David Steele, co-founder and executive chairman of the Flour + Water Hospitality Group in San Francisco, jokes that his role is creating restaurants — not investing in them.
[Sign up for stock news with our Invested newsletter.]
“A lot of people assume because I have a background in finance that I’m a rich guy who wanted to buy my way into the restaurant industry,” says Steele, who is also the managing partner of One Wealth Advisors, an independent advisory firm. “What a lot of people don’t realize is that I’m a restaurateur, not a restaurant financier.”
While many financial experts advise against investing in one-off concepts, Steele says such an arrangement can be successful.
Here’s what to consider before financially diving into the restaurant industry:
— Ask yourself if you want to be an active or passive investor.
— Understand the variety of ideologies.
— Review the business plan and cash-flow projections.
— Look at occupancy costs.
— Understand the projected rate of return.
— Consider a restaurant’s scalability.
Ask Yourself If You Want to be an Active or Passive Investor
“It is critical that you make that differentiation,” Steele says. That’s because most single restaurant investors are lifestyle investors who like the social cachet of owning a restaurant.
“The restaurant industry is very romanticized,” he says. “And it attracts people who aren’t strategic thinkers, people who have an abstract relationship with money. I don’t believe the restaurant industry is riskier than any other industry if you remove the romanticized players that aren’t real business people.”
The National Restaurant Association estimates that before the pandemic, on average, about 60,000 restaurants opened each year — and 50,000 closed annually. It’s also a fiercely competitive industry, with 1 million foodservice establishments in the U.S., and of those establishments, the average pretax margin is only 3% to 5%, according to the association.
Understand the Variety of Ideologies
“I believe that if you use local investors who are passionate about your concept they become ambassadors,” says Steele, who had 11 investors for the group’s Flour + Water restaurant, and about 25 to open three others — Trick Dog, Penny Roma and Flour + Water Pasta Shop. “But I am one of the unusual ones. A lot of people don’t want a lot of investors, because they think investors can be [difficult]. But I say screw that, these people enable you to open your businesses.”
That symbiotic relationship between those with capital and those with ideas and operational skills creates a delicate balance.
[SEE: 7 Clean Energy ETFs to Buy Now]
For Steele, all his passive investors are from the Bay Area and can regularly dine at his establishments. None are partners. Instead, he shares monthly profit-and-loss statements via a bullet-point narrative so investors can “take the temperature,” even if most of them don’t. He also hosts a biannual investor meeting to discuss evolutions in the menu, renovations and listen to suggestions — which prompted adding pasta to Penny Roma’s menu and turning down his blaring classic rock music, after much resistance.
“I was stubborn,” Steele says, but admits the investors were right.
Investing in such an illiquid asset starts by setting proper expectations about the tenor of the relationship. Steele says he always tells investors he will take their ideas under consideration, but won’t be beholden to them. “Very few restaurateurs are looking for active investors. In fact, I don’t know any,” Steele says. “I know restaurateurs who have misled investors into thinking they would be taking an active role because they couldn’t get the capital from anybody else because they weren’t aggressive enough in finding people.”
Review the Business Plan and Cash-Flow Projections
A new restaurant doesn’t have past performance to review in the way of records or tax returns. Instead, would-be investors must use some logic to test the numbers about the “reasonableness” of the projections, Steele says. See if the business plan is well-written and if there’s a narrative that makes sense with local projections.
While Wall Street looks at earnings before interest, tax, interest, depreciation and amortization, or EBITDA, restaurants look at the cash flow from operations. “If I’m seeing projections that equals less than one-third of the capital they are looking to raise, I’m suspicious if that’s a good investment,” Steele says.
That means if a restaurant says it needs an investment of $1.2 million, it should have a projected cash flow of $400,000.
Look at Occupancy Costs
Review how much money it takes to occupy and maintain a space, including rent, insurance, common area maintenance and taxes. The industry standard says this should be no more than 8% of sales. Although, it may be higher than 10% in New York City, where occupancy costs “are all over the place with some areas down and others up,” says Greg Wank, food and beverage practice leader at Anchin, Block & Anchin in New York.
Understand the Projected Rate of Return
When Steele needs investors, he bases the percentage of the business he is willing to give away on the cash flow projections and what will yield a 20% rate of return or higher via a 10-year calculation.
For example, Flour + Water required less capital than some of his other restaurants, so investors were only given 23% of the business, Steele says, versus 40% equity in Central Kitchen and Trick Dog. “It’s not the number of investors, but the projected cash flow versus capital needed to open,” he says.
It’s also important to consider how the Federal Reserve’s rate hikes have impacted investor perspectives. With interest rates much higher, the risk-adjusted return an investor is looking for may be a bit higher today than in years past, Wank says.
Consider a Restaurant’s Scalability
Institutional investors who are more interested in the exit value should consider how a corporation is hiring the right talent to scale a restaurant or chain and how it’s investing in the brand, instead of focusing on the cash flow.
Then look for restaurant operators with prior experience. “The best investment opportunity is with an operator who has already successfully launched one or two locations and now wants to build a brand, because the risk is not as high,” Wank says. “I’d much rather invest in an owner-operator who has failed once in the past and is now showing they’ve learned lessons from that experience and are now operating successfully.”
More from U.S. News
8 Best Real Estate Stocks to Buy
6 Facts to Know Before Investing in a Restaurant originally appeared on usnews.com
