Reduce the Risk of Opening a New Restaurant

By Jim Laube

For anyone evaluating the feasibility of opening a new restaurant, whether it's your first or your hundred and first, there's one key financial factor that points to success or failure in this business probably more than any other. It's referred to as the sales to investment ratio. That is, how many dollars of annual sales can you reasonably expect a proposed restaurant to generate for every dollar of invested capital it will take to take to open it. 

The sales to investment ratio is calculated by taking the projected annual sales of a proposed restaurant and dividing it by the total projected startup investment required to open the restaurant and get it operational.

Two Main Restaurant Structures

As the sales of a new restaurant increase relative to its startup investment, so too increase it's chances for profit and financial success. It's no secret that the chain restaurants with the highest sales to investment ratios are consistently among the industry's most successful profit performers too.

There are essentially two ways to structure a new restaurant venture in terms securing the capital assets required for operation. The most widely used method is to obtain the use of a building space by leasing a facility from an unrelated third party. The other option is to directly, or indirectly through an affiliate, purchase the land and develop the physical structure or buy the land with a building already in place

Leasehold Case

First, we'll examine a leasehold scenario. When deciding on the feasibility of a restaurant venture that will be operated in a leased facility, start by calculating the total projected startup investment. This would include the cost of the leasehold improvements, furniture, fixtures and equipment, utility deposits, soft costs like architectural, design, legal and accounting and startup costs including opening labor, training and inventory. It's also good to include a 10% to 15% contingency for change orders, cost overruns and a working capital reserve for operating losses for the first 3 to 6 months after opening. Here's a summary of the major cost categories usually included in the startup investment in a leasehold restaurant venture.

The next step is to estimate the annual sales volume of the proposed restaurant. A logical way to do this is to begin with the days of the week the restaurant will be open and estimate the table turns or number of customers you expect to serve during each meal period. One of the best ways to do this is to spend time during several meal periods on different days of the week in existing restaurants in the market area of the proposed restaurant. Find out what meal periods and days are the busiest, which days and shifts have the longest wait times and when it's slow. Also, find out when the slowest and busiest times of the year are.For purposes of calculating the sales to investment ratio include the cost of "all" the assets regardless of how they will be financed.

To save time and get loads of valuable information, make a point of introducing yourself to the managers in these local restaurants. Use some tact and diplomacy and they will probably tell you everything you want to know. I've often had managers, and even owners, tell me in vivid detail about their sales volume, when they're busy, slow and how they're doing this year compared to last. I'm constantly amazed about what other operators, even potential competitors, will tell you when you're face to face and just ask them questions about their restaurant.

Below is an example of a worksheet I've used frequently to make a more systematic and logical estimate of the sales volume in a proposed restaurant. Yes, this does take some time and it's only as good as the assumptions you make, but, going through this type of detailed, fact finding exercise now can save you loads of heartache and despair down the road.

Step 1: Estimate the number of customer you expect to serve at each meal period in a typical week.

Step 2: Enter the customer counts for each meal period along with an estimate of the check average. This will help you determine an estimated sales volume for a typical week. It's important to find out how many customers are in similar restaurants in your market area during these meal periods while taking into consideration seating capacity as well. Taking the time to do this will dramatically enhance your understanding of the local market and improve the quality of your sales projection, which is a "critical" component of your prospects for success.

In the restaurant business, success or failure hinges almost entirely on one number "SALES". If you go into a new venture expecting to do $1,000,000 a year in sales and instead do $600,000, chances are you're DONE, out of business, with little or no chance of turning it around. Take the time to run the numbers BEFORE you commit to a specific location. Make sure you can justify just how you're going to get to that $1,000,000, or whatever, a year in terms of customers, check averages and average weekly sales.To get an annual sales amount you can multiply this number by 52 weeks or you can go one step further and do a weekly sales projection for a week during the peak sales season, another for the slow season and a third for a moderate or middle of the road week. Then estimate the number of weeks for each of the three periods (peak, slow & moderate) and do the math to arrive at an annual projection.

Check out the Weekly Sales Projections Workbook to assist you in making these calculations.

From my experience, this approach works 100 times better than just pulling a sales estimate out of the air. Not only will this method impress your banker and potential investors but, most importantly, it will give you a much better basis to evaluate whether or not you should move forward on a particular location or not. Making a bad decision at this stage of the opening process often leads to a business venture fraught with red ink and failure. Don't pull the trigger on a location until not just your gut, but also "the numbers," point favorably to a good chance of profit and success.

With a reasoned and systematic estimate of the annual sales volume and startup investment you can use the sales to investment ratio give you the benefit of some reliable restaurant industry benchmarks and rules of thumb.

Leasehold Example

Based on being privy to over 100 startup ventures over the past 10 years, my sense is that a sales to investment ratio of 1.25 to 1 is too low and I would advise against moving forward on this particular location given the amount of investment required and the projected annual sales volume.

My rationale is this: Say, the development of this restaurant went forward and the startup costs came in at exactly $800,000 and the restaurant actually generated sales at the rate of $1,000,000 per year. Even if the operator did better than most restaurants, and netted a bottom-line net income of 10% or $100,000 a year, at that rate it would take at least "8 years" to recoup the $800,000 investment (actually longer if we considered income taxes). To me, that's too long to have your startup capital at risk in any restaurant venture. The goal should be to recoup all the initial investment in half that time or four years, at most.

A reasonable rule of thumb when evaluating leasehold ventures is to expect a minimum sales to investment ratio of 1.5 to 1. And that's a minimum. I believe it's prudent to set a 2 to 1 or higher sales to investment expectation in a leasehold case.

Something else to keep in mind in a leasehold venture is the rental rate on the facility. Even if the sales to investment ratio looks good, also make sure that the annual lease payments do not exceed 6% of your expected sales volume. Some landlords have been know to give generous build-out allowances (which lowers the startup investment) to entice restaurant tenants, only to jack up the rent to an excessive amount. Another rule of thumb: Don't sign a lease where your monthly building rent is in excess of 6% of your expected sales volume.Once rent starts to exceed 6% - 7% of gross sales it begins to seriously erode your chances of making an adequate profit.

Case in Point: Leasehold

Most, if not all, national chains use the sales to investment ratio or some variation of it to evaluate specific sites they're considering for expansion. Here's how a successful national steak chain uses this ratio.

This operator invests around $1,200,000 to open new restaurants in leased locations. They expect to do at least $3,600,000 in annual sales which gives them a very healthy sales to investment expectation of around 3 to 1.

Purchase Land & Building ScenarioThis chain's entire site selection philosophy is influenced by the sales to investment ratio. They often pass on high traffic corners and highly visible sites because they reason that the added cost of acquiring those locations won't result in proportionately higher sales. Instead, they often seek out class "B" locations in class "A" markets to obtain lower startup costs and rental rates that will enable them to maintain their high sales to investment ratio goals. This mindset has paid off handsomely as they are consistently one of the most profitable companies in our industry.

While not as common as leasing a building or space from a third-party landlord, many restaurants are operated in facilities where the owner/operator also owns the land and the building.

In these situations, the startup investment would include all the development and startup costs noted in the leasehold situation above except the cost of the land and building would be substituted for the cost of the leasehold improvements. Again, forget about financing when calculating the sales to investment ratio. Include the cost of all the assets regardless of how they are to be financed.

The annual sales volume would be projected in the same manner as noted in the leasehold scenario above.

In ventures where the land and building are owned by the operator, the sales to investment ratio can be lower than in a leasehold situation and still make good economic sense. In fact, the sales to investment ratio can be as low as 1:1. Personally, I advise my clients to expect a minimum 1.2 to 1 sales to investment ratio in ventures involving the acquisition of land and building but some might interpret this is as being a little too conservative.

Acquire Land & Building Example:

Assume we estimated the total startup investment of a proposed restaurant where the operator will also control the land and building to be $1,500,000 with a projected annual sales $2,000,000. This would yield a projected sales to investment ratio of 1.33 to 1.

Provided, of course, our cost and sales projections were reasonable, on the basis of sales to investment, I would conclude that this venture show positive economic potential and should be considered further.

You may be wondering why the sales to investment ratio can be lower when the operator owns the land and building versus leasing a facility. One way to look at this is to consider the residual value of an operator's startup investment six months after a restaurant opens and then fails. When this happens in a leasehold venture, much of the startup investment is lost. Even the value of the hard assets, the equipment and leasehold improvements, are greatly discounted, worth possibly pennies on the dollar at that point.

On the other hand, when the operator owns the land and building, a sizable portion of the value of the assets remain in tact even if the restaurant fails. Also, even though the debt service on purchasing the land and the building may be higher than it would be to rent a similar facility, part of the loan payments are paying down the loan and building equity in the venture. And at some point the loan will most likely be paid off. When this happens it's like running a restaurant with no rent.

Case in Point: Acquire Land & Building

According to their annual report a few years ago, Wendy's International invests about $1.2 million to buy the land, build a building and open a new Wendy's restaurant. At that time the average Wendy's did around $1.3 million in sales so their sales to investment ratio was around 1.1 to 1.

Final Thoughts

I'm reminded of a comment made to me by an operator several years ago. He had made a mark on his local restaurant scene by opening several relatively small, low investment Mexican restaurants which were very popular and quite successful. He then stepped out and built a large, magnificently appointed restaurant in a chic part of town. It was obvious he'd spent loads of money to open this restaurant.

A few months after it opened, I was in the restaurant with my wife. We waited nearly 30 minutes for a table. As we were leaving, I noticed the owner and made a point of congratulating him on another successful restaurant. He seemed appreciative but pointedly replied, "It's great to do $3.0 million in sales . . . but it's not so great to 'have' to do $3.0 million in sales."

Opening a new restaurant always entails risk. You can reduce your risk by carefully projecting and considering the sales to investment ratio of a proposed venture. Experienced restaurant startup professionals rely on the sales to investment analysis before they make any expansion decision. Every newcomer and even experienced restaurateur should too.

Check out the Restaurant Startup & Feasibility Workbook for a powerful tool to assist you in determining the Financial Feasibilty of your new restaurant venture.