How to Find Investors & Raise Startup Capital for Your First Restaurant

Posted by on Jul 16, 2013 in "The Smoking Log" | 0 comments

Joe Erickson’s initial foray into the world of foodservice ownership resulted when Joe teamed with a business acquaintance who owned a 57-foot catamaran. Together, they started a dinner cruise business on Clear Lake, which is just south of Houston.

Getting a small-business loan was fairly easy because the boat served as the

primary collateral. Joe and his partner put up some cash and Joe’s partner added a small bit of real estate to round out the collateral needs. The total investment was $80,000.

When it comes to restaurant financing, investments of $100,000 or less are typically financed in much the same manner. The owner/operator will usually contribute a portion of the capital and then seek the remainder of the financing needs through their bank, oftentimes seeking the endorsement of the Small Business Administration. That said, one of the most oft-repeated complaints I hear from would-be operators is they were turned down for their loan because they didn’t have enough collateral.

In fact, one of the greatest misconceptions of first-time restaurateurs is that they think that experience and a good business plan will be sufficient to get a bank loan. They wrongly assume that the restaurant, once completed, will serve as the primary collateral for the loan. They can’t believe it when the loan officer tells them that they have a good business plan, the restaurant concept looks like a “slam dunk,” and the numbers are believable; BUT, the only way they can give them a loan is if the borrower can put up more collateral.

One operator put it like this: “Banks are not in the risk-taking business! I thought that being in the business for years as a manager, and the ability to show a proven positive cash flow would be enough. It was not. The banks were most interested in what would happen if I walked away. What are the real assets that they could get their hands on to protect their investment.”

For some, this means they have to get a second mortgage, dip further into their savings, or get a loan against their retirement account. For others, they might seek a relative’s help either as a guarantor, investor or lender.

This practice is evidenced by the results of two surveys we conducted among members of RestaurantOwner.com. Respondents who spent $100,000 or less cited similar financing sources, including savings accounts, home equity loans, borrowing from relatives and “maxing out” their credit cards.

start quote. . . In fact, one of the greatest misconceptions of first-time restaurateurs is that they think that experience and a good business plan will be sufficient to get a bank loan.end quote
— Joe Erickson

 

 

But what if your restaurant idea will cost $200,000, $500,000, or even $1 million? The fact is, out of more than 400 survey respondents, the average spent to open their restaurant was around $450,000, and the median spent between the two surveys was $200,000 to $225,000. The huge gap between the median (this means that half the respondents spent below this amount and half spent above this amount) and the average can be attributed to several respondents spending way more than $450,000 to finance their restaurant.

Seeking Investment Capital

If you have a concept that will cost hundreds of thousands of dollars to open, then chances are the financing methods mentioned earlier just aren’t realistic options for raising that kind of capital.

So, if you don’t have enough money, and you don’t have the assets required to get a loan, the logical solution is to find an investment partner who does. Our survey results showed that once restaurant financing surpasses $300,000, there was a substantial increase in the number of respondents reporting that investors were a key part of the funding process.

So how does one go about finding investors? What will they want in return? How much do you have to give up to a prospective investor? These are questions I hear over and over again. But these questions are hard to answer with a one-fits-all response. The fact is investment relationships vary from one deal to the

next. What works in one scenario doesn’t necessarily work in another.

Repeat After Me: Investors Aren’t Lenders

To gain a better understanding for how to find an investor let’s first define an investor, particularly a restaurant investor. You need to understand that, with few exceptions, investors aren’t lenders. They are owners. That’s right; regardless of

your legal structure the reality is that an investor is your partner, not a lender. Banks are lenders, not your partner. Once you pay back a bank loan, they’re gone; they don’t get any more of your cash flow.

Consider also that investors want a better return on their money than a bank might demand. The banks get a relatively low return in the form of interest. The reason it’s lower is because they have collateral, which reduces their risk exposure. On the other hand, a would-be investor has only the assets of the business for security. In an industry that experiences a 60 percent failure rate within the first three years, restaurant investment is a risky proposition. Therefore, from an investment viewpoint the return needs to justify the risk.

For a restaurant deal to be attractive, the typical investor wants to see at least 20 percent annual return on their investment (ROI). However, that may not be enough to offset the inherent risk. You’re much more likely to get a better response if you can offer 25 percent to 30 percent annual ROI.

Take note; at this point we’re not talking about ownership percentage (equity). We’re simply expressing ROI. It really doesn’t matter if the investor is a 5 percent, 50 percent or even 90 percent equity owner; they’ll probably be more concerned with their prospective ROI. We’ll discuss this in more depth later in the article.

It’s Not Just About the Money

Don’t discount the allure of restaurant ownership. Keep in mind that just about anyone you meet has frequented numerous restaurants. In 2005 the average household spent $2,634 on food away from home. That number jumps to $4,544 when household income exceeded $70,000. It’s probably safe to assume that your average restaurant investor makes much more than $70,000 per year and therefore probably spends more in restaurants than those making less. The point I’m making is this: They have been in hundreds of different restaurants and have no doubt developed an impression of whether a restaurant is profitable. Many have probably uttered comments like, “These guys are raking it in” or “this place is a gold mine.”

The fact is this: Most anyone would relish the opportunity to own a piece of a successful restaurant. Add the prestige factor to a good ROI and you’ve got a recipe that might be attractive for investors.

Finding Potential Investors

I don’t want to rain on your parade, but I think it only fair to tell you that finding someone to invest in your restaurant will be a challenge. You may have heard or read about investment group terms such as venture capitalists, private equity firms, or angel investor organizations. In fact, conduct an Internet search on these terms and you’ll find plenty of wealthy investment groups looking for “home run” ideas to invest in. If you’re an established restaurant with franchise or growth opportunity, then pursuing these types of investment firms could yield dividends. However, for startup restaurants, chasing these professional investment groups is futile.

You need to look locally for partners. Many entrepreneurs turn to family and friends for capital needs, but I recommend that you give this route some serious thought beforehand. While your restaurant idea may be your greatest passion, it’s also risky by nature. Do you really want to risk their money and your relationship for this venture? When things go badly, and in this business things go badly more than 60 percent of the time, sometimes family is all you have to fall back on.

Consider instead, cultivating your existing business and social relationships. Run your idea by those in your network of acquaintances. Who knows, there may be an angel investor in your midst. The Angel Capital Education Foundation defines an angel investor as a high net-worth individual who invests his or her own money in start-up companies in exchange for an equity share of the business. Many are former entrepreneurs themselves and make investments to gain a return on their money, or to participate in the entrepreneurial process, or simply to “give back” to their communities by catalyzing economic growth.

Mike Owens, one of the founders of Brick Oven Courtyard Grille in Topeka, Kansas, found investment partners within the local community, several of which traded a portion of their services toward building the restaurant for equity in his restaurant. His attorney, general contractor, and real estate broker became investors as well as regular guests. He found that by garnering local support through investor relationships there is now a team of community leaders promoting the restaurant.

If you plan on finding multiple investors, keep in mind that the Securities and Exchange Commission (SEC) and your state’s commerce regulatory entity have strict rules when it comes to soliciting investment capital. Even though this is a private rather than a public offering, you’re well-advised to seek the counsel of an attorney who specializes in forming legal entities that have multiple investors and who can advise you on the formulation of a prospectus if warranted.

The SEC regulations prohibit you from using any form of public solicitation or general advertising in connection with your search for investment capital. This means you can’t throw a party, entice prospective investors to attend, and then solicit their investment with a Power Point presentation. (See “No Harm in Asking? Think Again!” below).

Before you start chasing prospective investment partners you better have a solid business plan in hand. A sophisticated investor should be able to evaluate the merits and risks of the proposed restaurant venture. The first thing they’re going to evaluate is you. The quality of your business plan will be a direct expression of your capabilities as an operator. (For more information, see “Mapping Your New Restaurant’s Journey,“)

A good business plan should reflect your qualifications, experience and track record, and that of your proposed management team if already selected. It needs to do a good job of detailing the restaurant concept and provide a convincing argument of how that restaurant concept can be successful in the intended market.

The business plan should include solid, realistic financial projections, including detailed startup costs, sales projections, profit-and-loss, and the expected ROI for the venture. You will be asked to validate your numbers so be prepared to defend them with authority and financial understanding.

If you are searching for an investment partner who can also bring their business expertise as well as their money, then having a work-in-progress business plan may be acceptable. You may be an expert at running a restaurant — you should be very confident with financial projections as well — however, you may lack general business experience, such as structuring your legal entity, dealing with landlords, or getting bank financing. An experienced business partner can help fill these gaps and is more likely to have faith in the capabilities you do have if you’re upfront about your shortcomings. They can help round out your business plan as the development progresses.

Be forewarned: If you plan on having multiple investors, then having an incomplete business plan is a sure way to scare them off.

Structuring the Deal

As I referred to earlier, the key considerations for investment will center on ROI and equity positions. I have heard this question over and over: “How much ownership should I give to an investor?

The short answer is, “every deal is different.” Typically, equity positions are influenced based on several factors, such as the number of owners (investors), capital contribution, liability and participation, to name a few.

First, let’s view a single-investor scenario. If you think you’re going to find an investor who will put up 100 percent of the capital, share full liability, and then ask them to take a 50 percent or less equity position, then you may be searching a long time.

To enhance your equity position you need to put up some capital as well.

However, the ratio-of-equity ownership percentages do not have to equal the capital contribution. You can still put together a deal that ensures you have a greater equity interest by following this simple rule: The investor gets their money back first.

For example, let’s assume your venture will cost $500,000 to fund and you plan to invest $50,000 of your own money. You then seek an investment partner who will contribute $250,000 in cash and co-sign for bank financing for the remaining $200,000. To enhance your 50 percent equity position, you maintain a modest salary for running the restaurant, but you designate cash distributions to be commensurate with the ratio of capital contributions. In this case, the investor would get

83 percent ($250,000 ÷ $300,000) of the cash distributions as compared with 17 percent ($50,000 ÷ $300,000) for you until the original capital investment is paid back. This is simply an example; actual percentages will be determined through negotiation.

When Owens put together Brick Oven’s investor package, he wanted to create, in his words, a “win-win” for all involved. He and his operating partners formed an LLC (limited liability company) that served as the “general partner” for the venture. He structured the deal so that the restaurant entity was separate from the real estate entity, creating an environment wherein the restaurant paid rent for the real estate. He divided the capitalization into 40 shares. Investors, as well as the general partner received an equity position in both that equals the number of shares purchased. Cash distributions are structured to be equivalent with the equity position. On top of that, the general partner receives a management fee for operating the restaurant.

As I stated earlier, ownership percentage doesn’t have to be equivalent with investment percentage. I was involved in a partnership in the early ’80s (before LLCs existed) wherein we wanted to garner community support, much like Brick Oven did, by searching out investors that resided in the community.

In this deal, we formed a limited partnership, establishing ourselves as general partner with a 51 percent equity interest in the form of a sub-chapter S corporation for purposes of limiting our liability. My partners within the general partnership owned the land and leased the space to our restaurant. We needed to raise $210,000 for the restaurant deal so we divided the capital contributions into 35 shares of $6,000 each with the general partner committed to

The conscientious This packaging. Both all it skin. And this “shop” in sandalwood that.

a minimum of one share. In the partnership agreement, we stipulated that cash distributions would be allocated according to the percentage of shares owned until such time that the original investment for each share was repaid, at which time the cash distributions would revert to the percentage of equity owned, which was 51 percent to the general partner and 49 percent to the limited partners.

A Good Deal is When It’s Good for Everyone

Successful investment partnerships don’t happen by chance. They require planning and commitment. Involving a qualified attorney during the planning stage is a must. A good attorney can protect you against unforeseen pitfalls by addressing issues within the partnership or operating agreement such as what happens if additional cash contributions are needed or if one of the investors wants out or is in default of the agreement.

A lawyer friend of mine once told me, “The best way to plan for a good partnership is to plan for when it goes bad.” Hopefully you’ll find investors who are as enthusiastic about your restaurant venture as you are, and that it ends up being a good deal for all involved. Perhaps you should adopt the philosophy that Mike Owens and his Brick Oven partners had, to create a “win-win” situation for all involved.

 


A Few Words of Advice for Restaurateurs With More Cash Than Experience

Your decision to enter independent restaurant ownership probably stems from either a love of food, affection for entertaining, entrepreneurial longing, past business successes, or all of the above. Whatever the reason, we want you to know that this is an extremely challenging business that takes money, experience (both in business and in restaurant operations), and resolve. Chances are that you have three out of the four, lacking only in restaurant experience.

So, before you get too far down the development path — and make too many mistakes, consider finding an operating partner who can bring the right type of restaurant experience to your venture. Not all restaurant experience is equal. In other words, just because someone may have a successful background in running a 16-unit Wendy’s franchise, doesn’t mean they are properly suited to open your $2 million casual dinner house.

“Try to find an operating partner or general manager [who] has experience in a similar concept,” says Gary Turner, president of Hospitality Pro Search, a foodservice management placement firm in Houston. Turner then recommends that you do a background check, check their references, and before you hand over the keys to your $3 million- to $5 million-a-year operation, consider doing a credit check to see how they handle their personal affairs.

Once you think you have the right person, at least on paper, go into the interview process with the objective of establishing a comfort level with the prospect. He recommends you spend a lot of time together in a short period. Is this the type of person you can sit across the table from and enjoy their company? What are their interests? What do

you have in common? “If you enjoy golf but the person across the table has an affinity for needlepoint, then you may have a problem,” Turner says in jest.

Keep in mind that there are a lot of great general managers, many of them who work for chains, who are looking for entrepreneurial opportunities themselves. They have the restaurant experience but not the cash or business ownership experience. Finding the right operating partner is the first step in turning you restaurant dream into reality.


No Harm in Asking? Think Again!

Be Sure to Stay on the Right Side of Securities Laws When Raising Capital

Raising money from investors is easy. All you have to do is ask for it, explain how it will be used, give the investor part of the company and promise a fair return within a reasonable time, right? Wrong. Dangerously wrong.

When you use, or even want to ask for, other people’s money as capital invested to finance your business, you cross the great divide that separates those who invest money and time in themselves from those who finance business ventures not to own and operate them, but rather to obtain a return on their invested capital. In exchange for their money investors, unlike creditors such as banks that earn a fixed return (interest) on money lent, expect a piece of the action — ownership of some part of (an equity position in) the company, since that likely will yield to them a greater return on their investment than what they would receive if they simply lent money.

The seemingly innocent acts of accepting or even asking for other people’s money in exchange for a piece of your company (for example, offering shares of stock in a corporation or a membership interested in a limited-liability company — both of which are securities) in exchange for startup or seed money, trigger federal and state securities regulations designed to protect unwary investors from unscrupulous profiteers.

In general, unless an exemption applies, every security issued must comply with securities registration laws (often a fairly expensive and cumbersome process). Exemptions often key on factors such as a limited number of investors; residence of all investors in a single state; investor sophistication (as measured by wealth and income, with the upper end termed “accredited”); a pre-existing relationship between the investor and the company or its principals; the absence of any advertising or promotional information; and a commitment from the acquirer that the stock purchase is for his or her own account and is not being made as a securities dealer, with an eye to further distribution. State regulations often are referred to as “Blue Sky Laws” because that is all that some disreputable companies delivered to their investors in exchange for their hard-earned and often forever-lost cash.

Many of the reforms that continue to govern today (Federal Securities Acts of 1933 and 1934) were created in the aftermath of “Black Friday,” the October 1929 stock market debacle. Consistent with former U.S. Supreme Court Justice Louis Brandeis’s admonition that “Sunlight is said to be the best of disinfectants,” by calling for specific disclosures and warnings, these rules partially level the playing field to help neophytes participate alongside more experienced investors.

Regulation does not mean that raising money is taboo; just that anyone not an expert in the area should retain an attorney who specializes in securities laws to guide them through the process, whether by way of registration, qualification or exemption. Depending on the complexity of the financing structure, the entire process can be fairly straightforward and involve minimal filing requirements or incredibly complex, requiring extensive disclosures such as those found in a prospectus or private placement memorandum.

The failure to comply with securities laws can have dramatic consequences, so take care to obtain legal advice applicable to the securities being issued or transferred and the company (issuer) issuing or acquiring them.

Marty Bombenger…Miami & Florida Keys Restaurant Broker 305.310.1982

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