From the April 2011 issue of Investment Advisor • Subscribe!

April 1, 2011

An Appetizing Investment

A San Francisco-based investment advisor recently wrote me to inquire how to best illustrate that the start-up restaurant investment his high-net-worth client was contemplating was a bad idea. Truth is—it is not that simple. Encouraging your client to walk away from a restaurant investment could be a mistake.

Recipe for Success
In addition to death and taxes, venture investors invariably field requests to consider backing new restaurants. Considering the National Restaurant Association (NRA) estimates that 50,000 new restaurants are launched each year, that more than half of these start-ups are independently owned and operated venues, and that institutional financing sources like banks and venture capital firms will not finance independent restaurants start-ups, restaurant investing is perhaps the largest forum of venture populism.

It is also a market too large for venture investors to simply ignore. According to the NRA, sales at the nation’s 960,000 restaurants are expected to reach a record $604 billion in 2011 and represent 4% of U.S. GDP. If the U.S. restaurant industry was a country, it would rank as the 18th largest economy in the world. Restaurants are the nation’s second-largest private sector employer accounting for nearly 10% of the nation’s work force.

Beyond their own personal resources, independent restaurant entrepreneurs rely almost exclusively upon “friends and family” financing. Consequently, your HNW clients frequently find themselves getting pitched these opportunities and turning to you, their trusted financial advisor, for advice.

Let’s begin by tossing out the “90% of restaurants fail in their first year” myth. It is not a true statement. The most accepted assessment of restaurant failure rates is derived from a 2005 Cornell University study which identified the first-year failure rate at 30%. Considering that independent operations have a higher failure rate than corporate or franchised restaurant ventures, let’s peg the first year failure rate for indie-owned restaurants at one-third. Considered in the context against other start-up ventures (e-commerce, tech, biotech, cleantech) and taking the upside into account, those are not daunting numbers for the risk tolerant.

Of course there are the obvious risks. Undercapitalization is a principal contributing factor to early restaurant failures as it often takes customers a while to patronize a new venue for the first time. The American consumer is demanding, fickle and faced with many dining options so customer loyalty is elusive or at best, short-lived. A host of incontrollable factors including seasonality, weather, labor regulations and commodity price fluctuations can substantially influence the top-line revenues and operating margins.

On the other hand, a successful restaurant can provide stellar cash flow and annual returns as high as 40%.

The Right Ingredients
I will drill down into the specific factors that should be considered when evaluating the potential for a start-up restaurant to be successful in next month’s column, but let’s take a closer look at the deal structure and terms most typical to friends and family restaurant financings.

The cost of new restaurant ventures vary widely from as little as $100,000 dollars for a hot dog stand or small bakery in a college town up to $10 million for a 200-seat fine dining establishment in a tier-one location in a major metropolitan market with a star chef and interior designer. The majority of restaurants are financed through the SEC-exempt sale of ownership units to accredited investors (as well as up to 35 non-accredited investors) according to Rule 506 of Regulation D. Equity partnerships rarely (and frankly, should not) provide investors with control over operating details or decisions.

The most investor-friendly deal structure features a low initial salary to the owner-operator and a high incentive pay which kicks in once net revenues exceed the cumulative construction, start-up and ongoing operating costs of the business—otherwise known as the break-even point (BEP).

In this scenario, investors receive all operating profits (assuming of course that the venue is turning a profit) until their original stakes have been returned. For investments structured around the BEP, it is typical for 100% to 125% of the distributable profit (after net profit and prudent cash reserves are taken into account) to be paid out to investors until the BEP is reached.

After the return of the investor’s initial capital (and in some cases some premium above the initial investment) the “equity flip” occurs and the investors continue to receive 40% to 60% of the distributable profit on a quarterly or semi-annual basis in perpetuity of the enterprise.

It is not unusual for a successful restaurant to return capital to investors in as little as two years, which in turn provides for a high double-digit ROI with respect to the ongoing distributions thereafter. But, of course, identifying these high-return opportunities is a function of smart due diligence and knowing what to look for in a restaurant deal. Let’s tackle those issues next month.  

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