From the May 2011 issue of Investment Advisor • Subscribe!

An Appetizing Investment: Second Course

In last month’s column we turned our lens toward one of the more populist venture investment opportunities—the restaurant business. If you advise a high-net-worth clientele, it is nearly inevitable that one of your clients will be pitched to invest in a restaurant startup by a friend or family member. Such that successful restaurant investments can yield annual IRRs of 30% or more, and that “90% of restaurants fail in their first year” is a woefully inaccurate statement, a discreet advisor should resist the instinct to simply disregard the idea. Rather, you can initially screen the opportunity for your client by evaluating the venture in the context of the following criteria.

Location – The single most important criteria in terms of assessing the probability of achieving the pro forma sales assumptions, and consequently the viability and sustainability of the business. A high-traffic area with robust commercial activity is always preferred. There is an obvious reason why quick-service restaurants and gas stations end up across the street from each other. Key elements of location consideration include population base, demographics, traffic volume, parking, accessibility, commercial attractions and visibility.

Occupancy Cost (Property Leasing Fees) – Many restaurateurs will tell you that you cannot sign a lease where monthly rent exceeds 10% of your expected sales volume. That number is simply too high. Unless you have a very high alcoholic beverage-to-food ratio, or are in an extraordinarily high walk-by traffic location like Times Square or the Vegas Strip, walk away from any project where rent exceeds 6% or 7% of expected volume. A higher fixed cost will invariably erode your chances of making an adequate profit. The franchisee and corporate-owned store mantra is “secure a class B location in a class A market” to lower startup and fixed operating costs while benefitting from a high-traffic location.

Revenue Projections – Although the entrepreneur is forecasting the unknown, these numbers need to be a by-product of more science than art. Scrutinize the underlying assumptions carefully to ensure that days of the week and hours of operation have been considered, as well as seating, number of table turns per meal period, average check per meal period, food-to-beverage ratio per meal period. Then challenge the owner/operators as to the source of their conviction behind each assumption.

Food-to-Beverage Ratio – The top line revenue expectations are only valid if the operator is successful at controlling the critical variable key costs: food, LBW (liquor, beer, wine), and total payroll. Such that LBW costs are generally lower, and in turn produce a higher profit margin, the investor should favor ventures that are likely to provide larger LBW revenue relative to food. Generally speaking, costs for liquor are between 15% and 18%, between 20% and 25% for beer, and between 30% and 40% for wine. Food costs, on the other hand, can run as low as 25% (in a pizza restaurant, for example) to as high as 35% for fine dining.

Sales-to-Investment Ratio – When evaluating the feasibility of a restaurant startup, this key financial factor tends to have the highest predictive value of the probability of an attractive investment outcome. The sales-to-investment ratio tells you how many dollars in revenue you can reasonably expect for every dollar of invested capital to open the doors. The investment is the sum of all of the assets required to build and open the establishment (regardless of how they are financed).

When evaluating leasehold ventures, a reasonable threshold is an absolute minimum sales-to-investment ratio of 1.5:1; that (again) assumes a high LBW-to-food ratio and a premier location. Otherwise, a 2:1 ratio is probably more prudent. (Most national restaurant chains use 3:1 as their benchmark.)

To illustrate, a 2:1 ratio for a startup investment of $1.5 million is expected to produce annual revenues of $3 million. If the operator is capable enough to net a 15% bottom line ($450,000) each year, and assuming that the investors are receiving a 100% preference on distributions until their capital is returned, the payback period is an acceptable 40 months. Thereafter, in this scenario, investors would likely receive an IRR in excess of 25% per annum.

If the restaurant startup passes these initial tests, it is advisable to engage an experienced restaurant pro to take a closer look the opportunity on behalf of your client.

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