Where do you go for money if you have reached store-level profitability at your existing restaurants and want to expand?
As our Restaurant Financial Success Guide mentions, expansion should only be considered once you have ideal unit economics and a profitable business model. If you’re producing 15-30% store-level pre-tax profit margins, you can probably bootstrap the entire expansion, but that will only get you so far. Depending on your growth rate and ambitions, taking on debt and raising capital from investors could be inevitable.
In this article, we’ll explain the steps you must take and the implications of funding your restaurant group’s expansion.
Step 1 – Calculate the funding needed and assess the project’s viability
Total funding needed to open a new restaurant/location includes all costs incurred before opening day, including buildout, equipment, furniture, deposits, inventory, and other pre-opening expenses such as supplies, salaries, accounting, legal fees, architects, etc. We recommend adding a working capital reserve to sustain operating losses until operations are locked down.
In an existing restaurant, retaining one month of operating expenses (not including COGS) in cash is healthy (unless you are not profitable or seasonal). Still, in a new restaurant, you need at least three to six months of operating expenses as cash, depending on your experience opening restaurants. If you are a restaurant group opening its nth location, you probably have a better idea of how long it will take you to reach profitability.
You must ensure you can generate enough sales relative to the total funding needed; otherwise, investors will not be attracted to the deal. The minimum sales-to-investment ratio for a new location should be 2:1. Still, you should aim for 3:1. You must be highly diligent and pragmatic when estimating sales because your projected sales will determine your fundraising journey from here on out.
There are a variety of tools available on RestaurantOwner.com that allow you to project sales accurately. You can also refer to Assessing a Restaurant Valuation to understand why the sales-to-investment ratio is important and how to calculate it.
Once you know the total funding needed, add another 10-20% because things will get delayed, and the project will cost more than expected. Ensure you spend the appropriate time on this step before approaching funders. Suppose your total funding is needed, and your projections are not accurate or realistic. In that case, you can lose creditability with funders and waste a lot of money on legal fees by redrafting the term sheets and other paperwork.
Step 2 – Determine Debt vs Equity Ratio
During this step, you’ll want to consider the ratio of debt-to-equity investment. You can ensure the highest return for you and your investors if 70-80% of financing comes from debt. The higher the interest rates, the lower the amount you’ll want to finance via debt. With 70-80% of your financing coming from debt, your financial projections should yield a Debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio of 2-5 and an EBITDA-to-interest expense ratio of at least 5, ensuring healthy liquidity and an enticing return on investment for equity investors.
Suppose you don’t have the appetite for carrying or guaranteeing debt or don’t qualify. In that case, you’ll need to give equity investors a faster or higher preferred right to distributions, as discussed in the next step. Here are some of the advantages and disadvantages of debt and equity financing:
| Financing | Advantages | Disadvantages |
|---|---|---|
| Debt | - Yields the highest and quickest ROI (return on investment) for the restaurateur - Less reliance on investors | - It must be repaid regardless of your restaurant's performance - If you're borrowing through an institutional lender, you'll most certainly need to put something up as collateral |
| Equity | - Low risk to the restaurateur. - Raising equity financing is typically more manageable if your previous ventures have made the same investors a return. | - It will take longer to get a return because investors will be prioritized over the restaurateur, as you will see in the next step. - If your new location doesn't succeed, you could tarnish the relationship with your investors. - Investors might start breathing down your neck if you're not making them money. - You have a fiduciary duty to provide specific reports and respond to investors. - It's hard to remove investors; they're in it forever unless there is a bad actor clause and you have bad-acting investors. - Your investors' reputation and bad acts can reflect poorly on your brand. - You may have to buy out your investors to get rid of them. |
Step 3 – Determine Your Equity Structure
There are multiple ways to structure restaurant equity deals, but it typically boils down to two types: (1) short-term or (2) long-term.
Short-Term
Short-term refers to investors who want to invest in one or two restaurants at a time and quickly earn their return on investment. They want their return on investment quickly because they understand that restaurants are high-risk and frequently short-lived, and they want a reward for taking that risk. In a short-term equity deal, the investor will typically have ownership at the restaurant level, not holding/management company level, because they may not be in it for the long haul.
For example, assume Jane Restaurant Management Co. owns the intellectual property (IP), such as trademark and recipes, of Bob’s Shrimp Co. and plans to open five Bob’s Shrimp Co. locations over the next 5 years. A short-term investment would give an investor direct ownership in one of the Bob’s Shrimp Co. locations., but not in the other locations, management company, or IP. Although, that investor may have a right of first offer to invest when raising capital for more locations.
The investors in a short-term investment model are typically given between 20-40% ownership but are entitled to a preferred distribution. A preferred distribution model creates two or more classes of ownership – Class A (the money investors) and Class B (the managing partners/proprietors), and assigns majority diluted ownership (60-80%) to Class B partners while entitling Class A investors to a majority (70-100%) of distributions until they receive their investment back plus a certain percentage.
For example, Class A partners invest $1m in Bob’s Shrimp Co.; the only Class B partner, Jane Restaurant Management Co., invests nothing. The agreement requires 80% of profit distributions to be issued to Class A partners and 20% to Class B partners until Class A partners receive 120% of their investment. After Class A partners receive 120% of their investment, 80% of distributions go to Class B partners and 20% to Class A partners.
After they’ve made a solid return, many investors may prefer to be bought out since they’re not in it for the long haul. Suppose they have a change of heart and see that there is potential for serious growth. In that case, they may want to participate in a “roll-up,” which allows them to exchange their ownership in one of the locations for a smaller equity percentage in the holding company that owns all the locations.
Long-Term
Long-term refers to investors investing for a stake and appreciation in the rights of the entire concept or brand. This is akin to the tech-start-up model, where investors are not expecting an immediate return on their capital but are betting on a more significant and later successful exit. Instead of raising money at the restaurant unit level, investors invest at the holding company level and own all locations where that holding company or concept will open.
In a long-term model, investors don’t expect to recoup their investment quickly; instead, they want to reinvest their profits into opening more locations and participating in the long-term growth of the multi-unit restaurant group. The goal is typically to reach 10-30 locations, then sell to a private equity group and earn a much larger return than a percentage of profit distributions at the single-unit level.
Ownership in a long-term deal is typically pro-rata unless profits interests are issued to sweat equity partners. A valuation price is set during each capital raise and dictates the diluted ownership of each partner. For example, partners A and B contribute $1m each for a 50% stake in a $2m restaurant. They reinvest all profits and open five additional locations in 5 years. By year 5, the restaurant group is worth $10m, and they need to raise $5m from partners A and B to expand further. Partner B doesn’t want to contribute, but Partner A is willing to contribute the entire $5m. Partner B agrees to Partner A contributing the whole $5m as long as Partner B retains their 50% share of the $10m valuation.
As a result, immediately after the $5m capital contribution, the restaurant group’s post-money valuation is $15m, and the diluted ownership percentages are:
Partner A: $10m/$15m = 67%
Partner B: $5m/15m = 33%
In fast-growth restaurant groups, sweat equity is common. In a partnership/LLC, sweat equity is typically issued via profit interest; in a corporation, sweat equity is generally issued via stock options/restricted stock. Refer to Profits Interest: Tax Free Equity in a Restaurant Partnership to learn more about profits interest and how they can be utilized to grow your restaurant group.
Pitching Investors
Before pitching investors on your equity offering, you’ll want to consult an attorney to assemble a term sheet and other required paperwork, such as subscription agreements. We recommend working with Helbraun Levey, a law firm specializing in restaurants, bars, and nightclubs.
Before engaging an attorney, ensure your projections and total funding are buttoned up and realistic. The last thing you want to do is solicit capital using a term sheet you invested a lot of money drafting, then go back to investors and redo the offering. It creates distrust with investors, costs you a lot in time and attorney fees, and can lead to an overly complex structure and waterfall for issuing distributions.
Whether you choose to go down the short or long-term route for equity financing, consider who owns the rights to your intellectual property (IP) and whether investors have a first right of the offer, and communicate this clearly in your pitch. If you go the long-term route, your investors will assume the IP is part of the deal.
Step 4 – Determine Your Debt Financing
The debt financing a lender will offer is based on factors such as your existing locations’ cash flow and profitability, the guarantor’s credibility, and your track record as a restaurant group. It’s best to reach out to a lender and see how much of the total funding can be financed by debt. We suggest working with Everfund to understand how much they can borrow and which lender is the best option.
Most lenders will care about EBITDA and your existing restaurants’ free cash flow when assessing how much you can borrow to fund a new location. The lender will also want to see at least 2 years of projections and a business plan that proves the ability to repay the debt. The EBITDA in the projections should be at least 1-1.5x the debt payment amounts.
The profitability of the current locations is more important because if you default on the expansion loan, the bank will request payment from the existing locations. When rates are low, you can typically borrow a higher multiple of your EBITDA.
For example, when rates were around 4-5%, you could borrow between 4-6 times your EBITDA. With higher interest rates, the amount you can borrow is between 3-5 times EBITDA. You and the bank must ensure your pre-tax and interest cash flow can cover your debt payments.
A lender will most likely recommend an SBA 7a loan for your restaurant’s expansion unless you have a solid track record and financials because the SBA guarantees a portion of the loan, reducing risk for the lender. The SBA 7a loan has many benefits, such as a 10-year repayment period, low interest rates, no balloon payments, flexible use of funds, and low down payment requirements.
However, they will require any owner with 20%+ ownership (or a key operator such as a sweat equity managing partner) to guarantee the loan. The guarantor’s credit will significantly impact the debt amount and terms.
The lender will also assess whether the guarantors have commonly owned collateral, such as another business that has taken on SBA 7a debt in which the guarantor owns 20%+. 20%+ ownership refers to diluted ownership. Partners who receive 20%+ profit distributions temporarily in the form of a preferred profit distribution, as mentioned in step 4 above, are not considered 20%+ owners
The lender will also assess your track record as a restaurant group. They will look at your reputation, brand, concept, and success of previous locations.
The lender generally defaults to an SBA 7a loan, but if you have a proven concept and track record with the bank, they might offer other loan options with different terms from a 10-year SBA 7a loan.
Regardless, an institutional lender will always require some collateral, whether a personal guarantee or pledging other assets of the restaurant group (such as your other restaurants/properties). If you’re purchasing real estate in your new location, your lender may also recommend an SBA 504 loan. The SBA 504 loan is a 25-year fixed-rate loan used to finance real estate that’s part of expanding or opening a small business.
Line of Credit
If you’re reaching the finish line and fall short on cash, a Line of Credit (LOC) may be an ideal option to fill the gap because you can get the funds much faster.
A Line of Credit can be attained faster because they require a lot less documentation than an SBA loan, and they’re generally determined based on revenue from existing locations instead of EBITDA or profit. You might get .5-2x your monthly revenue in cash through a line of credit. A line of credit will allow you to buy time (sometimes up to 3 years).
However, you must make payments towards the line of credit almost immediately until the loan payoff date. Sometimes, you can get a 12-month interest-only Line of Credit, which allows you to keep your payment low until you’re up and running. You also only use what you need, another benefit of LOCs.
Talking to your banker about a line of credit is a good place to start because they should be able to make it happen quickly since they already have access to your existing accounts and cash flow.
Other Sources of Debt
Other creative sources of financing not discussed in this article include but are not limited to Tenant Improvement (TI) Allowances, mezzanine debt, Equipment financing, equipment sale-leasebacks, deferred rent, vendor terms, and partnering with inKind to receive advances on your sales. You can explore these options besides the traditional debt and equity financing described above.
Summing it Up
Your ability to negotiate and leverage your restaurant group’s financing lies in your financials’ accuracy, credibility, and performance.
The best time to raise capital is when your restaurants are performing well, and you have a proven concept and track record.
From there, you’ll need to determine the total funding required, identify the ideal debt-to-equity ratio based on your appetite for debt and/or dealing with investors and sharing your ROI, determine and pitch your equity offering, and finalize your debt financing sources.
With a track record, you can leverage 70-80% of your expansion via debt, maximizing your ROI. You can diversify the financing of your expansion through all the equity and debt options described in this article.
Don’t hesitate to contact us if you want to get your restaurant group’s accounting and financial reporting up to industry standards and investor expectations.
