Going Into the Restaurant Business With Eyes Wide Open

Marty Bombenger…Key West Restaurant Consulting

Even for businesspeople who have been successful in other industries, opening a restaurant can be one of the most challenging yet fulfilling entrepreneurial ventures one can encounter. Each year tens of thousands of people begin the process of creating a new restaurant. Their chances of success often hinge on how well prepared they are to face the challenges. Those who approach this business with “eyes wide open” are often in the best position to ensure the process doesn’t turn into one of the worst experiences they’ve encountered. Starting and failing at a business can leave in its wake financial setbacks and personal crises. The purpose of this article is to provide some basic knowledge on why people succeed or fail when they open a new restaurant and to provide some realistic benchmarks that you can use to enter or expand into this multifaceted business. The authors know what they’re talking about. Both are experienced and successful entrepreneurs/independent restaurateurs, who know the challenges and rewards of this business. In this article, they share their advice, informational resources, and words of wisdom of successful independent restaurateurs.

It’s often said that there’s a thin line between success and failure in any venture. The difference is not just having the desire or enough capital or being persistent, all certainly important, but success is also the ability to understand what you’re getting into at the time you’re getting into it.

A big advantage current restaurant owners have when they open a new location is that they’ve done it before. While experienced independent restaurateurs have a slightly different decisions matrix versus first-time restaurateurs, there are reference points that are common to all successful restaurant operations. The major chains have been able to take these basic techniques and refine them to a level of sophistication that borders scientific.

It’s important to remember, however, particularly for the first-timer, that the restaurant business is not all about chains. There is plenty of room in this dynamic industry for smart independents who can give the customer a unique experience that will be remembered and talked about again and again. In fact, according to National Restaurant Association statistics, 7 out of 10 restaurant operations are still independently owned and operated. Industry sources also point out that last year local governments issued 52,000 new restaurant business licenses. The statistics indicate there are a lot of entrepreneurs still out there opening their own places. The big question: Should you 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 in a well-thought-out business plan. This plan is not necessarily for potential investors (although much of the thought and research that goes into it can be used later for that purpose), it is to help you decide if opening a restaurant is something you really want to do and are prepared to do.

It’s true that with enough capital anyone can open a restaurant, but that’s not really the point. Anyone can throw money down the drain. We assume you want the word “profitable” in the list of adjectives that describe your business. There’s an old saw that says the restaurant business is about making the customer happy while the business of a restaurant is about making the owner happy. A business plan helps sort out how to do both.

This article is not about how to create a business plan. For a good overview of that process, we recommend that you read “Mapping Your Restaurant’s Journey: The Fundamentals of Creating a Sound Business Plan,” RS&G, May 2005. The following will help you form ideas on the opportunities you might want to grasp and the threats you will want to avoid when creating your blueprint for success.

Why restaurants fail. Over the last few years several industry-specific research projects have quantified and helped identify some of the key attributes of successful restaurant operators. These research studies can be a great help in not only putting together a business plan but also help to formulate some of the questions you need to ask yourself as you compile and consider your restaurant startup options.

The most extensive of these published research articles appeared in the August 2005 Cornell Hotel and Restaurant Administration Quarterly. Titled “Why Restaurants Fail,” it is a must-read for anyone considering investing and owning a restaurant operation. You can find this report 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 in your new restaurant but according to media mogul Sumner Redstone (CBS and Viacom), “Success is not built on success. It’s built on failure. It’s built on frustration. Sometimes it’s built on catastrophe.” It’s better to read about somebody else’s failure and learn about it rather than experience it firsthand.

The research by professors H.G. Parsa, John Self, David Njite and Tiffany King provides key insights into what it takes to open and operate a successful restaurant. The study can offer a reality check on the clarity of your vision as you plan your new business or expansion efforts.

In their commentary, several very specific elements of both successful and failed restaurants are mentioned. While you’ll have to consult the entire study for the list of the 12 “Elements of Success” and the 21 “Elements of Failure” (the difference in number of items alone can be a tip-off that it’s easier to fail than succeed), here are some highlights:

  • A successful restaurant requires a clear concept that drives all activities.
  • A restaurant’s inability to differentiate itself from its competition can be fatal.
  • Undercapitalization or poor financial skills are a critical factor in restaurants but the authors note that in the personal interviews they conducted that many successful operations have been started for no more than $100,000.
  • External forces, other than too many restaurants in one area (restaurant density), are seldom reasons for failure.
  • The ability to balance family and restaurant business time is a key component of success … and “failure stems in large part from an inability or willingness to give the business sufficient attention.”
  •  Food quality does not guarantee success.
  •  Good relationship marketing is common to successful restaurants.
  •  Solid record keeping including keeping track of food costs and customers is essential.

These common-sense pointers need to be specifically applied to the restaurant environment that you are creating, as well as the fundamental financial numbers that go into making a restaurant a good investment. That’s what we’ll talk briefly about now.

Keep your eyes on the numbers. There are two basic financial terms anyone starting an independent restaurant must understand: Return on Sales (ROS) and Return on Investment (ROI). These often-confused terms are particularly important and vary greatly depending on what type of operation you’re going to start.

These and other important financial formulas were discussed in the article “Rules of Thumb” and they’ll play an important role in many of your basic financial decisions.

“Return on investment” is, as the name says, the amount of money you can expect to be returned to you for each dollar you put into your new restaurant. Most experts agree that a successful restaurant should return its original investment in three to four years. That would equate to a 33 percent to 25 percent ROI.

“Return on sales” is simply the percentage of return you receive on your sales volume. Restaurant ROS normally ranges from 2 percent to 12 percent or more. An excellent source for these types of numbers can be found at the National Restaurant Association with its “2006/2007 Restaurant Industry Operations Report.” You can order the NRA survey by calling the association at (202) 331-5900 or going to its Web site at www.restaurant.org and clicking on the “Industry Research” button.

The difference between these two numbers is substantial and understanding it can make a big difference in attracting potential investors to participate. ROI is very attractive while ROS percentages can be captured in much safer government bonds.

There are other critical numbers featured in the January 2007 “Rules of Thumb” article that offer important insight into the financials you’ll need to calculate as you look at the business side of your startup. 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 sales for each $1 invested or, if you’re investing $500,000, you need sales 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-service and $200 to $300 psf for limited-service, restaurants with effective cost controls may begin to approach break-even. At sales levels of $250 to $325 psf for full-service and $300 to $400 psf for limited-service, restaurants may see moderate profits defined at 5 percent to 10 percent of total sales. High profits can be defined as sales levels of more than $350 psf for full-service or $400 psf for limited-service.

Food Cost

Should range from 28 percent to 32 percent but there are exceptions on both the high side for steaks or seafood at 38 percent-plus or pizza at 20 percent or less.

Other Costs & Expenses

  • Liquor Cost – 18 percent to 20 percent
  • Bottled Beer – 24 percent to 28 percent
  • Draft Beer – 15 percent to 18 percent
  • Wine Cost – 35 percent to 45 percent
  • Soft Drinks – 10 percent to 15 percent
  • Regular Coffee – 15 percent to 20 percent
  • Specialty Coffee – 12 percent to 18 percent
  • Iced Tea – 5 percent to 10 percent
  • Paper Costs – About 4 percent (as a percentage of total food sales. This figure applies to quick-service restaurants only)
  • Total Payroll Costs – 30 percent to 35 percent full-service; 25 percent to 30 percent limited-service
  • Hourly Employee Gross Payroll – 18 percent to 20 percent full-service; 15 percent to 18 percent limited-service
  • Employee Benefits: 5 percent to 6 percent of total sales
  • Prime Cost (payroll + cost of sales) – 65 percent or less for full-service; 60 percent or less for limited-service
  • Rent Cost – 6 percent or less
  • Occupancy Cost – 10 percent or less

Business Value Calculations

  • Gross Sales Method – 38 percent to 42 percent of gross sales.
  • Cash Flow Method – Three to four times net income before depreciation, debt service, owner compensation.

Know Your Entry Points

As a prospective owner/operator, there are several ways to get into the restaurant business. Here are brief descriptions of the primary options available.

You can develop a new concept from scratch. Entrepreneurs with restaurant experience, especially those with a creative flair, often want the challenge and freedom to create their own restaurant from the ground up.

Typically, this path entails the most startup cost and risk. Often new concepts are developed from the perspective of what the owner likes, with little regard to analyzing the demand for a particular type of concept within a particular geographic area. Building a concept around the preferences of an owner alone has proven to be the kiss of death to many an upstart restaurant venture.

Notwithstanding the inherent risks above, developing a restaurant from scratch and making it a success is possible. The owners who do it right find a way to converge on an appealing concept in the right market at a good location with the right ambience and environment. Sure, there are many other factors that influence success but in most start-from-scratch restaurants these are the essential elements that a startup operator can’t afford to miscalculate without putting the venture in a precarious position right out of the blocks.

Franchising a restaurant concept has been a common way for thousands of people, especially those with limited restaurant experience, to get into the restaurant business. When you license a franchise, you’re essentially purchasing a proven business system, managerial know-how as well as ongoing guidance and support from the franchisor.

Starting out with a turnkey business system from Day One can greatly reduce the risks of developing a new concept from scratch. For one thing, with a franchise you can at least find out how successful the concept has performed in their previously developed restaurants. When developing a concept from scratch there is no such operating history or track record to evaluate.

Having already constructed and opened similar restaurants, franchise owners have a generally easier time estimating startup costs upfront. In addition, there is usually a shorter development period, which means a new restaurant can get open and, hopefully, begin operating profitably quickly. Instant name recognition can also be a big plus. On the downside, franchisees pay for these advantages with an upfront franchise fee that can cost tens of thousands of dollars plus ongoing royalties and advertising fees that typically run 6 percent to 8 percent of gross sales.

Purchase an existing restaurant. With hundreds of thousands of independently owned restaurants in the United States, there are always plenty of restaurants available for sale. Some of the potential advantages to purchasing an existing restaurant include access to past operating history, a shorter opening time with less red tape for licenses, permits, etc., less startup cost than new development, an already established customer base and the chance of obtaining owner financing.

Some of the potential disadvantages include higher repair and maintenance costs than a new facility, having to overcome a poor reputation of past management and a lack of documented systems and procedures to maintain consistency and quality after the previous owner leaves.

As in buying any business, a thorough examination of the existing restaurant prior to the sale is essential. At minimum, a prospective buyer will want an experienced attorney and CPA on their due diligence 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 how they were able to capitalize their first restaurant. The top three sources of financing, regardless of the amount of startup costs was, first, personal savings, then relatives and, third, funds from a home equity loan. Other popular sources were SBA (Small Business Administration) loans, one or more investors, conventional bank loans, seller financing, and a surprising number said they used credit card financing to fund some part of their startup costs.

Nearly all respondents indicated at least two of the above sources and many indicated three. In startups of $100,000 or less, the prevailing sources of funding were from savings, relatives and credit cards. As the cost of the startup increased to $250,000 or more, bank financing and investors/partners become more common and in restaurants requiring $500,000 of startup capital or more, close to half indicated they had received startup funding from one or more investors/partners.

When asked about the most important lessons they learned in opening their restaurant, the most common response by far involved the amount of startup capital needed. Here are just a few of the hundreds of comments that echoed the same theme:

  • “You cannot have too much money to start.”
  • “I would have been in a better position had I borrowed more of the initial startup cost, and kept my savings account intact for operating capital.”
  • “A lot of money does not go a long way.”
  • “You need capital. Start with a business plan and borrow more than you think you will need.”
  • “Always find more funds than you think you might need. You will find yourself using these extra funds.”
  • “You never have enough money. Something always gets forgotten. Nothing is easy. Plans go wrong. But it is rewarding when your restaurant becomes a success!!”

Prospective restaurant owners should take heed that the importance of accurately projecting startup costs and the importance of securing an adequate amount of capital cannot be understated.

Survey responses also repeatedly echoed the importance of thorough planning, the crucial role of having a professional business plan to secure loan and investor financing and having the right contractor to handle the construction and buildout process.

We recommend that you read “How to Create Realistic Financial Projections for Your New Restaurant,” a 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, in ways, an almost insurmountable challenge because of the immense body of knowledge required and the significant financial exposure that comes with nearly all restaurant ventures.

However, there are many enterprising and determined folks who found a way to overcome the maze of difficulties and create a successful restaurant business. Most of them wouldn’t think of doing anything else. Here are some comments by seasoned restaurant owners on what they find to be most rewarding about owning and operating their own restaurant:

“I really enjoy the creating-community aspect of running a restaurant — hearing that people enjoy coming to our cafe is very fulfilling. We donate to a lot of charitable organizations, host benefit events here and really work at being a community gathering place. That is very rewarding. “I also enjoy the creative side — designing the restaurant itself, working with graphic designers on the menu look, managing the aesthetics of the cafe, working with the merchandise, etc.”

Laile Fairbairn
Snow City Café, Anchorage, Alaska

“The most rewarding aspect of my business is watching my employees work so hard for me to make our places such a success. Without them I would not have been able to accomplish my goals. I have several employees who have been with me for all 14 years growing from one location and 11 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 to the grindstone and reasonably clean. My rewards have been recognition by my family, friends and customers both emotional and financial. I love the business and hope to continue for another 10 years at least. This has been my most financially rewarding year. Business is up and I 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 little restaurant has a big impact on the local community. Being a cog in the wheel of the community is important to me. But when it gets down to brass tacks, the most rewarding aspect is knowing that what we do makes people happy. A good meal, in a good restaurant with good friends or family or even alone, is sort of an escape from reality and having the 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. That’s one of the attractions of the business. Pulling together all the elements, from financing to location to menu to service staff is certainly a challenge but also a reward in itself. These are tasks that when completed successfully lead to a lot of self-satisfaction and independence that most other careers simply can’t offer. It’s not hard work; it’s damn hard work. But joining this fraternity of restaurant owners with your eyes wide open can change your life in very positive ways and serves not only your lifestyle needs but adds to the community you live in. For us, it is worth doing.

Words of Wisdom

We asked some existing operators how they would advise someone who is thinking about getting into the restaurant business.

“Remember, this is a business. Forget whatever glamorous notions you may have. There is a lot of work involved and you have to have a lot of energy. If you are getting into the business because you think it will be ‘fun,’ you are probably making a mistake.”

Bill Reichenbach
David Copperfield’s House of Beer
New York, New York

“I’ve seen too many people get into the ownership side of the business without knowing what really to expect, and, being highly idealistic, they inevitably fall flat on their faces. Some who do know what to expect and are experienced still fail some of the time. To lower your odds of failing, I would say to gain as much experience as possible before putting any consideration into owning your own restaurant.”

Edmund Woo
Greenville, South Carolina

“Buy a successful restaurant even though it may cost more in the beginning but will ultimately cost you less in the long run. You earn and learn at the same time. I have had more than a few folks say they wished they had listened to this advice.”

Don Stull
Baker Street
Virginia Beach, Virginia

“Don’t do it unless you have lots of experience, a great location and plenty of capital. Ten percent margins do not allow for romance — it is nonstop attention to detail.”

Paul Rottenberg
Orchestrate Management
Des Moines, Iowa

Marty Bombenger…Key West Restaurant Consulting   305.310.1982