Going Into the Restaurant Business With Eyes Wide Open
Marty Bombenger….KEY WEST & FLORIDA KEYS RESTAURANT BROKERÂ (305) 310-1982
Even for businesspeople who have been successful in other industries,Â opening a restaurant can be one of the most challenging yet fulfillingÂ entrepreneurial ventures one can encounter. Each year tens of thousandsÂ of people begin the process of creating a new restaurant. Their chancesÂ of success often hinge on how well prepared they are to face theÂ challenges. Those who approach this business with “eyes wide open” areÂ often in the best position to ensure the process doesn’t turn into oneÂ of the worst experiences they’ve encountered. Starting and failing at aÂ business can leave in its wake financial setbacks and personal crises. The purpose of this article is to provide some basic knowledge on whyÂ people succeed or fail when they open a new restaurant and to provideÂ some realistic benchmarks that you can use to enter or expand into thisÂ multifaceted business. The authors know what they’re talking about. Both are experienced andÂ successful entrepreneurs/independent restaurateurs, who know theÂ challenges and rewards of this business. In this article, they shareÂ their advice, informational resources, and words of wisdom ofÂ successful independent restaurateurs.
It’s often said that there’s a thin line between success and failure inÂ any venture. The difference is not just having the desire or enoughÂ capital or being persistent, all certainly important, but success isÂ also the ability to understand what you’re getting into at the timeÂ you’re getting into it.
A big advantage current restaurant owners have when they open a newÂ location is that they’ve done it before. While experienced independentÂ restaurateurs have a slightly different decisions matrix versusÂ first-time restaurateurs, there are reference points that are common toÂ all successful restaurant operations. The major chains have been ableÂ to take these basic techniques and refine them to a level ofÂ sophistication that borders scientific.
It’s important to remember, however, particularly for the first-timer,Â that the restaurant business is not all about chains. There is plentyÂ of room in this dynamic industry for smart independents who can giveÂ the customer a unique experience that will be remembered and talkedÂ about again and again. In fact, according to National RestaurantÂ Association statistics, 7 out of 10 restaurant operations are stillÂ independently owned and operated. Industry sources also point out thatÂ last year local governments issued 52,000 new restaurant businessÂ licenses. The statistics indicate there are a lot of entrepreneursÂ still out there opening their own places. The big question: Should youÂ be one of them?
It All Starts With a Good Business Plan
You’ve heard it before: The place to start looking for the answer is inÂ a well-thought-out business plan. This plan is not necessarily forÂ potential investors (although much of the thought and research thatÂ goes into it can be used later for that purpose), it is to help youÂ decide if opening a restaurant is something you really want to do andÂ are prepared to do.
It’s true that with enough capital anyone can open a restaurant, butÂ that’s not really the point. Anyone can throw money down the drain. WeÂ assume you want the word “profitable” in the list of adjectives thatÂ describe your business. There’s an old saw that says the restaurantÂ business is about making the customer happy while the business of aÂ restaurant is about making the owner happy. A business plan helps sortÂ out how to do both.
This article is not about how to create a business plan. For a goodÂ overview of that process, we recommend that you read “Mapping YourÂ Restaurant’s Journey: The Fundamentals of Creating a Sound BusinessÂ Plan,” RS&G, May 2005. The following will help you form ideas on theÂ opportunities you might want to grasp and the threats you will want toÂ avoid when creating your blueprint for success.
Why restaurants fail. Over the last few years several industry-specificÂ research projects have quantified and helped identify some of the keyÂ attributes of successful restaurant operators. These research studiesÂ can be a great help in not only putting together a business plan butÂ also help to formulate some of the questions you need to ask yourselfÂ as you compile and consider your restaurant startup options.
The most extensive of these published research articles appearedÂ inÂ the August 2005 Cornell Hotel and Restaurant Administration Quarterly.Â Titled “Why Restaurants Fail,” it is a must-read for anyone consideringÂ investing and owning a restaurant operation. You can find this reportÂ at http://www.hotelschool.cornell.edu/research/chr/pubs/quarterly/featured/execsummary.html?name=restaurantsfail.pdf. It may seem pessimistic to read about failures while seeking success inÂ your new restaurant but according to media mogul Sumner Redstone (CBSÂ and Viacom), “Success is not built on success. It’s built on failure.Â It’s built on frustration. Sometimes it’s built on catastrophe.” It’sÂ better to read about somebody else’s failure and learn about it ratherÂ than experience it firsthand.
The research by professors H.G. Parsa, John Self, David Njite andÂ Tiffany King provides key insights into what it takes to open andÂ operate a successful restaurant. The study can offer a reality check onÂ the clarity of your vision as you plan your new business or expansionÂ efforts.
In their commentary, several very specific elements of both successfulÂ and failed restaurants are mentioned. While you’ll have to consult theÂ entire study for the list of the 12 “Elements of Success” and the 21Â “Elements of Failure” (the difference in number of items alone can be aÂ tip-off that it’s easier to fail than succeed), here are someÂ highlights:
âˆš A successful restaurant requires a clear concept that drives allÂ activities.
âˆš A restaurant’s inability to differentiate itself from its competitionÂ can be fatal.
âˆš Undercapitalization or poor financial skills are a critical factor inÂ restaurants but the authors note that in the personal interviews theyÂ conducted that many successful operations have been started for no moreÂ than $100,000.
âˆš External forces, other than too many restaurants in one areaÂ (restaurant density), are seldom reasons for failure.
âˆš The ability to balance family and restaurant business time is a keyÂ component of success … and “failure stems in large part from anÂ inability or willingness to give the business sufficient attention.”
âˆš Food quality does not guarantee success.
âˆš Good relationship marketing is common to successful restaurants.
âˆš Solid record keeping including keeping track of food costs and customers is essential.
These common-sense pointers need to be specifically applied to theÂ restaurant environment that you are creating, as well as theÂ fundamental financial numbers that go into making a restaurant a goodÂ investment. That’s what we’ll talk briefly about now.
Keep your eyes on the numbers. There are two basic financial termsÂ anyone starting an independent restaurant must understand: Return onÂ Sales (ROS) and Return on Investment (ROI). These often-confused termsÂ are particularly important and vary greatly depending on what type ofÂ operation you’re going to start.
These and other important financial formulas were discussed in theÂ article “Rules of Thumb” and they’ll play anÂ important role in many of your basic financial decisions.
“Return on investment” is, as the name says, the amount of money youÂ can expect to be returned to you for each dollar you put into your newÂ restaurant. Most experts agree that a successful restaurant shouldÂ return its original investment in three to four years. That wouldÂ equate to a 33 percent to 25 percent ROI.
“Return on sales” is simply the percentage of return you receive onÂ your sales volume. Restaurant ROS normally ranges from 2 percent to 12Â percent or more. An excellent source for these types of numbers can beÂ found at the National Restaurant Association with its “2006/2007Â Restaurant Industry Operations Report.” You can order the NRA survey byÂ calling the association at (202) 331-5900 or going to its Web site atÂ www.restaurant.org and clicking on the “Industry Research” button.
The difference between these two numbers is substantial andÂ understanding it can make a big difference in attracting potentialÂ investors to participate. ROI is very attractive while ROS percentagesÂ can be captured in much safer government bonds.
There are other critical numbers featured in the January 2007 “Rules ofÂ Thumb” article that offer important insight into the financials you’llÂ need to calculate as you look at the business side of your startup.Â Here’s a brief review:
Sales-to-Investment + Annual Sales/Startup Costs
Leasehold: Sales-to-Investment should be at least 1.5 to 1 ($1.50 salesÂ for each $1 invested or, if you’re investing $500,000, you need salesÂ of $750,000).
Own Land & Building: Sales-to-Investment can be $1 to $1
Sales per Square Foot
At sales levels of $150 to $250 psf (per square foot) for full-serviceÂ and $200 to $300 psf for limited-service, restaurants with effectiveÂ cost controls may begin to approach break-even. At sales levels of $250Â to $325 psf for full-service and $300 to $400 psf for limited-service,Â restaurants may see moderate profits defined at 5 percent to 10 percentÂ of total sales. High profits can be defined as sales levels of moreÂ than $350 psf for full-service or $400 psf for limited-service.
Should range from 28 percent to 32 percent but there are exceptions onÂ both the high side for steaks or seafood at 38 percent-plus or pizza atÂ 20 percent or less.
Other Costs & Expenses
Â· Liquor Cost – 18 percent to 20 percent.
Â· Bottled Beer – 24 percent to 28 percent.
Â· Draft Beer – 15 percent to 18 percent.
Â· Wine Cost – 35 percent to 45 percent.
Â· Soft Drinks – 10 percent to 15 percent.
Â· Regular Coffee – 15 percent to 20 percent.
Â· Specialty Coffee – 12 percent to 18 percent.
Â· Iced Tea – 5 percent to 10 percent.
Â· Paper Costs – About 4 percent (as a percentage of total food sales.Â This figure applies to quick-service restaurants only).
Â· Total Payroll Costs – 30 percent to 35 percent full-service; 25Â percent to 30 percent limited-service.
Â· Hourly Employee Gross Payroll – 18 percent to 20 percentÂ full-service; 15 percent to 18 percent limited-service.
Â· Employee Benefits: 5 percent to 6 percent of total sales.
Â· Prime Cost (payroll + cost of sales) – 65 percent or less forÂ full-service; 60 percent or less for limited-service.
Â· Rent Cost – 6 percent or less.
Â· Occupancy Cost – 10 percent or less.
Business Value Calculations
Â· Gross Sales Method – 38 percent to 42 percent of gross sales. Â·Â Cash Flow Method – Three to four times net income beforeÂ depreciation, debt service, owner compensation.
Know Your Entry Points
As a prospective owner/operator, there are several ways to get into theÂ restaurant business. Here are brief descriptions of the primary optionsÂ available.
You can develop a new concept from scratch. Entrepreneurs withÂ restaurant experience, especially those with a creative flair, oftenÂ want the challenge and freedom to create their own restaurant from theÂ ground up.
Typically, this path entails the most startup cost and risk. Often newÂ concepts are developed from the perspective of what the owner likes,Â with little regard to analyzing the demand for a particular type ofÂ concept within a particular geographic area. Building a concept aroundÂ the preferences of an owner alone has proven to be the kiss of death toÂ many an upstart restaurant venture.
Notwithstanding the inherent risks above, developing a restaurant fromÂ scratch and making it a success is possible. The owners who do it rightÂ find a way to converge on an appealing concept in the right market at aÂ good location with the right ambience and environment. Sure, there areÂ many other factors that influence success but in mostÂ start-from-scratch restaurants these are the essential elements that aÂ startup operator can’t afford to miscalculate without putting theÂ venture in a precarious position right out of the blocks.
Franchising a restaurant concept has been a common way for thousands ofÂ people, especially those with limited restaurant experience, to getÂ into the restaurant business. When you license a franchise, you’reÂ essentially purchasing a proven business system, managerial know-how asÂ well as ongoing guidance and support from the franchisor.
Starting out with a turnkey business system from Day One can greatlyÂ reduce the risks of developing a new concept from scratch. For oneÂ thing, with a franchise you can at least find out how successful theÂ concept has performed in their previously developed restaurants. WhenÂ developing a concept from scratch there is no such operating history orÂ track record to evaluate.
Having already constructed and opened similar restaurants, franchiseÂ Â owners have a generally easier time estimating startup costs upfront.Â In addition, there is usually a shorter development period, which meansÂ a new restaurant can get open and, hopefully, begin operatingÂ profitably quickly. Instant name recognition can also be a big plus. On the downside, franchisees pay for these advantages with an upfrontÂ franchise fee that can cost tens of thousands of dollars plus ongoingÂ royalties and advertising fees that typically run 6 percent to 8Â percent of gross sales.
Purchase an existing restaurant. With hundreds of thousands ofÂ independently owned restaurants in the United States, there are alwaysÂ plenty of restaurants available for sale. Some of the potentialÂ advantages to purchasing an existing restaurant include access to pastÂ operating history, a shorter opening time with less red tape forÂ licenses, permits, etc., less startup cost than new development, anÂ already established customer base and the chance of obtaining ownerÂ financing.
Some of the potential disadvantages include higher repair andÂ maintenance costs than a new facility, having to overcome a poorÂ reputation of past management and a lack of documented systems andÂ procedures to maintain consistency and quality after the previous ownerÂ leaves.
As in buying any business, a thorough examination of the existingÂ restaurant prior to the sale is essential. At minimum, a prospectiveÂ buyer will want an experienced attorney and CPA on their due diligenceÂ team. (See “How to Buy an Existing Restaurant: The Twelve Points of Due Diligence”.)
How Independents Finance Their First Restaurant
In our online surveys, hundreds of operators provided feedback on howÂ they were able to capitalize their first restaurant. The top threeÂ sources of financing, regardless of the amount of startup costs was,Â first, personal savings, then relatives and, third, funds from a homeÂ equity loan. Other popular sources were SBA (Small BusinessÂ Administration) loans, one or more investors, conventional bank loans,Â seller financing, and a surprising number said they used credit cardÂ financing to fund some part of their startup costs.
Nearly all respondents indicated at least two of the above sources andÂ many indicated three. In startups of $100,000 or less, the prevailingÂ sources of funding were from savings, relatives and credit cards. AsÂ the cost of the startup increased to $250,000 or more, bank financingÂ and investors/partners become more common and in restaurants requiringÂ $500,000 of startup capital or more, close to half indicated they hadÂ received startup funding from one or more investors/partners.
When asked about the most important lessons they learned in openingÂ their restaurant, the most common response by far involved the amountÂ of startup capital needed. Here are just a few of the hundreds ofÂ comments that echoed the same theme:
âˆš “You cannot have too much money to start.” âˆš “I would have been in a better position had I borrowed more of theÂ initial startup cost, and kept my savings account intact for operating capital.” âˆš “A lot of money does not go a long way.” âˆš “You need capital. Start with a business plan and borrow more thanÂ you think you will need.” âˆš “Always find more funds than you think you might need. You will findÂ yourself using these extra funds.” âˆš “You never have enough money. Something always gets forgotten. Nothing is easy. Plans go wrong. But it is rewarding when yourÂ restaurant becomes a success!!”
Prospective restaurant owners should take heed that the importance ofÂ accurately projecting startup costs and the importance of securing anÂ adequate amount of capital cannot be understated.
Survey responses also repeatedly echoed the importance of thoroughÂ planning, the crucial role of having a professional business plan toÂ secure loan and investor financing and having the right contractor toÂ handle the construction and buildout process.
We recommend that you read “How to Create Realistic Financial Projections for Your New Restaurant,” aÂ primer on creating a restaurant financial plan.
A Rewarding Business, but Don’t Just Take Our Word
Particularly to an outsider, starting a restaurant can appear to be, inÂ ways, an almost insurmountable challenge because of the immense body ofÂ knowledge required and the significant financial exposure that comesÂ with nearly all restaurant ventures.
However, there are manyÂ enterprising and determined folks who found a way to overcome the mazeÂ of difficulties and create a successful restaurant business. Most ofÂ them wouldn’t think of doing anything else. Here are some comments byÂ seasoned restaurant owners on what they find to be most rewarding aboutÂ owning and operating their own restaurant:
Laile Fairbairn Snow City CafÃ©, Anchorage, Alaska
“The most rewarding aspect of my business is watching my employees workÂ so hard for me to make our places such a success. Without them I wouldÂ not have been able to accomplish my goals. I have several employees whoÂ have been with me for all 14 years growing from one location and 11Â employees to three locations having 80 employees.”
Darwin Hassen DJ’s Dugout, Bellevue, Nebraska
“I am a high school graduate who works hard and [I’ve] kept my nose toÂ the grindstone and reasonably clean. My rewards have been recognitionÂ by my family, friends and customers both emotional and financial. IÂ love the business and hope to continue for another 10 years at least.Â This has been my most financially rewarding year. Business is up and IÂ have a great team in place to continue on.”
Raymond Hottenstein The Olde Greenfield Inn Lancaster, Pennsylvania
“I am very proud of being a producer. I love knowing that our littleÂ restaurant has a big impact on the local community. Being a cog in theÂ wheel of the community is important to me. But when it gets down toÂ brass tacks, the most rewarding aspect is knowing that what we do makesÂ people happy. A good meal, in a good restaurant with good friends orÂ family or even alone, is sort of an escape from reality and having theÂ guests leave with a little of that euphoria makes it all worthwhile.”
Michael Passalacqua Angelo’s Restaurant Washington, Pennsylvania
Ultimately, You Have to Decide if It is Worth the Effort
The body of knowledge required of any restaurateur is significant.Â That’s one of the attractions of the business. Pulling together all theÂ elements, from financing to location to menu to service staff isÂ certainly a challenge but also a reward in itself. These are tasks thatÂ when completed successfully lead to a lot of self-satisfaction andÂ independence that most other careers simply can’t offer. It’s not hardÂ work; it’s damn hard work. But joining this fraternity of restaurantÂ owners with your eyes wide open can change your life in very positiveÂ ways and serves not only your lifestyle needs but adds to the communityÂ you live in. For us, it is worth doing.
— Restaurant Startup & Growth
How Independent Restaurateurs Capitalize Their Startups
Within the last 18 months, Restaurant Startup & Growth’s official WebÂ site www.RestaurantOwner.com has had more than 1,000 independentÂ restaurant owners respond to online surveys regarding the startupÂ costs* and financing of their restaurants. The responses confirmed whatÂ we had already suspected from our own experiences in the business –Â that most independent restaurant ventures require a substantial amountÂ of upfront capital. However, we were surprised to find that in one ofÂ our surveys, of the 400-plus respondents, one in eight reported theyÂ opened their restaurants for less than $125,000 (see below).
Of all respondents: Total startup costs* for restaurants in leased space: Median (50 percent of respondents above and 50 percent below)Â Â Â Â Â Â Â Â Â Â Â $212,000 AverageÂ Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â $460,000
Total startup costs for restaurant owning land & building: Median (50 percent of respondents above and 50 percent below)Â Â Â Â Â Â Â Â Â Â Â $400,000 AverageÂ Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â $700,000
Of the lower quartile (25 percent) of respondents who had the lowest startup costs: Total startup costs* for restaurants in leased space: Median (50 percent of respondents above and 50 percent below)Â Â Â Â Â Â Â Â Â Â Â Â $125,000
Total startup costs for restaurants owning land & building: Median (50 percent of respondents above and 50 percent below)Â Â Â Â Â Â Â Â Â Â Â Â $175,000
Of the upper quartile (25 percent) of respondents who had the highest startup costs: Total startup costs for restaurants in leased space: Median (50 percent of respondents above and 50 percent below)Â Â Â Â Â Â Â Â Â Â Â Â Â $500,000
Total startup costs for restaurants owning land & building: Median (50Â percent of respondents above and 50 percent below)Â Â Â Â Â Â Â Â Â Â Â Â Â $850,000
Another important consideration that is either overlooked or underappreciatedÂ by first-time restaurant owners is the amount of time it takes independentÂ restaurants to become profitable. It is common for even experienced chainÂ operators to budget three to four months of operating deficits after opening.Â Even with strong sales, when restaurants are new labor costs as well as food andÂ beverage costs can be particularly high for several weeks and even a few monthsÂ after opening. When sales start out weak, operating deficits can be significantÂ and can quickly put the restaurant at risk without additional capital. WhileÂ difficult to project, it is critical for independent restaurants to consider theÂ effect of initial operating deficits and have some amount of capital reservedÂ for this contingency.
Our surveys showed that few new independent restaurants becomeÂ profitable immediately after opening:
Number of months after opening to become profitable: Median (50 percent of respondents above and 50 percent below)Â Â Â Â Â Â Â Â Â 12 Months AverageÂ Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 18 Months
*Startup costs include but are not limited to the follow expenditures:Â land (not included in leasehold case); construction costs (referred toÂ as buildout or leasehold improvements); Kitchen and bar equipment;Â dining room and bar furniture; exterior finishes (landscaping, parkingÂ lot, signs, decorations); interior finishes and equipment (POS, officeÂ equipment, security system, sound system); professional servicesÂ (architect, engineering, legal, accounting, graphics); organizationalÂ and development (insurance binders, permits, deposits, menus);Â preopening expenses (employee training, menu development, openingÂ inventory); working capital for operating deficits.