If you own a restaurant and it's making money, you are probably, and justifiably, quite pleased about that fact. But while profits are clearly better than losses, is the restaurant making enough money and is there actually a correct answer about how much that is? This article investigates.
Can a restaurant with profits of £100,000 be considered unsuccessful?
We recently came across a situation of a couple who bought a restaurant for £400,000, who then both worked hard to make it a success and, in their partnership accounts, showed a profit of £100,000 a year. A chef friend thought that this was quite an achievement, noting that each partner was taking away £50,000 a year from the business and asked our view. On the face of it, it does look good and also suggests that the payback period on the initial investment is just four years. A closer look at the situation however suggests this is not in fact anywhere near as good as it looks.
The issue at the heart of the problem, and one that is almost universally missed, is that the £50,000 the partners draw from the business each year has to cover two expenses, not one. In no particular order, the £50,000 has to compensate each partner for both the initial investment they made in the business (£200,000 each) and the time they spend each week working to ensure it's a success. Put another way, each partner has committed capital and labour; the reward for capital is profit, and the reward for labour is (usually) salary. Does the £50,000 adequately reward both their labour and capital investment?
How much money should a restaurant make?
Consider the idea that you have £100,000 to invest and two competing ideas. First up, your financial advisor suggests you invest it in the stock market, a traditional home for long term savings. However, a friend is opening up multiple restaurants and wants you to help fund the investment. Which should you do? We'll consider both investments on a ten year time horizon.
First off, how much might a stock market investment make you? Jeremy Siegel (professor of finance at Wharton) showed in his book Stocks for the Long Run that in the period 1871 - 2001, stocks returned 8.8% (gross) per annum to investors. On this basis, after 10 years, your £100,000 investment becomes £232,428 with returns reinvested.
The investment in the restaurant option is superior to the stock market if the return at the end of 10 years provides for a higher sum than the £232,428 calculated above, but we all 'know' that restaurants are more risky. In April 2007, an article in Bloomberg Businessweek reported that in a study of 2,500 new restaurants in Ohio, over a three year period, three in five restaurants failed. Assuming this is correct, we obviously need to factor this in to our calculation. Of the initial £100,000 invested in restaurants then, 60% can be expected to be lost in restaurant failings so your pot of savings will only grow based upon returns achieved on just £40,000 of the initial investment.
It then becomes a simple matter to show that on £40,000 of productive capital, returns of 19.24% per annum are needed to build a sum equivalent to the size of the expected pot if the money were invested in the stock market. If the restaurants that do succeed generate in excess of a 19% return on capital, the investment in the restaurant venture might be the better of the two options.
It is somewhat oversimplifying to say this (but this is a blog post not a book), but depositing your money in a bank is essentially risk free and will deliver returns of 1-2%, investing in the stock market is risky but not too risky and can therefore be expected to deliver 9% per annum, while investing in a restaurant is significantly higher risk and should therefore deliver at least 19% to compensate for that extra risk. There are a number of arguments that suggest the required return should be even higher than this, but those are for another time.
Returning to the case study
Back to our original case study, we noted that the initial cost to buy the restaurant was £200,000 per partner. If this money had been invested in the stock market, it would have made each partner (theoretically) 9% so £18,000 per annum. However, if the reward for capital should be higher for the additional risk of investing in a restaurant, the required return on capital for their chosen investment (that of the restaurant) should be 19% x £200,000 = £38,000.
If we ignore the effect of taxes to keep it simple, for the £50,000 of cash/profit received by each partner, if £38,000 is considered the adequate return on their capital investment, it leaves just £12,000 to compensate them for their labour, clearly not a big wage. Assuming they work a 60 hour week, their hourly rate of pay is just £3.84, substantially less even than the national minimum wage which is currently set at £6.19 an hour. The partners in this restaurant are paradoxically exploiting themselves, working for less than four pounds an hour, and less than any of their employed staff.
The outcome for the partners is by no means the worst one possible of course, but they are actually under compensated for the dual commitment of hour worked and capital committed. Financially, they would be better advised to an alternative route.
For sure, there are plenty of counter arguments to be made, for example, that they are investing in themselves, not a generic restaurant risk, that they are their own boss etc, but these are arguments from the heart and neither will translate well to a spreadsheet or your bank manager. It's not wrong to make these arguments or to proceed with the investment on that basis, but one should always be aware of the hard arguments.
Conclusion
The key conclusion of this short article is that two things are needed to make any business successful: labour and capital. Labour is rewarded by a salary, capital is rewarded by profit. Capital is more risky and sees fluctuating returns; it is also possible that capital can be lost in its entirety and because restaurants are risky, returns to financial investors need to be commensurably higher to compensate for that risk, with our basic calculation suggesting that a 20% return is probably the minimum.
Chef patrons that have invested capital in the business and who commit daily labour to that business should be rewarded for both, but many often fail to spot the fact. We take it as a given that most business owners want to create wealth for themselves from their business and build an adequate pension pot for retirement, but to do so, a clear understanding is needed on the returns being delivered on both invested capital and labour. Without that understanding, maximising wealth ceases to be a matter of analysis, simply falling into the realm of guesswork and luck.
Can a restaurant with profits of £100,000 be considered unsuccessful?
We recently came across a situation of a couple who bought a restaurant for £400,000, who then both worked hard to make it a success and, in their partnership accounts, showed a profit of £100,000 a year. A chef friend thought that this was quite an achievement, noting that each partner was taking away £50,000 a year from the business and asked our view. On the face of it, it does look good and also suggests that the payback period on the initial investment is just four years. A closer look at the situation however suggests this is not in fact anywhere near as good as it looks.
The issue at the heart of the problem, and one that is almost universally missed, is that the £50,000 the partners draw from the business each year has to cover two expenses, not one. In no particular order, the £50,000 has to compensate each partner for both the initial investment they made in the business (£200,000 each) and the time they spend each week working to ensure it's a success. Put another way, each partner has committed capital and labour; the reward for capital is profit, and the reward for labour is (usually) salary. Does the £50,000 adequately reward both their labour and capital investment?
How much money should a restaurant make?
Consider the idea that you have £100,000 to invest and two competing ideas. First up, your financial advisor suggests you invest it in the stock market, a traditional home for long term savings. However, a friend is opening up multiple restaurants and wants you to help fund the investment. Which should you do? We'll consider both investments on a ten year time horizon.
First off, how much might a stock market investment make you? Jeremy Siegel (professor of finance at Wharton) showed in his book Stocks for the Long Run that in the period 1871 - 2001, stocks returned 8.8% (gross) per annum to investors. On this basis, after 10 years, your £100,000 investment becomes £232,428 with returns reinvested.
The investment in the restaurant option is superior to the stock market if the return at the end of 10 years provides for a higher sum than the £232,428 calculated above, but we all 'know' that restaurants are more risky. In April 2007, an article in Bloomberg Businessweek reported that in a study of 2,500 new restaurants in Ohio, over a three year period, three in five restaurants failed. Assuming this is correct, we obviously need to factor this in to our calculation. Of the initial £100,000 invested in restaurants then, 60% can be expected to be lost in restaurant failings so your pot of savings will only grow based upon returns achieved on just £40,000 of the initial investment.
It then becomes a simple matter to show that on £40,000 of productive capital, returns of 19.24% per annum are needed to build a sum equivalent to the size of the expected pot if the money were invested in the stock market. If the restaurants that do succeed generate in excess of a 19% return on capital, the investment in the restaurant venture might be the better of the two options.
It is somewhat oversimplifying to say this (but this is a blog post not a book), but depositing your money in a bank is essentially risk free and will deliver returns of 1-2%, investing in the stock market is risky but not too risky and can therefore be expected to deliver 9% per annum, while investing in a restaurant is significantly higher risk and should therefore deliver at least 19% to compensate for that extra risk. There are a number of arguments that suggest the required return should be even higher than this, but those are for another time.
Returning to the case study
Back to our original case study, we noted that the initial cost to buy the restaurant was £200,000 per partner. If this money had been invested in the stock market, it would have made each partner (theoretically) 9% so £18,000 per annum. However, if the reward for capital should be higher for the additional risk of investing in a restaurant, the required return on capital for their chosen investment (that of the restaurant) should be 19% x £200,000 = £38,000.
If we ignore the effect of taxes to keep it simple, for the £50,000 of cash/profit received by each partner, if £38,000 is considered the adequate return on their capital investment, it leaves just £12,000 to compensate them for their labour, clearly not a big wage. Assuming they work a 60 hour week, their hourly rate of pay is just £3.84, substantially less even than the national minimum wage which is currently set at £6.19 an hour. The partners in this restaurant are paradoxically exploiting themselves, working for less than four pounds an hour, and less than any of their employed staff.
The outcome for the partners is by no means the worst one possible of course, but they are actually under compensated for the dual commitment of hour worked and capital committed. Financially, they would be better advised to an alternative route.
For sure, there are plenty of counter arguments to be made, for example, that they are investing in themselves, not a generic restaurant risk, that they are their own boss etc, but these are arguments from the heart and neither will translate well to a spreadsheet or your bank manager. It's not wrong to make these arguments or to proceed with the investment on that basis, but one should always be aware of the hard arguments.
Conclusion
The key conclusion of this short article is that two things are needed to make any business successful: labour and capital. Labour is rewarded by a salary, capital is rewarded by profit. Capital is more risky and sees fluctuating returns; it is also possible that capital can be lost in its entirety and because restaurants are risky, returns to financial investors need to be commensurably higher to compensate for that risk, with our basic calculation suggesting that a 20% return is probably the minimum.
Chef patrons that have invested capital in the business and who commit daily labour to that business should be rewarded for both, but many often fail to spot the fact. We take it as a given that most business owners want to create wealth for themselves from their business and build an adequate pension pot for retirement, but to do so, a clear understanding is needed on the returns being delivered on both invested capital and labour. Without that understanding, maximising wealth ceases to be a matter of analysis, simply falling into the realm of guesswork and luck.