Buying a Bar


Productive Ownership                                                                      6/27/2012
A blueprint for maximizing the growth and profitability of a hospitality business

Forward and Disclosures

This paper is intended for a narrow audience.  The intention is to discuss some of the things I’ve learned over the years that I think are important ingredients in the successful operation of a privately held, single unit, bar/restaurant/nightclub (collectively a “hospitality business”) that produces $1M or less in total revenue. As the business scales- whether through unit growth or higher sales volume- the key performance metrics important to the management and ownership will change, to some degree, as well. 

Some of the following discussion is basic academic principles you could find by reading a “how to” book on the subject.  Others are things I learned while working for larger companies in the past.  Most, however, are concepts born out of necessity or from tedious trial and error in the day to day operation of the business.  I wanted to pass along some of these learnings to others who may benefit from their evaluation and potential implementation.  A note of caution: There may be additional concepts others feel are important or disagreements as to the merit of those discussed here.  I would suggest any reader who falls into the defined audience of the paper solicit additional advice from a variety of informed sources with direct experience before making any material changes to their operation.  Always seek appropriate legal advice for acquisition, divestiture or related decisions.

One other important distinction in regards to the intended audience has to do with the “type” of owner (or future owner) in which this paper is written for.  For the purpose of this paper, I will broadly categorize hospitality business owners into two distinct groups: Lifestyle and Investment owners.  Lifestyle owners use their business as a vehicle to facilitate personal enjoyment. Investment owners focus on profit maximization and overall financial return. While I find the vast majority of single unit hospitality owners fall into the former classification, this paper is intended solely for those in the latter distinction.

There are also several nuances between the different types of business- nightclubs, restaurants and the combination bar/restaurant.  Most of the paper was written from the perspective of a bar/restaurant operation and would be directly applicable to any operation that has a combination of food and alcohol sales and without any one component consisting of more than 85% of total revenue.  Those that operate outside of this range represent more of a pure play on food or alcohol. Although they may adhere to slightly different operating models, most will find many of the core concepts applicable.  

Finally, a warning about turnaround situations.  Turnarounds situations are those particular cases where you are purchasing a business with a history of poor financial performance, possibly even in bankruptcy or closed.  While these types of investments can provide enormous upside for the courageous investor, they can also expose the investor to substantial loss and unlimited liability in some cases.  Always seek qualified legal advice before proceeding. 

Background

Of all of the professional experiences I’ve had, my purchase, operation, and sale of a restaurant and bar was probably the most unique.  Even years after I completed the sale it still continues to generate a healthy level of conversation with a variety of different people.  Many are just curious about the whole experience and have questions like: “Why did you do it?”  What was the craziest thing that happened?”  And while these types of questions make for a great story, I’ve always been more intrigued by the minority of people that I have met that are actually seriously considering following a similar path.  Their questions are typically categorized around one of the general business disciplines such as marketing, operations, finance or vendor management and how that applies to actively running a hospitality business. 

To understand the context of my thoughts, it’s important that you know a few other details about my background:  1) I have no formal training in the restaurant or hospitality business beyond my first job, which was at McDonalds 2) I used no professional help except for an accountant to file the year-end taxes.  Not a single banker, accountant or lawyer accompanied me on either the day of purchase or divestiture 3) I held a majority stake in the holding company that owned the business and there were no outside partners or investors that had any level of influence on decisions large or small.  4) My approach had strong financial underpinnings.  I actively sought a turnaround or special situation where I believed a large gap between price and value existed.  5) I returned a solid profit commensurate with time, invested capital and opportunity cost.  For me to offer thoughts or you to read them on an experience that didn’t produce a good return wouldn’t make any sense for either of us.  All of these are important because it sets the foundation for what I believe is, to some extent, independent thinking on the topic.

What I have written is an abridged version of my own experiences, thoughts and advice for those who are interested or find themselves in a similar situation. In general, I hesitate to give advice because it often sounds as if the narrator has done everything right.  Let me assure you, I did not.  However, there are certain concepts and ways of thinking about the business I have developed through experience and time that may benefit a beginner in the field.  Things like “the first owner rarely makes money”, and “you can only be a little smarter than your dumbest competitor”, and “the best cooks (bartenders) make the worst owners” rarely, if ever, are included in theoretical literature on the subject but I’ve found the statements to be more like timeless principals then misguided conjecture.  Here is my story... 

Acquisition

Opportunity

In April of 2007, I had the opportunity to purchase a restaurant/bar outright through a holding company I controlled.  The business was located in a mixed-use commercial building, which was also purchased as part of the transaction, and was located in a downtown setting on the main street in a Wisconsin town that also had a university with 10,000 students.  The business held an on-premise consumption liquor license which were limited by the city and helped create a significant barrier of entry for new competitors.  The real estate had been completely gutted, modernized and rebuilt two years earlier by the previous owners who also owned and operated a construction company.  They had completed the build-out with extravagant touches both inside and out and had completely modernized the entire infrastructure throughout the building.  The look and feel of the building also set it apart from the local competition and the quality of construction ensured that capital expenditures would remain low for years into the future. 


 

The roof of the building.  From this picture you can see the completely refinished roof that included new commercial-grade A/C units and a hood vent/air-exchange system that allowed for air inside the restaurant to be recycled and kept fresh.
 Although no detail or cost had been spared in its design or build-out, by the time I looked at the business it was bankrupt and closed.  This created an investment opportunity known as a turnaround. In this particular turnaround situation, I needed to definitively answer three questions before I could proceed:  First, why did the business fail?  And what would I bring to the table that would allow for a different result?  Second, did I have the liquid funding to complete a turnaround under the worst case scenario?  The nature of a turnaround requires time and time requires absorbing losses before the strategy takes hold.  Third, could I purchase the building and real-estate for a price low enough to  mitigate a decent portion of the  risk?  I needed to minimize any loss to my own capital should all fail and I was forced to sell in a distressed position.  The only way to do that was to buy low.

Due Diligence

To answer these questions confidently, extensive due-diligence was performed.  This included a complete historical financial review of the business, interviews with former employees and vendors, and discussions with others in the community, each of which provided clues and perspectives on the past, present, and future prospects of the business and its assets. 

As I neared the end of the due-diligence process, several themes became apparent, each of which helped to answer my stated questions and form the foundation of the eventual turnaround plan.  I became very confident that what was broken wasn’t any single major problem that would leave the business terminally ill or cause it operate unprofitably for an indefinite period.  Rather, there were a series of smaller issues that that had manifested over time and had either been left unchecked or had not been been dealt with properly.  Most of these deficiencies revolved around expense control, operational and financial discipline and the overall target market of the business.  Fixed costs, especially debt service, as a percent of revenue was also extremely high.  There were very little operational best practices that had been implemented into the business.  The operation was being run by two managers who lacked proper training, experience and oversight/accountability to do the job properly.  This was exacerbated by the fact that the owners wished to remain largely absent from the day to day operation of the business.  The revenue mix was another concern.  The owners had sought to run the business as an upscale restaurant and had focused on lower margin lunch and dinner food sales, largely ignoring the dependable and profitable alcohol sales to college students.  

Overall, I was confident that each of these areas could be addressed and fixed quickly through right-sizing the balance sheet, implementing operational and financial discipline and refocusing the business on a more profitable target market.

From a funding perspective, I was able to do several cash-flow projections under scenarios ranging from optimistic to very stressed.  I estimated the business would burn approximately $5k/month for six months under the worst-case scenario.  This meant an additional $40k in working capital ($30k for “turnaround burn” and $10k for operations) plus opening inventory expense at the time of closing.  I also secured a $20k revolving line of credit that would act as a buffer in case of an emergency.   

Purchase Agreement

Purchase agreement negotiations spanned over four months and proved to be extremely stressful at times.  Since this was a “special situation” transaction, many stakeholders including the bank, vendors and other lien holders needed to be involved and approve of the plan.  Throughout the negotiation, I stuck to my plan and initial offer.  My offer was to pay book value (essentially, in this case slightly less than the appraised value) for the real estate and nothing ($0) for the furniture, fixtures and equipment (FF&E), including the liquor license.  We would do the transaction as an asset sale and all lien holders would be extinguished at closing.  (Be sure the research if Bulk Sales laws are applicable in your state as part of an asset purchase).  All I would need to close the transaction was 15% of the real estate value as a down payment and $40k in working capital.  The financing would all be provided through a traditional real estate loan that would be amortized over 25 years, carrying a low rate of interest (relative to funding sources that are either unsecured or secured by other types of assets) .   This would provide for lower debt service and higher cash flow.  There would be no cost associated with the FF&E, wiping out over $150k off the balance sheet and freeing up thousands of dollars in annual cash flow previously used to cover related the related debt service.  

Closing and the next seven days

After months of negotiating, the offer was finally accepted and we officially closed the transaction on Thursday, April 12, 2007.  Now that I owned the business, real-estate and other assets, I needed to get them producing cash as quickly as possible.  To accomplish this, I planned to open the business back up the following Friday, leaving only seven days to rebuild everything from scratch.  I had already begun to work on various administrative tasks once the purchase agreement was signed and had hired my management team.
Once we closed, the key priorities became staffing/training, purchasing inventory and all the various housekeeping/administrative tasks that needed to be accomplished in order to open the doors. 

During the next seven days, we worked around the clock in preparation for the Grand Re-Opening.  We hired and trained 19 new employees, scheduled meetings and placed inventory orders with all vendors and suppliers, updated all back office systems including security, inventory, accounting and POS, had walk-throughs with various local and state inspectors and completed many, many other tasks necessary to open that Friday.  The team literally worked right up to 3:59pm, a minute before we officially opened, before pausing to have a quick celebratory drink.  Then at 4pm we opened the doors-ready for business-with a new staff, new management, and a new operating philosophy. 

At some point during that week, I gave this brief interview to a local newspaper reporter:  Newspaper Link

The Plan

After all of the initial changes, the plan was to get the business operating profitably and cash-flow positive by the end of the third month, allowing it to self-sustain from a cash perspective going forward.  In six months, I would put the business up for sale, selling only the FF&E and offering to lease the real-estate to the new buyer.  The payment for the business (covering the name, FF&E, Goodwill, liquor license etc.) would be equal to or greater than my down payment on the real estate and since I had a zero cost basis on the FF&E, this essentially meant I would have no net capital tied-up in project.  I would own a premium piece of real estate, bought at a discount to par value, which would generate a positive stream of cash each month secured by a liquor license and paid for by the owner of the business and renters in the residential portion of the property.
   
Reality

The reality was that I closed the transaction in April of 2007.  With the benefit of 20/20 hindsight, we  now know that this was not time to be buying assets of any kind, especially real estate.  At the time, the world was just months away from a major crisis that would shake the financial and real estate markets to their core.  Banks started to get nervous and tighten lending requirements.  HELOCs and other forms of home equity loans were frozen.  Stock prices fell.  Suddenly, all of the liquidity that was fueling this easy money and asset price gains was gone, practically overnight.  The music had stopped and I was left with a substantial portion of my balance sheet locked into one venture. The marketplace full of able and willing buyers for small businesses had also vanished overnight and flipping the operating business to a new buyer in my six month plan was now not an option.  I was fortunate to have bought low, even in a high-priced market.  I was even more fortunate to have a business that was still profitable, allowing me to hold onto it for the time being and look for a sale at a later date, on hopefully much better prospective terms.   

I was now the general manager of a bar/restaurant until the market turned around and I could sell.  Just the totality of the thought gave me much anxiety but I knew I couldn’t do anything to change the market.  I had to control what I could control and that was running the business in the best and most profitable way I could.  Doing this would give me the best chance at building value in the business and eventually selling it to a buyer on good terms. 

Over next thirty months I spent nearly every day personally operating the business, acting as the general manager and overseeing all aspects of the day-to-day business operations.  The following is a culmination of that experience.

Important Qualities of an Owner

For most professional careers, the skills needed for success are explicitly spelled out for the job seeker.  In this business, however, there is no such thing.  Potential owners are left only to guess at what might be the important areas to have experience in and what skills will be necessary to ensure long-term success when they contemplate owning a hospitality business.  Understanding exactly what you bring to the table as an owner- the net sum of your educational and professional experiences- is critical to your successes in this business.  Previous bartending experience, chef training, salesmanship, or a college degree are all nice to have but are far from what will make you a top performer.  The two skill sets that I believe have the highest correlation to success, as measured by profitability, are financial acuity and operational discipline.

Financial acuity means being able to read standard financial statements, having an understanding of how different decisions will impact the business’s overall financial performance, and being able to take historical data, mixed with current trends, and perform forecasting and budgeting.  It also means understanding the underlying economic concepts that drive the business.  These are not “back-office” tasks to be delegated to the accountant but rather the bedrock of sustainable performance.  Owners should never be in a position where someone else has to explain to them how their business is performing.  It should be noted that a common misunderstanding is that the owner should know how to perform tasks like filing year-end taxes, processing payroll, etc.  Activities such as those can be technical and time consuming with a low return on investment and can/should be delegated to an accountant or qualified professional.

Bizstats.com which aggregates the financial statements of privately held companies is a good source to begin the financial benchmarking and research process of owning a hospitality business.  According to the latest data available, only 64% of “Food and Drinking Places” are profitable and the average net profit is only 1.8% of sales.  With only a little over half of "food and drinking” businesses operating profitably and the average net profit margin of under 2%, attention to every operational and financial detail becomes imperative and must be done consistently by the owner.

The second important skill is operational discipline.  This is a concept and skill that is often times either foreign to, or forgotten by, the small operator but one that is absolutely critical to success and a universal trait of larger companies. I was fortunate to have worked for several large companies over the years including McDonalds, Best Buy and Target- all of whom are very talented operators.  Working for these companies, I was able to observe, up-close, how they ran their operations using very specific processes and best practices.  By systematizing their business, they have been able to grow their enterprises exponentially while managing their operations with pinpoint precision.  For the small operator to survive and thrive in the long-run, adoption and implementation of some basic operational principles are critical.

It is commonly thought that being a good operator means having a black belt in Six Sigma or reading extensive textbooks on the topic.  I would strongly disagree with this notion and further recommend saving your black belt for karate. Being a good operator is really more about being a good leader, having common sense, and developing a solid understanding of the underlying business economics and then knowing how each of these impacts the overall profitability and vitality of the business.

The relationship between financial and operational skills is often complimentary when running a profitable business. When a particular area or aspect of the business is showing poor performance financially, it is very likely that the root cause of this performance is a direct result of a need for operational improvement.  Similarly, as you make improvements or changes operationally, it is essential to measure and compare the financial impacts of each adjustment to ensure both are in alignment.  Owners will find a high-degree of positive correlation between the operational and financial aspects of their business when the changes they implement are focused on the right areas and executed in the right ways.

In identifying the key areas to focus the operational improvements, it is critical to start with those aspects of the business that either represent the largest expense or have the greatest impact on the customer.  Many times owners spend enormous amounts of time and resources improving aspects of the business that offer little to no return on investment.  Their prioritization of projects results from either dealing with things that are personal “pet peeves” or from a lack of understanding of how to measure the potential impacts and/or return for the business.

For owners to truly identify the areas of the business that the investment of time and resources will have the greatest impact, it is critical that they be able to read and understand the business’s Profit and Loss Statement.

Financial Basics

The profit and loss statement (P&L) shows all operational business transactions that occurred in any given period.  In very general terms, there are two basic types of transactions that occur in the operation of the business, sales and expenses.  Total sales (also called “revenue”), represents all the money that flows into the business from customers when they make purchases.  Total expenses, represents all the costs of owning and operating the business, essentially money that leaves the business.  At the very bottom of the statement the net income (or loss) line shows the computed difference between total sales and total expenses for the period.  While all of this may seem elementary to some, it is absolutely critical that the owner get comfortable with reading, processing and turning this statement into actionable data.

The first step necessary in the financial analysis of the business is to have the ability to produce financial statements.  To do this, it is important to obtain and install on the back-office computer, updated accounting software capable of creating accurate financial documents.  The “put the receipts in the coffee can for the accountant at the end of the month” philosophy might work fine for the basic Girl Scout cookie selling operation but should be avoided for businesses that are any larger or more complex.

Inputting sales and expenses on a daily basis should be the job or the owner or a trusted General Manager.  There are several basic software programs that can handle this task and will easily export to your accountant when needed.  For those currently not using or not familiar with brand names, Quickbooks is a popular choice and my personal preference.   I find it to be fairly intuitive in its set up and operation and more than capable in its functionality for the smaller business.  Larger operations, ones with greater than several million dollars in revenue or those that want fully integrated inventory capabilities for example, would need to explore other options.  Regardless of the software option chosen, the P&L will have the exact same format and be read exact the same way.

While each line item on the P&L statement is important and tells a unique story in understanding how the business is preforming, those that have the most impact, are the most controllable, and should be paid particularly close attention to on an ongoing basis by the ownership and management are:  Sales, Cost of Sales/Gross Profit, and certain key Operational Expenses (marketing, payroll, and occupancy).
The typical format of a P&L statement

 Revenue

The very first financial line of profit and loss statement is Revenue (Sales).  The Revenue line states the total amount of money that entered the business as a result of transactions with customers and provides an idea as to the overall size of the business.  One important function of the revenue line is its use in analyzing nearly every other expense as each of these subsequent expenditures should be listed not only in aggregate dollars but also as a percentage of total revenue.  It’s these percentages that allow for the benchmarking of different sized business to one another and the comparison of different performance metrics. These percentage metrics then provide important clues as to how well management is running the overall business when compared to industry peers of different (revenue) sizes. 

The other step that is important when evaluating the sales of the business is the analysis of historical revenue trends.  This should always be done with an eye toward the overall growth rate and the comparable, or organic, growth rate in situations where there are multiple units (stores) that generate sales.  Organic revenue trends can be an important indicator of the businesses competitive position and relevancy in the marketplace it operates.  A substantial decline in revenues should be carefully evaluated to determine its root cause.  This evaluation should look at both business specific as well as certain micro-economic trends that are known of the local marketplace.   

Cost of Goods Sold

Cost of Goods Sold (COGS) or Cost of Sales (COS) is the single biggest expense for the vast majority of operators.  COGS represents all of the direct expenses incurred to generate the business's revenue and is usually calculated as the total cost of the food, alcohol and other inventory that was sold during the period.  Larger operations, usually with multiple units, may include other supply chain or selling expense in this calculation as well but this is not typically applicable to the smaller operation.  

After COGS is subtracted from revenue, what’s left over is gross profit (GP), or when expressed as a percentage of sales, gross profit margin (GPM) and represents the total amount available to cover all the other expenses in the operation.  The fact that purchasing and selling inventory is such a large expense for the business makes the careful management of this metric, and its percentage to total sales, absolutely critical to the success of the business. 
  
What is the correct percentage?  Some books and other so-called experts will often claim the existence of an ideal gross margin percentage that usually lands somewhere around 70% (~ 3x mark-up) for a small, lower volume operator.  A gross profit margin at this percentage, while certainly ideal, will also be very difficult to achieve unless the business operates in an equally ideal marketplace with strong demand and no competition.  If we assume the marketplace has fairly normal economic characteristics and there are also several other competitors offering similar products, then the actual gross margins achieved will be pressured by these variables as well as influenced greatly by the overall volume strategy of the business. The combination of these factors will cause gross margins to end up much lower than the academic target of 70%.  This is a direct result of the forced discounting and promotional strategies necessary to drive incremental foot traffic that will lower average selling prices and increased COGS as a percentage of revenue. Taking all this into consideration, it is important to remember that although front-line pricing may reflect mark-ups at or near the 70% GPM level, it would be a serious mistake to plan the business using this assumption.

In my particular situation, I bought a business where COGS was a major problem and one that I made a top priority to fix.  The business operated with a consistent gross profit margin in the low to mid-50% range, which was not only significantly less than ideal, but there was also not nearly the sales volume levels need to offset such a low percentage.  The result, amongst other things, was very high fixed costs as a percentage of gross profit which severely strained the business financially.  Low gross profit margins and low sales volume is a near universal recipe for disaster in business, one of those timeless principles that many, unfortunately, learn the hard way. 

To improve gross profit margins, you must first identify the underlying cause(s) for the sub-par performance.  In my particular situation, I was able to identify three variables that were causing the majority of the gap between the actual gross margin percentage and what I thought was a more ideal and realistic gross margin percentage.  From there, a plan was developed to address and close the difference between  actual and ideal margins within three to six months.  Although we never reached the 70% milestone, the gross profit margin did significantly increase, moving from the mid-50% range to a very consistent 63%-65% by the sixth month of operation and sustained at that level throughout the duration of my ownership. 

Of the many changes that occurred during the first few months of ownership, several standout as having had a significant positive impact on the gross margins and contributed greatly to the large majority of the 10%+ increase we were able to achieve and sustain:

      1)Revenue Mix Shift- When I took over the business, it had historically done about 70% of its revenue in food sales with drink/alcohol sales accounting for the remaining 30%. One of my very first priorities was to shift this mix, essentially leaving the upscale dinner business intact but going aggressively after the late-night drink business once the dinner clientele had gone home for the night. The goal was to have alcohol sales account for 60% of revenue  by year end while maintaining or slightly growing the overall total food sales in the same period.  (see “Final Thoughts” for a more detailed explanation behind the rationale for the emphasis on drinks vs. food).
To shift the revenue mix, we had to shift the atmosphere.  Here the staff is getting ready for the late-night crowd by lower the lights and changing the music
    2) Inventory Management- Having adequate inventory is important to any hospitality business and typically, this investment represents a large portion of the business’s liquid assets.  Because the size and nature of the investment, having a well-thought out strategy in regards to managing this inventory can maximize the businesses sales opportunities while minimizing any negative impacts.  

Inventory can be a big investment.  Here my brother is helping to put away a shipment of liquor.
 The two most important strategies I choose to focus on from an inventory management perspective was to decrease waste and theft and lower the unit cost of the inventory.  I defined waste as any inventory that needed to be thrown away because it could not be served to a customer.  While some waste in the food business is unavoidable, most can be attributed to three main causes: over-ordering on perishables, poor food preparation, or sloppy handling.  In each of these cases, the waste was generated by human error and could be better controlled.

I found waste could be reduced substantially simply by talking to the staff about why it was important to focus on and creating a simple tracking sheet that let them record anything that got thrown away.  I also found it counterproductive to tie a bonus or incentive plan to a target decrease goal.  This substantially reduces the accuracy of the tracking.  Use the tracking sheets to identify trends and then develop best practices for the areas that are the biggest opportunities.  One example I found was that we lost a lot of our soup due to the fact that it was located in our “server station” and not in the kitchen.  When the closing kitchen staff did a visual inspection, everything checked out but they would constantly forget about the soup located in a different part of the building.  Not a huge problem but over time, it certainly adds up. By identifying it through the tracking sheets, we were able to add it to the closing task checklist and the problem was easily solved.  This alone probably saved a few hundred dollars in food costs each year.

Theft is a completely different topic and one that needs to be addressed with a comprehensive plan by the operator.  I had the advantage of living onsite in one of the building's apartments during my ownership.  Anyone thinking of being an absentee owner without a trusted General Manager and a detailed security plan is asking for big trouble.  My approach, though far from perfect, had four simple tenants.  First, I would sit down with every new employee on their first day and make my views on theft one of only three bullet points on the agenda.  This helped them to realize how serious the topic was.  Second, I gave every employee a 50% discount, which I believe for most was enough incentive to outweigh the risk of stealing.  Third, I never delegated the cash deposits or throwing away liquor bottles.  Until my very last day, I personally threw away every single empty bottle of liquor with very few exceptions.  The staff was under the impression I inventoried each empty bottle and compared that against the on-hand counts.  In reality, I rarely did, but the mystery of exactly what I was doing with the counts was enough of a deterrent most.  Last, the only acceptable response once verifiable theft has occurred is immediate termination.  This conveys a clear message that theft is not tolerated.  It’s always a hard thing to do and sometimes, for me, meant that I had to work that employee’s next shift because no one was available to cover.  In the end, the result was always worth 100x the short-term inconvenience.

The second important strategy of inventory management is to reduce the overall unit cost per item.  Certainly growing the business’s volume will increase your purchasing power and lower some of the unit expense organically but there are also other steps an operator can take that can have a great impacts in this area. I found that developing relationships with more than one food supplier to be of great benefit.  When I took over, the restaurant depended entirely on Sysco for its food order each week.   Working exclusively with one food vendor had the advantage of convenience but also meant that there was little incentive for that salesperson to pass along the best price and no opportunity to compare prices of similar items.  In partnership with my food manager, we began to form relationships and procure menu items from two other vendors, a move that immediately resulted in lower food costs.  This not only ensured we received the best pricing but also allowed us to expand the menu in certain ways.  Finally, I found that I could purchase all of the commodity items (ketchup, fryer oil, croutons, paper products, etc.) at much lower prices through a “warehouse” supplier (i.e. Sam’s Club) than I could through any of the available food distributors.

On the drink side of the business, it is much harder to cross-compare between vendors because of current three-tier distribution laws.  Although the process varies slightly by state, typically a distributor owns exclusive distribution of certain brands within a geographic territory.  There is very little price competition, leaving the operator essentially at the mercy of the distributors cost structure, in what might be similar to a local utility company but without the strict price regulation.  Because of this, there is little incentive for the distributor to improve operating efficiencies.  Instead of investing in technology to create an online ordering platform that eliminates a salesperson with a college degree walking door to door with a clipboard and taking orders, most distributors continue this practice,  passing along the additional expense burden under the protection of the law.  This results in regular, annual price increases almost without exception.  Someday, I am confident that the alcohol industry will adopt supply chain practices similar to those in nearly every other industry and eliminate mandatory three-tier distribution and  exclusive territories.  When this happens, additional competition will compete for this important supply chain function and all current distributors will be forced closely reexamine their value proposition in relationship to their cost structure.  You can be assured that bars and consumers will be the winners.

Inside of the beer cooler.  With limited competitive options, it can be hard to reduce your unit cost on beer and liquor

    3) Higher Margin Offerings- The final component to increasing the GPM of the business was to focus on higher margin offerings.  Implied by their name, these are usually products that can be sold at premium prices yet require little additional costs.  Creating a separate menu for unique martinis and other specialty drinks and serving them in fancy glasses was one example of something we did.  Another was offering proprietary drinks with premium liquor that could be sold at premium prices.  Anything that differentiates the offering and prevents price from being the sole determinate in the buying decision will help increase the overall GPM.

Operating Expenses

Once the business is operating efficiently above the gross profit line, it's time to turn your attention to the key operating expenses that have the most impact on the business’s overall financial performance.  Operating expenses are everything you spend money on to keep the business running and, in the aggregate, make up a large portion of the business's total expense. While nearly every operating expense can be measured and controlled to ensure maximum performance and profitability, several warrant a more detailed discussion.

Employees and Payroll Expense

There is a lot at stake for a business when it comes to managing its people and the related payroll expense.  It’s almost universally recognized that people are one of the most important assets in any business.  In a hospitality business, employees are often the face of the company, and having a great team can be a differentiator from the competition and a critical component to success.  While it important to recognize the value good people bring to a business, it is equally important to recognize that people also represent a significant expenditure as well.  This recognition, of both value and expense, necessitates that businesses place a high degree of emphasis on maximizing the potential of each employee while minimizing the related expense where possible.  When businesses fail to either maximizing their team’s potential or appropriately manage the related expenses, the consequences, both financially and culturally, can be severe and a wide-range of variables from customer service to overall profitability will suffer as a result.  

From a pure dollars perspective, payroll usually accounts for the largest operating expense and second largest total expense in running a hospitality business.  The major portion of this expense is the direct wages, usually paid every other week, to employees.  But there are also other related costs in addition to direct wages such as state/federal taxes, benefits, and training that must also be accounted for in the calculation.  Typically these related expenses represent a 20%-30% burden, in addition to direct wages.  It is important to take into consideration these additional related expenses when developing any pro-forma expense budgets or forecasting documents.  

The key to getting positive leverage from this expense category rests in the understanding of the delicate balancing act required between the appropriate quantitative and qualitative metrics needed to make decisions and evaluate performance.  Unfortunately, it is quite often this balance between financial analysis and leadership that poses the biggest challenges to owners who either struggle to correlate the financial impacts of their decisions or have difficulty setting performance expectations and holding their teams accountable. 

From a quantitative perspective, payroll expense should be managed as a percent of the business’s revenue.  While sales mix and total revenue will play an important role in determining what the appropriate ratio should be, most hospitality businesses should aim for having payroll account for no more than 35% of total revenue.  Additionally, few businesses with less than $500k in total revenue will have enough total gross profit dollars to support any type of administrative payroll expense.  This means that the owner should be solely responsible for all back-office and other tasks that take place during non-revenue generating time.  The only exception might be a small allowance made for daily cleaning but even this should be reviewed regularly and cut altogether if the business is not operating profitably.  

One of the other important concepts in the successful quantitative management of payroll is the recognition that it is a controllable expense with direct variability to sales after a certain floor amount.   The floor amount is set by the minimum number of employee hours needed to operate the business in a given period regardless of revenue-essentially what it takes to be open.  Beyond that, in a perfect situation, payroll should scale directly with sales.  To achieve this variability, it is important to incorporate mechanisms in the business that allow for better scheduling, employee utilization, and the ability to flex the staffing level up or down  in response to sales volumes.

To give perspective to the conversation, when I purchased the business, payroll accounted for almost 30% of total revenue.  However, in the trailing twelve months before I sold it, payroll expenses were only 22.4% of the business's revenue, a nearly 8 percentage point reduction.  While a portion of the reduction is directly attributable to higher sales volumes, there were also several key processes implemented which I believe accounted for at least 3-5% payroll expense reduction as a percent of total sales. 

Scheduling

One of the very first areas to begin with when evaluating the effectiveness of the business’s payroll spend is the scheduling process.  Every business utilizes a schedule to tell employees the days and times they are needed to work and an effective scheduling process is the backbone of managing payroll expense.  When evaluating a scheduling process, three important components should be thoroughly analyzed: 1) who creates the schedule?  Is it the owner, department manager, or done by a collaborative effort?  2) How is it created?  Is there a process?   What are the main considerations or data used?  3) What, if any, course correction is evident in the culture-either explicit or implied- should sales differ materially from the plan?

In my particular case, the schedule had been created by both the service and kitchen manager for their respective teams using what could be described as a “cut and paste” approach from week to week.  This resulted in the total weekly hours spent in each department remaining relatively consistent from day to day and week to week irrespective of the actual sales volume.  Since the business did not forecast sales previously, the team had no framework to use when making the schedule and worse yet, this inevitably meant that on some days the business would be over-staffed, significantly reducing profitability and on others days it would be understaffed, missing key sales opportunities and frustrating customers.  However, to the untrained eye, looking only at total payroll expenditures in comparison to total revenue, the blended result actually appeared on the surface to be satisfactory and not representative of that larger underlying opportunity. 

To improve the overall scheduling process, the first step was to identify exactly who would be involved in producing the schedule going forward.  Once it was decided that the department managers would be responsible for the scheduling process, the next step was to hold a meeting with those individuals.  The purpose of this meeting was to talk about the importance of having a good scheduling process, discuss what data points should be used when determining schedules, and to set appropriate expectations going forward.  There was also an introduction of a small incentive plan for the managers that set the objectives discussed at the meeting in writing and rewarded them directly for controlling their department’s payroll spend.  This helped to gain buy-in for this important initiative by allowing them to share in some of the savings they produced for the business.

The cumulative effect of the above steps yielded immediate, positive results both in terms of reducing payroll expenses as a percent of sales and producing a better staffed business during the busier times.  The managers became much more thoughtful in creating the schedule and even added an additional component that looked to upcoming events at the local university that were new or may not have factored into actual sales the previous year such as playoff football games.  Over time, we also got better with the smaller details as well.   We became more aggressive with sending people home when it was slow and establishing an “on-call list" in case it was busier than expected.  We set clock-in and clock-out expectations, which instructed employees not to clock in more than 5 minutes before a scheduled shift and required manager approval for them to work longer than originally scheduled.  We reduced administrative tasks for shift managers during non-business hours.  Instead, they were now expected to accomplish many of those tasks during times we were open but slow.   In totality, these small but important changes helped improve the overall financial results and increase the level of service we provided to our customers.

Productivity

Productivity, in this context, is the measure of how much output you get with a given input.  In a hospitality business, productivity measures how many payroll hours you need to do a certain job or amount of revenue and how efficiently your team can handle workload.  As an example, imagine a new server in the restaurant with no prior experience.  As this person starts out learning the job, the amount of tables they can serve at any one time with any degree of effectiveness will be limited to only a few.  However, assuming they have the proper work ethic, the number of tables will gradually grow over time through training and on the job experience.  As their productivity increases, they will be able to accomplish more production in each hour and during each shift.  Eventually, they will reach a performance plateau- a level where it is very difficult to continue to increase output and productivity. 

It is the job of the owner to establish performance related benchmarks and expectations for the team and oversee, in partnership with the management team, the day-to-day execution of the work relative to these standards.  It is a common mistake to believe that that it is the sole responsibility of management to set the standards and oversee the execution.  In a small business, the owner must play a significant role in this process if he or she expects any degree of accountability to the standards.   The primary reason for setting common performance expectations is to clearly define the amount of work that is expected and ensure each employee is assessed in a consistent and fair way against these performance expectations.  This also allows managers to compare each individual employee’s performance plateau to the benchmark or standard and provide additional coaching or training if necessary. 

Performance expectations should be both aggressive and realistic.  They should also be measurable.  They should set the baseline for performance productivity in terms of either rates, units or other tangible output goals and be used in all functions of the business that are measurable (cooks are expected to make X many plates per hour or servers are expected to handle a section consisting of X many tables during peak dinner hours).  In general, managers will find that many top performers easily exceed the benchmark and can take on or do more.  Average employees are able to consistently meet the expectation with a focused effort.  New employees or poor performers are not able to produce at the required level and must be dealt with appropriately.

Once performance metrics are established and communicated, ownership and management are responsible for continuing to A) assess each employee to ensure they are working at or near their performance plateau level and B) are constantly looking for ways to increase this plateau level through coaching/training , adding additional resources, or incorporating technology in the business to increase efficiency.

Assessments of performance should never be limited to a yearly review but rather these assessments and corresponding conversations (either to congratulate or coach) with employees should be happening on a daily basis in the business and should be driven by the management team.  The best managers are the ones that take an active and sincere interest in their team’s performance.  They are constantly coaching team members and taking every opportunity to recognize a great performance by an individual employee or team.  If you find that these conversations are not taking place, make sure you’ve trained your leadership staff and set the proper expectations in regards to the frequency and content of the conversations.  If they still aren’t happening, don’t wait!  Take the lead yourself and look to replace your managers with leaders who will be able to fulfill this obligation fully.  Having leaders on-board that contribute to improving productivity and performance is vital to success.

A word about poor performers

Poor performers are those who consistently do not meet expectations.  Most poor performers will fall into one of two categories: Can’t or Won’t.  Can’t are the employees that just can’t seem to meet the day-to-day expectations that are required of them on the job.  They could sometimes be classified as slow learners or lacking in a critical skill necessary to do the job.  Often times these employees have positive attitudes and demonstrate “heart” in accomplishing tasks.  Regardless of the effort given, these employees must be coached to perform at the expected level, moved to a different role or asked to leave the organization.  This is one of the hardest things an owner or manager will have to do but is a necessary step in building a culture of performance in the business.  The “won’t” employees are those that typically have the right skill set and are capable of performing at the required level but, because of laziness or a poor attitude, often fail to do so.  They will sometimes demonstrate short, motivated bursts in which they raise their performance to meet the expected standard in response to coaching or feedback but rarely sustaining this improvement for any period of time.  Once identified, they too must be quickly coached or asked to leave the organization to prevent their attitude from permeating the culture.

Marketing Expense

Hospitality businesses operate in a competitive and highly promotion environment, making advertising and marketing (the combination of both referred to “marketing”) critical to driving sales and establishing differentiation from competitors.  At its best, marketing can create an identifiable brand, drive foot traffic, increase sales and provide a return that has positive correlation to the investment for the business.  While most owners and managers tend to accept that fact that marketing is essential, wide deviations can be observed in areas such as frequency, mediums, content, etc. with many having unanswered questions in relation to what and how much should be done to accomplish their specific objectives.  Thankfully, there are many resources available to an owner wishing to learn more about the nuts and bolts of implementing specific marketing activities.  However, for those wishing to learn about the proper framework, budgets, and measurements that should be used to maximize their marketing investments, most traditional resources tend to fall short. 

As an owner, it is vastly more important that you approach the marketing of your business with a disciplined framework than it is to have had any real past marketing experience.  Today, with the proliferation of the internet and social media resources, there are many low-cost and highly effective options available to reach the business's current and potential clients.  There are also still plenty of ways to spend $1 and get 50 cents back in return.

Recognizing, first and foremost, that marketing is an expense like any other is key.  Many are fooled into a false complacency because, unlike spending cash on janitorial supplies, marketing expenditures have the potential to increase sales and profits.  To avoid this trap, setting a marketing budget and having a good understanding of the available mediums and other options should be the first step in managing this expense effectively.

Differentiate

The first important concept is to differentiate your marketing spend into two distinct categories by classifying and budgeting all marketing expenditures as either brand-driven or sales-driven activities.  This becomes critical because it establishes the base rational as to what the goal for each activity is and provides a better framework for the later step of allocation.   

At a high level, brand-driven marketing activities create a general business awareness or long-term goodwill in the community while sales-driven activities tend to promote more near-term business stimulus.  Effective, long-term marketing campaigns will successfully include some combination of each activity, while taking into account the business need and maturity.   These expenses can include activities like the sponsorship of a charity or other special causes which is not directly related to the operation business.  The way to think about the return on marketing activities like these is they will not only create goodwill in the community, but when you sell the business, your return will be the “goodwill” amount paid by the buyer over and above the cost of the physical assets. 
Brand-driven marketing strategies can take shape in many different ways.  Here I pose for a quick picture with the Governor of Wisconsin during a fundraiser

Sales-driven marketing activities are usually more near-term focused and designed to stimulate immediate action from your current clientele or expose the business to new customers.  Sales-driven marketing activities may take the form of advertisements placed in traditional mediums, special promotional events, or a variety of other ways that projects a message about the business out to customers.  Any investment in these activities should be measurable and the returns seen almost immediately, often in the form of higher gross sales or foot traffic to the business. 

Allocate

The next important concept is to allocate, or budget, your marketing expenses.  Small holes can sink big ships and an operator without a marketing budget or framework is prone to make decisions that will not result in an adequate return for the business.  The budget should be managed as a strict percent of the businesses revenue and move up and down in terms of absolute dollars based on sales.  This obviously implies that the business forecasts future revenue. 

What is the right allocation of marketing dollars to budget as a percentage of total sales?  While it definitely  varies from business to business, I have found that creating a quarterly marketing budget between 4%-5% of forecasted revenue for the period works great.  This allowed us to run a variety of year-round and seasonal programs but, also challenged us to be thoughtful when we spent the money.  I also dedicated an employee to oversee part marketing budget and activities.  This resulted in approximately 1-2 hours a week of additional payroll which was planned for and deducted from the overall marketing budget. 

Originally, when I bought the business, it had marketing expenses closer to 10% of revenue and about 10-15 hours a week in additional payroll expense from an employee who managed all the marketing activities.  As a buyer, I knew immediately there was probably a few points of easy profit just in the marketing line of the P&L alone and after doing a more thorough review of each line-item expense, I raised my estimate closer to 5%.  How did I know there was five percentage points of profit in the marketing line of the P&L statement?  When I reviewed the detailed expense reports on exactly what the marketing dollars were spent on, I was amazed. 

Evaluate the mediums

When assessing the overall potential of the business’s marketing expenditure, it’s critical to not only differentiate it into classifications and then budget correctly but, it’s also important to dig deeper and evaluate the specific mediums that are used to accomplish the objectives.  The business I bought was paying an enormous amount of money each month for two full-page ads, one in the yellow pages and another at a small motel on the edge of town.  Both represented outdated thinking about marketing, were expensive, and provided little to no measurable return on investment.  These were in addition to many other marketing programs that made no sense like paying large amounts of money for a band to play and then practically giving the drinks away with no cover.  These practices are not only wasteful but can significant impacts on the financial performance of the business as their costs were equal to several percentage points of gross revenue. 

Today, there are many low and no cost alternatives to traditional advertising that smaller hospitality businesses should be taking advantage of.  Creating a Facebook page and finding ways to add as many people as possible is an easy one to do.  Once completed, you can send “advertisements” and other messages to every customer on the page for free.  Get the email addresses of your customers and add them to a database with as much detail as possible.  You can use this to send out customized messages, like birthday wishes or gender-based promotions for example, all for no cost.  At the university, I would pay someone $10 an hour in a bar tab to run around and write messages in chalk or hand out flyers.  The creative options are endless and when utilized effectively, will substantially lower the cost of marketing and increase its effectiveness.

Occupancy Expense

The last of the important operational expense categories that requires special attention is the overall occupancy expense of the business.  Occupancy expense refers to all of the costs related to the physical structure or real estate the business operates out of.  These costs include the debt service obligation the mortgage (or lease payment in the case of a rental), applicable taxes, and all routine maintenance costs associated with the building, common areas, and land. 

The nature of the hospitality business generally requires it being located in highly visible, easily accessible, and densely populated location to be successful.  While a good rule of thumb, this often times requires that the business occupy some of the most premium and priciest real estate available.  Like marketing expenses, occupancy costs should also be managed on a strict percentage relationship to the overall historical (and projected) sales of the business.  The exact target percentage of sales, however, will vary based on the projected sales mix of the business.  Shown below is the max percentage of sales that the occupancy expense should account for based on the sales mix of the business (horizontal axis) with 100% food to the left and 100% drinks to the right.

You can see there is a clear balancing act that must be performed when forecasting sales/sales mix, making location based decisions and negotiating real estate or rental pricing.   The higher the forecasted overall percentage of food revenue is, the lower the occupancy costs need to be as a percentage of sales.    

Often times, buildings are purchased or rented based on appraised value with no consideration given to the amount of projected (or historic) sales generated.  This is a huge mistake and should be avoided under all but a select few situations.  The value paid for a building must be in direct proportion to the amount of sales it can generate, forecasted on a conservative basis, with a decent margin for error.  Failure to sustain the occupancy expense % within an acceptable range will surely result in operational losses over time and is one of the leading reasons hospitality businesses are put up for sale in distressed condition.

Other Thoughts

Buying it

Brokers

It is very common for owners to list their business for sale through an intermediary known as a business broker.  This allows the owner to focus their attention on running the business while the broker handles day-to-day administrative tasks that accompany a divestiture like meeting with perspective buyers.  Unlike a typical residential real estate transaction though, there is usually little or no money reserved in the commission payment by the seller for a buyer’s agent.  That means that in most situations, the buyer either represents themselves or pays, out of their own pocket, for a broker/agent to represent them.  In many cases the buyer will elect to represent themselves but use an attorney and/or accountant to review certain aspects of the transaction.  Regardless of elected representation, it is critical for a buyer to always remember that the seller's broker represents and works for the seller.  This means it is the job of the buyer to verify all information given, especially those assertions that are subjective in nature such as the reason for sale, marketplace competitiveness, etc.  The factual basis of these assertions often can play just as an important of a role in determining the final offer price as certain quantitative measures like sales, profits, and cash flow.

Seller’s Discretionary Cash Flow

One of the financial calculations flaunted by sellers and very often a source of confusion amongst buyers is Seller’s Discretionary Cash Flow (SDCF) or sometimes referred to as just Cash Flow.  Very often, this reported figure is relatively large in comparison to the business's total revenue, giving the impression of above-average or excellent profitability.  For this metric to be meaningful and useful to a buyer, it's important to understand the origins of it's calculation.

To calculate SDCF, first start with the business’s pre-tax earnings.  Add to that number all non-operating expenses including interest expense paid on any debt and subtract all non-operating income.  Then, add all non-cash expenses like depreciation plus any salary paid to management (SDCF assumes the owner works full-time in the business) and finally add back all other owner benefits such as car allowance, etc.  This final number is what will be listed as the SDCF or cash-flow of the business in the prospectus. This calculation assumes you own the business outright with no debt and also serve as the general manager for day-to-day operations.  Don’t be fooled by this number.  Using the data provided, carefully build your own pro-forma estimate of SDCF that incorporates variables like debt-service and management salaries (if applicable) to arrive at a more accurate estimate of the real owner cash flow potential.   

It is also important to research the cash flow for the previous 3-5 years as well.  Sellers can often make cash-flow look far better in the year prior to putting the business for sale by holding off on some key maintenance or expenses to pad the numbers.  Seeing a presentation of the historical cash-flow will help to put the last fiscal year into better perspective and make projected estimates of future cash-flow more accurate.

 The First Owner and FF&E

First owners often approach the prospect of building their business with extreme optimism.  Their decisions are emotional, driven by the bright future they see on the horizon rather than a more systematic analysis of the facts. Unfortunately, it is this emotion-lead decision making in the initial stages of building the business that causes many first owners to make serious, and sometimes fatal mistakes. The mistakes often occur when purchasing furniture, fixtures, and equipment (FF&E) for the business which is a major expenditure and usually the largest fixed asset investment besides any real property.  Because of the size and nature of this investment, FF&E can have many ramifications for the business’s long-term return rates and solvency prospects.

By definition, building or completing a major renovation in a hospitality business implies the purchase of FF&E which will include all of the equipment needed to run the business and all the upgrades that are done to the physical building structure.  One of the major reasons that disciplined analysis should be undertaken by the first owner when determining what to buy and how much to spend on equipment and related expenses lies in the volatility of the equipment’s valuation after the purchase or during a sale.  In an asset sale, FF&E is typically valued at less than 50 cents on the dollar and far less should the seller be in a distressed position.

For these reasons, it is very difficult for the first owner, or an owner that completes a major build-out, to earn a high rate of return over the long-term.   The quantitative principal behind this concept is fairly straight forward and starts with the fact that the first owner purchases the FF&E at 100 cents on the dollar and finances it with either debt or equity.  The market value of this investment (in theory) is then immediately marked down, using mark-to-market accounting, to 50 cents.  Regardless of how the equipment was financed, it still needs to produce a stream of cash relative to its cost that covers the debt service obligation or provide an adequate return for the equity holder.  When financed with debt, FF&E carries much higher rate of interest due to the risk profile of the underlying asset.  Likewise, actual returns on equity financing will need to be even higher to compensate for the unsecured risk.  These high hurdle rates, coupled with assets employed in a low margin business, provide a serious challenge to achieving an acceptable, risk-adjusted rate of return for owners and their investors.  

Rapid depreciation of equipment and bloated balance sheets are one of the major underlying principles in the theory that states “the first buyer rarely makes money”.  The second buyer, who buys a business and acquires FF&E that still has many years of expected life for pennies on the dollar has effectively recapitalized the balance sheet by offloading a major capital expense and positioned the business for maximum profit potential. Assuming the business produces identical financial results, the new owner can now divert the stream of cash that once paid debt service to other areas of the business like marketing or take the cash out of the business to be used elsewhere.

Running it

Management, Supervisors, and Compensation

If you are going to have people help you run the operation, you need to first make sure you hire the right people for the job by developing a hiring process that focuses on finding those individuals with the right mix of qualities and skills that will allow them to be great leaders in your organization.  Often times, management promotions are based on tenure or a high level of technical skill performing the job that needs to be supervised.  Fighting the temptation to overweight these characteristics is critical to filling the position with right person, and sometimes requires looking outside of the company.

Once the right management team is in place, their actions and incentive plan should align with the goals of the business and promote the growth in long-term company value.  One of the best ways to ensure this happens is to keep the base salary low and build a good incentive plan around the most important key performance indicators (KPIs) of the business.  This will help conserve cash-flow in times when the business is not performing well and allows the leadership team share in the upside when the business is doing well.   There is not a “one size fits all” approach to the compensation plan.  Each plan should be customized to the specific business and take into consideration variables such as business size, profitability, and any unique challenges or priorities that must be addressed by the team.

One thing to avoid is hiring management before you can afford them.  A business will always need good management to help run the operation but, it is the job of the astute owner to determine when it makes good financial sense to step back from managing the entire operation and turn over part (or all) of it to hired help.  This characterization of management does not include supervisors, which can be effectively utilized in businesses of all sizes.  What separates “management” from a “supervisor” for purpose of this discussion is the amount of administrative time each week that person spends doing non-revenue generating work. 

At under $500k in total revenue, a hospitality business should have no management.  The owner should be doing all administrative work.  That doesn’t mean the business can’t have positions like a “head cook” or “head bartender” to complete tasks like scheduling, inventory and occasional interviewing for example.  These would be considered supervisors and most of these tasks can and should be completed during slow or off-peak hours when the business is open.  This is a great way to take some of these tasks off the plate of the owner and empower a select group of high performing employees by giving them a title and more responsibility.

Dumb Competition

A dumb competitor is one that runs their business with no regard for economic principles.  An old saying that is highly applicable and one that many operators have learned the hard way is: “You’re only a little smarter than your dumbest competitor”.  Dumb competition is one of the great uncontrollable variables in the hospitality business and a challenge that nearly every owner who lasts long enough will face at some time or another. 

Some may initially have a different perspective and think that the prospect of competing against someone who is “dumb” would be a good thing and, in some cases, they are right.  However, it is important to recognize that there exists a certain class of individuals that are not only dumb but dangerous. It is critical to be able to distinguish between these two variations and operating philosophies.  Imagine for a minute that the the marketplace is a freeway.  Using this analogy,  the first type of dumb competitor would be a 10-speed bike.  Slow to innovate, poor service, and probably still advertising in the yellow pages would all be fair characterizations of their business.  This type of competition is very much welcomed for a well-run business.

Continuing on with same analogy, the next type of dumb competitor would probably drive an old Caprice cop car they bought at a police auction.  With a V8 engine, rear-wheel drive, and a red light on the dash, they barrel down the freeway at twice the speed limit with no regard for what might be in the way.  These competitors are not only dumb, they are dangerous.  These operators think foot traffic = profits, they don’t understand their own business's financial statements, and they typically have the lowest prices in town and the highest cost structure.  This can cause major heartburn for the good operator as they potentially lose sales and customers to this road warrior while waiting for the engine to explode.  

Many will face a similar dilemma during their ownership.  The most important part decision becomes whether to face the threat head on or wait for the principles of capitalism to work naturally.  When deciding on the appropriate response, the main considerations should be the estimated margins, liquidity, and cost structure of the competitor.  Of those, liquidity will be the hardest to estimate.  Because of three-tier distribution, estimation of their margins should be fairly easy and calculating operating costs within a reasonable range can be done with a little research.  Internally, the considerations for aggressive action should be the sustainability of the campaign based on margins and cost-structure as well as the implications of the campaign.  Since these typically focus on price, the biggest risk would the inability to raise pricing at a future date when the competitor is out of business. 

In any good business plan, competition is always a consideration and helps to shape the overall strategy.   For those that do face a dumb and dangerous competitor, it is comforting to know that tenants of capitalism will always eventually form an unavoidable brick wall for those that drive recklessly.  But, these competitors can cause much pain, and even death, to the well-run business making the quick identification of the threat and the development of a containment strategy key to success.

Food/Drink Ratio

This can be one of the most overlooked and underestimated ratios in the business. Many operators often look past how these very different revenue sources can also have very different financial impacts on the business’s net profit.  Generally speaking, food and drink gross margins tend to be initially similar, which could explain why many view each revenue stream as homogenous.  However, a more detailed look into each stream reveals a much different picture, particularly when viewed in relation to the operating expense portion of the P&L statement. 

Much of the variation is caused by the incremental expense of running a food operation.  Factors such as the average wage rate of the employees (kitchen staff make more than bartenders), perishable food spoilage, utility expense required to run the grills, coolers, and freezers, carrying cost of inventory, prep time while the business is closed, and other direct overhead expenses related to the restaurant portion of the business all add extra costs to the business  that must be accounted for before there is leftover profit for the owner.  The best strategy for a food operation is to control these costs as much as possible and substantially grow the business’s revenue, which fixes many of these incremental expenses and makes them much smaller in comparison to total sales.  Without scale, most restaurants that have a high concentration of revenue from food sales won’t be viable in the long run without some other major competitive advantage over their competition. 

The drink/alcohol business tends to have more attractive economics for the small operator.  One of these desirable characteristics is the barrier of entry created by the city-mandated and liquor license.  These licenses, which are usually in limited supply, naturally fix the competition in a given geographic area, creating the potential for better pricing power. Drink businesses also tend to operate with lower average wage rates, less spoilage, and fewer operating hours.  There are also important risks that must be considered when expanding aggressively into selling more alcohol.  Higher insurance costs, risks of violence/damage, late-night hours of service and harder to track inventory shrink potential are all factors that should be weighed against the profitability upside.  

Selling it

Exit Strategy

If you buy and run your business with some vision of the endgame in mind, selling it can be a fun and profitable experience.  The best way to approach the purchase of a bar or restaurant is with a good idea of what an ideal ending would look like.  Will it be a quick flip, a medium-range holding or a long-term dream job?  Each one of these scenarios sets a different time horizon, agenda, and prioritization for many of the key decisions that will have to happen. 

One common example is the dilemma that an owner often faces with whether to report 100% of the business's revenue or keep a few $20 bills off the books here and there.  Besides the face that it is illegal to not report the income, there is also a return on investment-based case that can be made for reporting 100% of the gross sales, especially if the planned holding period falls into the short or medium range.  When you eventually sell the business, you should expect the buyer to form their valuation based partially or solely on the historical “earning power” of the business, applying a multiple to whatever metric they chooses to use.   The “earning power” used to make this calculation will probably be some derivative of historical net profit such as EBITDA, operating earnings, net income, etc.  In any case, $1 taken out of the business and not reported for tax purposes saves approximately 30 cents in taxes (or less depending on the specific tax rate) but $1 left in the business theoretically increases the reported earnings power by $1 and will result in a likely $3-$7 return when the business is sold depending on the exact multiple used for valuation. 

The same thinking should also be applied when making the purchase.  Too often, sellers tell a story of how the financial statements only show $x but the business really does $y and that's because it’s a "cash business" and they don’t report all of the income.  Do not be fooled.  A buyer, basing his valuation using some income based metric should not allow for any add-backs of unreported income.  The seller saw their benefit when then didn’t report the income and saved some money in taxes.  Do not allow them double dip and get a credit for this unreported income at the time of sale.  If you stick to only reported income, you can be sure that your financial forecasts will reflect, to the best that is factually known about the business, the true potential of the operation. 

Closing

Owning a bar or restaurant can be a dream job and a great investment.  It can also drain a lifetime of savings and become a grueling nightmare.  Each situation is unique and poses a different risk/reward structure that must be met with a carefully constructed plan of attack. I believe successful ownership is less about previous experience and more about being a good leader, a disciplined operator and having an insatiable appetite for learning.  The best advice is to seek advice from those who have traveled the path before you and remember,  there is often times a better lesson in failure then in success. 

1 comment:

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