants a fighting chance and technology can help restaurants embrace their digital future, villainizing the 3PDs is not productive, nor my intent. They are here to stay and good for the economy, diners, and the food industry in the long-run; consumers want food delivered (and to consume it off-premises more broadly).
The Future of 3PDs
With sky-high valuations and mounting unprofitability, how the public markets respond to 3PDs over the next several years remains to be seen. But ultimately, balancing market dynamics is good for the 3PDs as well. For one, their entire business is predicated on a healthy and diverse restaurant industry. Purchase frequency on marketplaces would undoubtedly decline if brands that consumers know and love disappear — most don’t want McDonald’s every day. Some might argue that restaurants which pop up in place of shuttered “legacy” businesses will be better-positioned for the modern epoch (the “circle of life” argument) — digitally-native storefronts and ghost kitchens. There is a place for these new futuristic restaurant business models, but in a dystopian future where that’s all that remains, “restaurants” become social media experts not food experts; that’s not a future we as consumers (or our city leaders) actually want.
A more “competitive marketplace” — one where restaurants actually stand a chance of using data to build sustainable and direct relationships with customers to drive lifetime values that their business model depends on — will spur the exact innovation that will drive the 3PDs forward. Beyond logistics, the 3PDs will create software-as-a-service revenue streams that bring them into symbiotic partnership with the restaurants themselves (for instance, expect 3PDs to vertically integrate into the point of sale, perhaps drastically undercutting the pricing of legacy providers). Of the three remaining horsemen, Doordash has led in this direction, diversifying their products beyond just the Doordash-branded marketplace application with their white-label Doordash Drive offering (used by Walmart) and collaborative marketing partnerships with their flagship customers.
Though they will fight from the get go, Doordash, Uber and Grubhub will ultimately accept the regulation and be better for it. And we (consumers) — with local government support — will save restaurants.
Photo illustration credit: Brennan Gilbert, Thanx
