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Venture capital in the restaurant industry
Venture Capital in ' the Venture capital is an available and desirable form of
Restaurant
growth financing for the restaurant industry. This article provides an introduction to venture-capital terms and
Industry
practices, an overview of the history and structure of the venture community, and a summary of venture-capital activity and performance.
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0 portunity knocks. It takes money to make money. Those two well-known sayings have rarely been truer than they are today. There are opportunities in the marketplace, and investment m o n e y is available, yet many entrepreneurs are ignoring a source of financing that could accelerate the growth of their companies: venture capital. Discussions with restaurateurs and venture capitalists about restaurant-growth strategies reveal a great deal of misunderstanding and mis-
BradfordT. Hudson is an adjunct professor in the School of Hospitality Administration at Boston University and a consultant to growing hospitality and retail businesses. © 1995,CornellUniversity
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EBRNELLHOTELANDRESTAURANTADMINISTRATIONQUARTERLY
F O C U S
trust. Few restaurateurs have a sophisticated understanding of venture capital, and many fear giving away control of their companies. Few know how to find or approach a venture-capital firm. For their part, most venture capitalists target hightech industries, and many are uninformed about opportunities in restaurants. Few comprehensive studies of venture-capital activity in restaurants have been conducted. This article is intended to introduce the venture-capital community and the restaurant industry to each other, increase understanding on both sides, and demonstrate that venture capital is a viable and growing form of restaurant financing.
Venture Capital The definition of venture capital has changed somewhat over the years and even varies from firm to firm, but it is generally understood to be capital provided to new ventures. Investors pool money for investment in growing companies,just as other investors deposit money into mutual funds. The investment funds are actively managed by venturecapital firms, which evaluate potential investment targets, disburse funds, and monitor the progress of investments.Venture capitalists provide large amounts of cash to new and growing companies that might otherwise be unable to obtain financing, owing to the youth of the company or the risk associated with its products or markets. In return, entrepreneurs usually give up a portion of their equity in the company and frequently place a representative of the venture firm on the company's board of directors. As partners with entrepreneurs, venture capitalists may hold their equity for several years as the company grows, and then "exit" the investment through a stockexchange offering or an acquisition by another corporation.
Venture firms today are involved in a wide variety of growth financing activities, some of which do not fit the traditional definition of venture capital. However, classic venture capital can be distinguished from other types of financing in several ways, as follows. • Venture capital is usually provided in exchange for equity rather than debt. • Venture capital is usually provided by independent venture funds rather than banks or investment banks (although some banks and investment banks have venture-capital subsidiaries). • Venture capitalists provide funds to young companies and frequently maintain the investment for long and unspecified periods, rather than for short periods with definite payback deadlines (common with debt instruments). • Venture firms make their money from growth (selling shares in a company that has grown significantly in size and profitability since the initial investment) rather than from prenegotiated percentage-return agreements (common with debt instruments). • Venture capital is frequently subordinate to other types offinancing and is not secured by the personal assets of the entrepreneur; therefore, if the company fails, the venture-capital firm may recover little. • The venture-capital community is generally not regulated by federal or state authorities, unlike the securities and banking industries. 1 Types o f venture capital. Venture capital can be categorized by the point in a company's life cycle ~The exception is a type of venture-capital firm called a small-business-investment company. Such companies are funded in part by tax dollars through the U.S. Small Business Administration. This article does not address such investment companies as a separate group.
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when the money is disbursed (also known as stages, or rounds, of financing). 2 Seed financing is provided to new companies to fund market research or the development of a business plan. Start-up financing is provided to slightly older companies, perhaps a few months in existence, to develop or test a prototype. First-stage financing is provided to companies ready to begin manufacturing or service operations. Laterstage, or expansion, financing is provided to companies that are up and running and have proven the viability of their product or service in the marketplace. Later-stage financing includes second-stage financing, provided to companies that are fully operating but may not yet be profitable; third-stage, or mezzanine, financing, provided to companies that are about to expand rapidly; and bridge financing, provided to companies that plan an initial public offering in less than a year. Increasingly, venture-capital firms are also participating in transactions that mirror those conducted by Wall Street investment bankers, including acquisition financing and management buyouts or leveraged buyouts. Venture-capital firms may begin a relationship with a growing company at any stage) A venture capitalist could provide second-stage financing without providing either first- or third-stage financing. In many cases a venture-capital firm will provide follow-on investment (additional disbursements in later stages) for companies that are meeting or exceeding the venture capitalist's performance expectations. 2pratt's Guide to Venture Capital Sources, 1994 edition, ed.Yong Lira and Ted Weissberg (New York:Venture Economics/Securities Data Publishing, 1994), p. 12. 3The theory is that a company should be growing and successful (profitable) to be a good venture-capital target. Particularly, growth seems to be the paramount concern.There have been cases in which companies received funding even though they had not yet shown a profit.
June 1995 • 51
Various types of financing and investors may be involved during the life of a growing company. Early stage financing might be provided by the company's founders (and family and friends); second-stage financing, by a venture-capital firm; and third-stage financing, by yet another venture-capital firm. That is in addition to bank loans or trade credit that might be provided for short-term operating liquidity. Structure o f financing. Most venture-capital funds are structured as limited partnerships.Venture firms serve as general partners, while institutional and individual investors are limited partners. Venture capitalists make their money by taking a portion of the fund's share of the capital gains (15 to 25 percent) when an investment matures (i.e., when the capital is freed by an initial public offering or a buyout) and by assessing the fund an annual management fee (2 to 3 percent). Limited partners make their money by taking the lion's share of the fund's capital gains (75 to 85 percent) and the return of the original principal invested. 4 O f course, the fund's share of the capital gains depends on the equity percentage of the original investment. If an entrepreneur gives up half of her or his company in exchange for venture capital, then general partners and limited partners divide half of the capital gains (depending on their individual investments) and the entrepreneur keeps the remainder. Venture firms generally use the following four types of instruments, sometimes in combination, for their investments. They are presented here in ascending order of investment security. • C o m m o n stock, the best-known form of equity, is ownership of a portion, or share, of a company.
• Preferred stock, a special type of
equity, gives the holder preference over common shareholders should the company fail and be liquidated. • Subordinated debentures are debt instruments that have preference over equity but are subordinate to other forms of debt. • Senior debt, which most closely resembles a commercial bank loan, generally has preference over other forms of debt and equity; it is frequently used for later-stage financing in low-risk companies, s While venture capital has traditionally focused on equity, debt instruments are increasingly being used. From the venture capitalist's point of view, senior debt is the safest form of investment, since it may have a fixed rate of return and preference over other instruments. C o m m o n stock is the riskiest instrument, since it has no specified rate of return and the lowest preference in the liquidation hierarchy. However, a fixed rate of return may not ultimately be the highest rate, because appreciated common stock may yield a higher return despite the risk. History. Individuals have invested money in business ventures for thousands of years, but organized, professionally managed investing in new companies is less than 50 years old. Georges Doriot, a professor at the Harvard Business School, and Ralph Flanders, president of the Federal Reserve Bank of Boston, are considered to have started the venture-capital community when they founded ARD in 1946. The goal of ARD was to finance companies that would license and develop commercial applications for scientific discoveries at Boston-area
universities. As a result, many of the firm's founding partners were faculty members at the Massachusetts Institute of Technology. Its most celebrated investment was in Digital Equipment Company. An investment of about $70,000 in 1957 gave the firm 77 percent of DEC'S stock, which by 1971 had increased in value by 5,000 percent. 6 ARD's success, especially in the DEC investment, set a tone and character for venture capital that lasts to this day.While the range of industries targeted has broadened and expectations for extraordinary returns have diminished, the community maintains a strong bias toward high technology and high returns. Bygrave and Timmons make a compelling argument, however, that venture capital has changed significantly since its inception.Venture capital, as practiced by Doriot and his disciples, was a long-term investment approach that focused on building value through advice and consultation. ARD concentrated on early-stage investments in new companies with superior management teams and market potential. It patiently held its investments for ten years or more. That is the original, classic approach to venture capital. Two changes occurred during the 1980s. First, venture-capital funds became increasingly dominated by institutional investors, such as pension funds and universities. The effect was an increase in the size of venture funds (resulting in larger disbursements) and a change in performance measures (resulting in less patience and a lower tolerance for risk). Second, as new techniques in finance for example, mergers and acquisitions and junk bonds-were developed, they were adapted to venture capital.
SStanley Golder,"Structuring the Financing" in Pratt's Guide to Venture Capital Sources, p. 57.
6patrick Liles, "Sustaining theVenture Capital Firm;' unpublished doctoral dissertation, Harvard Business School, 1969, p. 29.
4William D. Bygrave and Jeffry A. Timmons, Venture Capital at the Crossroads (Boston: Harvard
Business School Press, 1992), p. 11.
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ClIP,NELLHOTELANDRESTAURANT ADMINISTRATION QUARTERLY
A "greedier, speedier breed" of venture capitalist emerged who concentrated on "financial engineering for quick entry and exits," later-stage financing, and buyouts. 7 It is not unusual now for a venture deal to have more debt than equity or for venture capitalists to prefer well-established ventures. Bygrave and Timmons call that "merchant capital" and suggest that it has more in common with investment banking than classic venture capital. As Wall Street heated up during the 1980s, as deals grew larger, and as the holding period of investments decreased, there was more venture money chasing fewer attractive opportunities. A destructive competition developed, the quality of due diligence declined, bad deals were made, and venture-capital returns plummeted. Ironically, while merchant-capital behavior caused the crisis in venture capital, it was the reputation of classic venture practices that suffered. The poor returns were mistakenly associated with classic, early-stage, long-term investing.The result was a shortage of venture money, especially for earlystage investment, that created a "venture capital gap...for new, small and mid-sized businesses.''8 The only positive change during the 1980s was the development of niche venture funds, which specialized in particular industries or types of investing. For example, strong interest in biotechnology helped buoy the overall number of"seedstage" (the earliest stage) deals. 9 Recent developments suggest a rebound in venture-capital investing. After a steady decline from 1988 through 1991, fundraising (collecting of money by venture capitalists from investors) has been
7Bygrave and Timmons, p. 291. 8Robert A. Mamis, "Risky Business," Inc., Vol. 12, No. 3 (March 1990), p. 20. 9Bygrave and Timmons, p. 61.
increasing since 1992. In fact, activity in the first half of 1994 broke the previous record set in 1984. T h e c o m m u n i t y . Today there are more than 500 venture-capital firms in the United States, and total capital under management is nearly $40 billion. Two-thirds of those firms are headquartered in three states: California has 26 percent; NewYork, 25 percent; and Massachusetts, 15 percent. Other active communities can be found in Illinois and Texas) ° A disproportionate share of dollars disbursed go to companies in California, which receive almost five times as much as those in Massachusetts, the state with the next greatest amount. ~ Venture-capital firms stick together not only geographically but also in their investment targets. Syndicates are venture-capital firms that team up to invest in the same companies. The syndication effect can be explained by a desire to spread risk and a need to share expertise and information. Between 1982 and 1984 the National Science Foundation studied activity of 464 venture firms. 12Although less than 3 percent of them co-invested in the same companies, the number was much higher among industry and regional specialists, reaching 69 percent among the leading venture firms specializing in California high-tech companies. It has been said that 100 decision makers control the investing of the entire community. P e r f o r m a n c e and exit. Venture Economics, a private information and research company serving the venture-capital and investmentbanking communities, analyzed nearly 400 venture investments beWVenture Capitaldournal, Vol. 29, No. 3 (March 1989), p. 16. HStanley E. Pratt, "The Organized Venture Capital Community," in Pratt's Guide to Venture Capital Sources, p. 83. ~2jeffryTimmons et al., National Science Foundation, unpublished study, 1984, ISl82-13157.
tween 1969 and 1985. Less than 7 percent of them returned ten times the invested capital or more; 60 percent lost money or returned less than a bank savings account. 13 As Bygrave and Timmons say, venture capital is a business of exceptions. Classic venture-capital investing in young companies is a high-risk affair; statistically, success is improbable. To balance the large losses (possibly in the millions of dollars) on most investments, venture capitalists must occasionally make a big score. Historically they have done so with sufficient frequency and regularity to deliver industry-wide average annual percentage returns in "the teens, with occasional periods in the 20-30 percent range and rare spikes above 30 percent. ''14 During the late 1980s returns dropped to the single digits, but by 1993 they had rebounded to 18.3 percent. 15 Three factors affect the returns on venture-capital investments. First, a strong appetite for initial public offerings or acquisitions boosts performance.Venture firms provide capital and take equity in return, then wait for the company to grow and become profitable and for the stock to appreciate. They hope to cash out when the company is sold. The stronger the markets at the time of the desired initial public offering, the more likely the IPO will actually occur and the higher the price per share. In a good year a venture firm will realize gains from investments perhaps a decade old, and the returns on those investments will affect the availability of future venture funds. According to Bygrave and Timmons, "venture capital liquidity is 13Venture Performance (NewYork:Venture Economics/Securities Data Publishing, 1989), p. 5. ~4Bygrave and Timmons, p. I53. 15Jesse Reyes,"Venture Capital Returns Continue Ciimb," Venture CapitalJournal, Vol. 34, No. 8 (August-September 1994), p. 33.
June 1995 • 53
Exhibit 1
Sampling of investments in restaurant companies, 1989-94 Restaurant company
Au Bon Pain/Midwest Bertucci's Boston Chicken* Chevy's ChopChop EZ's
Java City Koo Koo Roo Levy Restaurants Outback Steakhouse Roadhouse Grill Taco Cabana
Venture,capital firm
Allstate Venture Capital US Trust Platinum Venture Partners Patricof Ventures
Consumer Venture Partners MVP Ventures Primus Venture Partners Austin Ventures Chancellor Capital Management Phillips-Smith Specialty Retailing Group InterWest Partners Casual Dining Concepts Allstate Venture Capital Kitty Hawk Capital Scimitar Development Capital South Atlantic Venture Fund Horn Venture Partners Prudential Equity Investors
* The company's name is now "Boston Market." Sources: Various issues of Venture Capital JoumaL Nation's Restaurant News, and local business joumNs.
quite sensitive to the health and vibrancy of the over-the-counter stock markets .... The ability to harvest an investment [depends] heavily on a hot new-issues market. ''16 When venture investments mature during weak markets, or when the number of potential initial public offerings exceeds the capacity of markets, exit strategies change, and acquisitions outpace initial public offerings. Even when markets are good, some venture capitalists prefer selling their investments to large corporations rather than going public.While public offerings raise large amounts of cash, securities regulations and the dynamics of the marketplace require venture firms to hold their shares for a while after the offering, rather than dump them on the open market. Furthermore, the costs of underwriting an initial public offering eat up some of the 16Bygrave and Timmons, p. 38.
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capital. In contrast, an acquisition can provide a quick exit at a premium price) 7 Second, the earlier an investment is made in a company's life cycle, the higher the return. An analysis of 77 venture-backed initial public offerings between 1979 and 1988 looked at rates of return for different stages of investment. The average first-round investment paid 22.5 times the original principal; secondround, 10.0 times; and third-round, only 3.7 times58 That is consistent with the classic risk-and-return theory of finance: the greater the risk, the greater the potential return needed to justify the investment. Third, the greater the experience of the venture capitalist, in both venture capital and industry of spe~7For more about acquisition strategy, see: Bradford T. Hudson, "Innovation through Acquisition," Cornell Hotel and Restaurant Administration Quarterly, Vol. 35, No. 3 (June 1994), pp. 82-87. 18Bygrave and Timmons, p. 170.
I ~ N [ [ I HOTELANDRESTAURANTADMINISTRATIONQUARTERLY
cialization, the greater the return. Analysis shows that between 1975 and 1988, follow-on funds outperformed funds raised by novice venture firms. 19 Knowledge, expertise, and information are important.
The RestaurantIndustry As mentioned earlier, venture capital has traditionally been focused on high-technology opportunities. Between 1987 and 1989, 30 percent of venture-capital investments were in the computer or electronics industries, 20 percent were in biotechnology or medicine, and 13 percent were in telecommunications. Restaurants, retail, and other services made up only 16 percent. 2° Venture capital has not been a major source of restaurant financing in the past. During the 1990s, however, retail and service businesses began to receive more attention from the venture community, especially nichefund specialists. By 1993 there were at least ten firms nationwide that regularly made significant investments in retail and consumer services, and in the first half of 1993, venture firms invested more than $175 million in consumer-related companies. Leading investors include CopleyVenture Partners, First Century Partners, Frontenac Company, Phillips-Smith Specialty Retail Group, and US Venture Partners. 21 An informal survey of venture firms listed in Pratt's Guide to Venture Capital Sources reveals that of the 77 firms in the Boston area, about 20 percent include restaurants among their areas of specialization. Earlier this year Patricof and Company, a NewYork investment bank and venture-capital firm, demonstrated 19Bygrave and Timmons, p. 202. 20Venture Performance (NewYork:Venmre Economics/Securities Data Publishing, 1989). 21"Retail, Consumer Services: More Attractive, But Still Tricky," Venture CapitalJournal, VoI. 33, No. 12 (December 1993), p. 15.
its commitment to the restaurant industry by hiring Max Pine (former chief executive officer of Restaurant Associates) as a special partner. ~2 In general, venture-capital investments in restaurants have grown, and by 1993 disbursements totaled more than $75 million. 23 Examples. Cucina! Cucina! is a popular restaurant company in the Northwest. At the beginning of 1994 it owned five upscale Italiantheme casual restaurants, a quickservice concept, and a retailing division. The company had 350 employees and 1993 sales of $20 million. To fund continued growth, executives raised $5.5 million from private investors and an additional $8 million in expansion financing from a syndicate of five venturecapital firms: BancBoston Ventures, Chemical Venture Partners, Norwest Venture Partners,Weston Presidio Capital, and USVenture Partners. 24 Takeout Taxi is aVirginia-based firm that offers home delivery for more than 2,000 restaurants in 140 cities. Using a franchising strategy, the company grew from sales of $1 million in 1991 to $50 million in 1994. 25 Last year the company received $3 million in financing from NationsBancVenture Capital in exchange for 35 percent of the company's equity and a seat on the board of directors. Takeout Taxi executives deemed it critical that the company gain a national market presence quickly, and venture capital enabled it to do so. Among other things, the money will be used to attract management talent and build corporate infrastructure. 22Samuel Foster, "Patricof Hires Restaurant Specialist," Venture Capital Journal, Vol. 34, No. 4 (April 1994), p. 28. 23Venture Economics/Securities Data Publishing, unpublished data, 1994. 24M. Sharon Baker, "Cucina Backers Put $13 Million in Pot," Puget Sound BusinessJournal, Vol. 14, No. 47 (April 8, 1994), p. 1. 2S"Takeout Taxi Inks $3M Equity Financing," Nation's Restaurant News, VoI. 28, No. 29 (July 25, 1994), p. 14.
Exhibit 2
Disbursements to restaurant companies, 1984-94, by year
Year
1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994
N u m b e r of disbursements
1 3 1 4 5 6 8 5 8 22 8
Mean amount per disbursement (O00s of dollars)
$1,020 1,644 2,000 2,488 4,072 1,665 1,423 6,525 3,279 4,359 2,012
Median a m o u n t per disbursement (000s o f dollars)
,
$1,020 1,782 2,000 2,250 1,100 1,528 1,138 4,000 3,100 1,125 1,911
25 20 15 10 5 O 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994
Source: Data from Venture Economics/SecuritiesData PuNishing
The House of Blues is a restaurant-and-nightclub concept created by Isaac Tigrett, cofounder of Hard R o c k Cafes. In 1993, with one successful unit in Cambridge, Massachusetts, Tigrett sought early-stage financing to open units in N e w Orleans, Hollywood, N e w York, Chicago, and London. He raised $32 million in a private placement effort coordinated by Montgomery Securities. Investors included entertainment-industry notables such as Dan Aykroyd, Jim Belushi, and Aerosmith, and three venturecapital firms: the Aeneas Group ($15 million), US Venture Partners
($2 million), and the Platinum Group ($1 million). In addition to building new units, the money will be used to develop a House of Blues record label and a merchandising operation. 26 A sampling of other venturecapital investments in the restaurant industry during the last five years is presented in Exhibit 1. In addition, there were a number of investmentbanking transactions orchestrated by venture firms, including acquisitions of Ground R o u n d and Davco/ 26Alexandra Alger, "The Birth of the (House or') Blues," Venture Capital Journal, Vol. 33, No. 8 (August 1993), p. 28.
June1995 • 55
N u m b e r of disbursements
Stage
Early stage Seed Start-up Other Later stage Second Third Other expansion Bridge Other Leveraged buyout Acquisition Acquisition for expansion
Seed
Start-up
Other
Second
4 6 4
Mean a m o u n t per disbursement ~ (O00s of dollars)
T
Median amount per disbursement (O00s of dollars)
$1,100 1,892 1,545
$1,100 1,020 1,753
11 20 15 6
1,064 2,933 6,439 470
742 1,900 3,900 470
1 1 3
7,650 3,700 3,979
7,650 3,700 2,479
Third
Other Bridge Leveraged AcquisitionAcquisition expansion buyout forexpansion
Wendy's by CiticorpVenture Capital. 27 Transaction analysis. Venture Economics has provided detailed data for all 71 individual venturecapital transactions with 28 separate restaurant companies that occurred between January 1984 and Novem271Richard Ringer, "Restaurant Chain Agrees to Takeover" New York Times, August 24, 1994, p. C3; and John Lombardo, "Crofton-based Wendy's Franchise Going Public," Baltimore BusinessJournal, Vol. 11, No. 3 (June 18, 1993), p. 3.
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ber 1994. 28The results of my analysis of those data appear in Exhibits 2 through 6. The first half of the 1990s has been an active period, with a large number of transactions and a high dollar value of disbursements (see Exhibit 2). In 1993 there were 22 transactions, almost three times the activity of the next highest year, and the median disbursement was $3 million, second only to 1991. A clear bias toward later-stage financing is evident (Exhibit 3), involving 73 percent of the transactions and significantly higher dollar values than other stages of financing. In fact, in terms of the number of transactions and the dollar values of individual transactions, 1993 was dominated by later-stage deals (see Exhibit 4). For 50 percent of the companies, the first disbursement--when the venture firm began its relationship with the company--was made during the later stages (see Exhibit 5). The most common first disbursement was a third-stage deal (21 percent), while the least common was seed-stage financing (4 percent). The first half of the 1990s has been a particularly good period for restaurant stocks and initial public offerings (notably Boston Chicken--now Boston Market-and Outback Steakhouse), and the performance of publicly traded stocks may be correlated with venture-capital disbursements (Exhibit 6). A significant increase in disbursements (1993) follows a strong showing by restaurant stocks from 1990 to '93. Similarly, a significant decrease in disbursements (1994) parallels some uncertainty about restaurant stocks in 1994. The data suggest that restaurants' venture-capital activity has in28Unfortunately, no data were available for rates of return on venture-capital investments in the restaurant industry.
Stage
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
Seed Start-up Other
0 1 0
0 0 1
0 0 0
0 0 1
0 0 1
0 1 0
0 0 0
0 0 0
1 1 0
2 0 1
1 3 0
Second Third Other expansion Bridge Other ~---Leveraged buyout Acquisition Acquisition for expansion
0 0 0 0
1 0 1 0
0 1 0 0
1 1 1 0
2 0 1 0
1 2 2 0
4 0 1 1
0 3 1 1
1 3 1 0
1 7 7 3
0 3 0 1
0 0 0
0 0 0
0 0 0
0 0 0
1 0 0
0 0 0
0 1 1
0 0 0
0 0 1
0 0 1
0 0 0
1
3
1
4
5
6
8
5
8
22
8
Total
Early stage
Later stage
Total
Stage Number of companies Early stage Seed 1 6 Start-up 5 Other 4 5 Later stage 4 Second 4 Third 6 3 Other expansion 4 Bridge 0 2 Other Leveraged buyout 1 1 Acquisition 1 0 Acquisition for expansion 2 Seed Total
Slad-up Other Second
Third
28
creased substantially since the mid1980s, especially in the past five years. The data are also generally consistent with the conclusions of Bygrave and Timmons regarding the venture-capital industry as a whole: that recent venture-capital transactions show a bias toward later-stage investing and against early-stage investing, and that the availability of venture-capital funds
11 20 15 6
71
Other Bddge Leveraged Acqui- Acquisition expansion buyout sition Iorexpansion
correlates with the strong performance of stocks and the appetite for initial public offerings. R e a s o n s t o invest. Restaurant companies have many advantages as investment targets: • They are popular in the marketplace and offer the sort of mass distribution potential normally reserved for consumer goods and entertainment products.
June 1995 • 57
• The corporate restaurant industry (especially in the upscale segments) is relatively young and fragmented, with low barriers to entry and good growth potential. • Restaurants don't have the technological risk or speed of life i.e.,
ae prodwing of ,ublic r exit for lrants ,~smulwth Lmunity mmber ies. increasure capitalists. • There are many restaurant entrepreneurs looking for money and therefore many deals from which to choose. Cautions. Despite the opportunities, many venture firms view restaurants with caution because of such negatives as the following. • Restaurants are a cash business with opportunity for fraud and theft. • Low barriers to entry make it harder to anticipate, and protect against, new entrants. • The restaurant industry generally does not have patent or other legal protection. While tradedress law is a growing field, it is still difficult to legally protect a concept. 29 • The dynamics of the industry are not well defined, and critical success factors differ for almost every operator and vary by region and segment. 29See:JeAnna Abbott and Joseph Lanza, "Trade Dress: Legal Interpretations of What Constitutes Distinctive Appearance" Cornell Hotel and Restaurant Administration Quarterly, Vol. 35, No. 1 (February 1994), pp. 53-58.
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• Consumers o f restaurant services
are less predictable in their buying behavior than consumers of other products and services. • Because o f the human element, service businesses are more difficult to manage than product businesses. • Restaurant failure rates are high, and venture returns have been low, relative to other industries. Balancing the two. Venture capitalists and restaurant executives offer pronounced and conflicting opinions about the last four "cautions" presented (bulleted list above), and researchers point out that few o f them have been substantiated through studies. In fact, Christopher Muller of Cornell University suggests that no accurate study of restaurant-failure rates has ever been conducted! 3° I interviewed venture capitalists, investment bankers, securities analysts, commercial bankers, and restaurant executives for this article. Many of the people interviewed, including venture capitalists themselves, suggested that the venture community does not really understand the restaurant industry. Poor performance of investments may reflect unsophisticated screening criteria, poor industry knowledge, or even bad judgment, rather than a weakness in the restaurant industry itself. More than one person suggested that restaurants offer tremendous opportunity for venture firms, especially for those venture firms that specialize.
The Entrepreneur's Perspective The entrepreneuer, too, will benefit from a venture-capital relationship. Benefits. A venture-capital deal can provide quick access to a large amount of money that may be unavailable elsewhere. Even if availS°Chris Muller and Robert H.Woods, "The Real Failure Rate of Restaurants," FIU Hospitality Review, Vol. 9, No. 2 (Fall 1991), p. 60.
able, the risk profile of new companies and the duration of the investments may make the cost of other sources' capital prohibitively high. Most entrepreneurs are unaware of another major benefit: good venture capitalists add value. They act as management consultants, helping entrepreneurs grow their businesses. They can help find and recruit executives that might otherwise avoid start-ups. They can provide industry expertise and savvy on matters as diverse as average margins and preferred suppliers. They can act as sounding boards, providing an objective perspective. Having worked extensively with growing companies, they can help former corporate executives finetune the entrepreneurial culture. They can help recruit key customers. Perhaps most important, they can provide support in periods of crisis and doubt. 31 That may sound altruistic, but it's just good business. Consider the following: In a study of 120 entrepreneurs and their venture backers, researchers found agreement that venture firms contribute more than just cash. In fact, entrepreneurs rated venture capitalists higher on value-adding than did the venture capitalists themselves. A securities analyst suggested that venture capitalists help polish entrepreneurial "diamonds in the rough," and an entrepreneur confided that a venture capitalist helped him attain his goals sooner. 32 Control. Despite those important benefits, many entrepreneurs are hesitant to seek out the assistance of a venture firm for fear of losing control. They have heard stories about "vulture capitalists" meddling in operational decisions, lacking a basic understanding of the business, replacing executives capri31Bygrave and Timmons, p. 208. 32Bygrave and Timmons, p. 217.
Exhibit 6
Disbursements to restaurantcompanies compared to restaurant-stockperformance, 1990-94 400
Stock-Price
~
¢
,n ex
350
Restaurant stock . , . . f .O. . . . . -O . . . . . O values, NRN _e4" .-" eJ -O . . . . . O""" j l ~ Numberof
300 250
.~'~"
_O-'-'"
" -'q---°""
/
200 ~ *
Restaurant stock
15o
/
X disbursements
/
X \
1oo 5o
Disbursements
0,
0
June'90 Dec'90 June'91 Dec'91 June'92 Dec'92 June'93 Dec'93 June'94 Dec'94
Sources:
-"
-" Venture Economics/Securities Data Publishing
O- - - 0 S&P Analysts' Handbook, March 1995 Supplement e
(New "fork: Standard & Poor's, 1995), p. 27 ~ Various issues of Nation's RestaurantNews, Volumes 24-28 (1990-1995}
ciously, forcing the founders out, and exploiting early investors. For example, a restaurant executive who has never been in a venture deal expressed to me the opinion that venture capital is "expensive and unforgiving" and that "all other financing options should be exhausted first." While there may be some truth to some of the horror stories, such experiences seem to be in a distinct minority. All the venture capitalists I interviewed stated firmly that the last thing they want to do is manage a company, and that they will avoid an investment if they envision such involvement. They want the founders and the executives to run the business.
June1995 ° 59
On the other hand, there are times in any entrepreneurial venture when visions conflict. Most frequently, that occurs when growth accelerates and a founder feels the company slipping through his or her fingers. Marly management theorists believe that entrepreneurship and ongoing management require different skills and that there is a point where entrepreneurs are out of their depth. Eventually, founders are encouraged to scale back their role and change from managing to influencing. If that occurs, it is usually for the good of the company and the investment, including the investment of money, time, and effort by the entrepreneurs themselves. Entrepreneurs must ask this questinn'What is the value of control? 'hose who accept venture capital generally believe that one can't succeed alone, and that a smaller piece of a bigger pie will yield greater returns.
Selection Criteria ture capitalists have their ruing and selection criteria tial investments; the crite,y firm and even within t in general, venture firms :he following: tgement team with a track record and a passion industry; business plan; anization with a good internal culture; • a concept that is differentiated and relatively new, with high value-added elements that allow for aggressive price-setting (for example, cutting-edge decor or culinary sophistication); • a company that is beyond the planning and testing phases and has a proven product (in the case of restaurants, that means five or more units up and running);
.o
EBRNELLHOTELANDRESTAURANTADMINISTRATIONQUARTERLY
• rapid growth (revenues increasing at least 25 percent a year) and large potential markets (market share of at least $100 million); hence, mass-market appeal and demographic longevity (in the case of restaurants, the concept must have the potential for easy reproduction of 100 units or more); • relatively weak competitors; and • perhaps most important, good unit economics (including cash flow, earnings before interest and taxes, return on investment, internal velocity of money). For restaurants an important measure is the ratio of unit-level revenues to cash required to open a unit, sometimes calculated by ignoring overhead or adding back depreciation (venture capitalists want the ratio to exceed 0.4 or 0.5 almost immediately).
Finding a Venture Capitalist A venture-capit~l firm receives thousands of inquiries and hundreds of business plans every year. Many of the proposals are never read. O f those that are, 60 percent are rejected after the first reading, another 25 percent are rejected after a second look, and only 15 percent are investigated in detail. In the end, 5 percent are judged viable, and only 3 percent make it to the finaldeal stage. Thus, entrepreneurs seeking venture capital have a significant challenge in attaining it. 33 The timing and s@e of approach are important.Venture firms frequently work in syndicates. If an entrepreneur impresses a venture capitalist, the venture capitalist will likely share the business plan with other firms. A referred plan always receives favorable treatment. On the other hand, bad news travels fast. 33Alexander Dingee, Brian Haslett, and Leonard Smollen, "Characteristics of a Successful Entrepreneurial Management Team," in Pratt's Guide to Venture Capital Sources, p. 25.
Once rejected by one firm, a proposal has dramatically decreased odds of acceptance elsewhere. The character of venture firms differs significantly, and it is important to have a good fit. An entrepreneur should look for a venture capitalist who cares about growing a business, offers value beyond money, and has good personal chemistry with the entrepreneur. Beyond that, the firm should be in the right geographical area, be interested in financing the stage that the enterprise is in, be prepared to invest the amount of capital the enterprise needs, and specialize in the right industry. A proper fit may be as important as the price of the deal) 4 A venture capitalist to avoid is one who: • has investments that are spread too thin; • has limited experience in or understanding of operations; • has a track record of problems or frequent management shake-ups; • has an exhaustive interest in monitoring day-to-day activities; • offers financing but little else (such as consultative expertise); and • is managing one fund while trying to raise another. 35 It is possible for entrepreneurs to screen potential venture firms and approach them directly. However, because of the delicacy of the courting process, the importance of the correct fit, and the complexity of deals, that is a risky approach. For example, on the issue of control, the intricate terms and conditions of the financing agreement may be more important than the percentage of equity ownership. Instead, several investors I inter34G.Jackson Tankersly, Jr., "How to Choose a Venture Capitalist," in Pratt's Guide to Venture Capital Sources, p. 43. 3SBygrave and Timmons, p. 225.
viewed recommended getting help from a venture-capital broker or an investment banker who can act as a coach and intermediary. (An entrepreneur who gets help from an investment banker usually pays a contingent fee.) The point is, \ the manner in which an in~ vestment proposal is packaged " - , ~ and negotiated makes a difference. " ~
j
,
j r ~ ~"~%' ( I[/
~ -
Implications Venture capital involvement in ,,... the multi-unit restaurant industry is a relatively new phenomenon. For restaurant entrepreneurs, it means increasing access to the ~ money and value-adding expertise of the venture community. Long-term benefits include the linkages that venture firms can provide to investment banks and :NN the capital markets, which are ~ critical to the process of going public. It is perhaps no accident that Outback Steakhouse, which has an amazing success sto W, was venture-backed. Venture-capital involvement can be an important competitive weapon for growthoriented entrepreneurs. There are equally intriguing implications for the venture-capital community. Specialized niche funds and focused investment strategies are increasingly popular. Disbursements to restaurant companies have doubled since 1990 (compared to the 1980s) and restaurant stocks have a strong following in the investment community. In the marketplace, restaurants are "hot," with growth propelled by fundamental changes both in the industry's structure and in consumers' lifestyles. These are superior investment targets that should not be overlooked. The relationship of the venturecapital community and the restaurant industry promises an exciting future of growth and profit. CQ
!! ~\ ~,;,..~, I
June 1995 • 81
Restaurant
growth financing for the restaurant industry. This article provides an introduction to venture-capital terms and
Industry
practices, an overview of the history and structure of the venture community, and a summary of venture-capital activity and performance.
,
I
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t
0 portunity knocks. It takes money to make money. Those two well-known sayings have rarely been truer than they are today. There are opportunities in the marketplace, and investment m o n e y is available, yet many entrepreneurs are ignoring a source of financing that could accelerate the growth of their companies: venture capital. Discussions with restaurateurs and venture capitalists about restaurant-growth strategies reveal a great deal of misunderstanding and mis-
BradfordT. Hudson is an adjunct professor in the School of Hospitality Administration at Boston University and a consultant to growing hospitality and retail businesses. © 1995,CornellUniversity
50
EBRNELLHOTELANDRESTAURANTADMINISTRATIONQUARTERLY
F O C U S
trust. Few restaurateurs have a sophisticated understanding of venture capital, and many fear giving away control of their companies. Few know how to find or approach a venture-capital firm. For their part, most venture capitalists target hightech industries, and many are uninformed about opportunities in restaurants. Few comprehensive studies of venture-capital activity in restaurants have been conducted. This article is intended to introduce the venture-capital community and the restaurant industry to each other, increase understanding on both sides, and demonstrate that venture capital is a viable and growing form of restaurant financing.
Venture Capital The definition of venture capital has changed somewhat over the years and even varies from firm to firm, but it is generally understood to be capital provided to new ventures. Investors pool money for investment in growing companies,just as other investors deposit money into mutual funds. The investment funds are actively managed by venturecapital firms, which evaluate potential investment targets, disburse funds, and monitor the progress of investments.Venture capitalists provide large amounts of cash to new and growing companies that might otherwise be unable to obtain financing, owing to the youth of the company or the risk associated with its products or markets. In return, entrepreneurs usually give up a portion of their equity in the company and frequently place a representative of the venture firm on the company's board of directors. As partners with entrepreneurs, venture capitalists may hold their equity for several years as the company grows, and then "exit" the investment through a stockexchange offering or an acquisition by another corporation.
Venture firms today are involved in a wide variety of growth financing activities, some of which do not fit the traditional definition of venture capital. However, classic venture capital can be distinguished from other types of financing in several ways, as follows. • Venture capital is usually provided in exchange for equity rather than debt. • Venture capital is usually provided by independent venture funds rather than banks or investment banks (although some banks and investment banks have venture-capital subsidiaries). • Venture capitalists provide funds to young companies and frequently maintain the investment for long and unspecified periods, rather than for short periods with definite payback deadlines (common with debt instruments). • Venture firms make their money from growth (selling shares in a company that has grown significantly in size and profitability since the initial investment) rather than from prenegotiated percentage-return agreements (common with debt instruments). • Venture capital is frequently subordinate to other types offinancing and is not secured by the personal assets of the entrepreneur; therefore, if the company fails, the venture-capital firm may recover little. • The venture-capital community is generally not regulated by federal or state authorities, unlike the securities and banking industries. 1 Types o f venture capital. Venture capital can be categorized by the point in a company's life cycle ~The exception is a type of venture-capital firm called a small-business-investment company. Such companies are funded in part by tax dollars through the U.S. Small Business Administration. This article does not address such investment companies as a separate group.
ON
F O O D
S E R V I C E
when the money is disbursed (also known as stages, or rounds, of financing). 2 Seed financing is provided to new companies to fund market research or the development of a business plan. Start-up financing is provided to slightly older companies, perhaps a few months in existence, to develop or test a prototype. First-stage financing is provided to companies ready to begin manufacturing or service operations. Laterstage, or expansion, financing is provided to companies that are up and running and have proven the viability of their product or service in the marketplace. Later-stage financing includes second-stage financing, provided to companies that are fully operating but may not yet be profitable; third-stage, or mezzanine, financing, provided to companies that are about to expand rapidly; and bridge financing, provided to companies that plan an initial public offering in less than a year. Increasingly, venture-capital firms are also participating in transactions that mirror those conducted by Wall Street investment bankers, including acquisition financing and management buyouts or leveraged buyouts. Venture-capital firms may begin a relationship with a growing company at any stage) A venture capitalist could provide second-stage financing without providing either first- or third-stage financing. In many cases a venture-capital firm will provide follow-on investment (additional disbursements in later stages) for companies that are meeting or exceeding the venture capitalist's performance expectations. 2pratt's Guide to Venture Capital Sources, 1994 edition, ed.Yong Lira and Ted Weissberg (New York:Venture Economics/Securities Data Publishing, 1994), p. 12. 3The theory is that a company should be growing and successful (profitable) to be a good venture-capital target. Particularly, growth seems to be the paramount concern.There have been cases in which companies received funding even though they had not yet shown a profit.
June 1995 • 51
Various types of financing and investors may be involved during the life of a growing company. Early stage financing might be provided by the company's founders (and family and friends); second-stage financing, by a venture-capital firm; and third-stage financing, by yet another venture-capital firm. That is in addition to bank loans or trade credit that might be provided for short-term operating liquidity. Structure o f financing. Most venture-capital funds are structured as limited partnerships.Venture firms serve as general partners, while institutional and individual investors are limited partners. Venture capitalists make their money by taking a portion of the fund's share of the capital gains (15 to 25 percent) when an investment matures (i.e., when the capital is freed by an initial public offering or a buyout) and by assessing the fund an annual management fee (2 to 3 percent). Limited partners make their money by taking the lion's share of the fund's capital gains (75 to 85 percent) and the return of the original principal invested. 4 O f course, the fund's share of the capital gains depends on the equity percentage of the original investment. If an entrepreneur gives up half of her or his company in exchange for venture capital, then general partners and limited partners divide half of the capital gains (depending on their individual investments) and the entrepreneur keeps the remainder. Venture firms generally use the following four types of instruments, sometimes in combination, for their investments. They are presented here in ascending order of investment security. • C o m m o n stock, the best-known form of equity, is ownership of a portion, or share, of a company.
• Preferred stock, a special type of
equity, gives the holder preference over common shareholders should the company fail and be liquidated. • Subordinated debentures are debt instruments that have preference over equity but are subordinate to other forms of debt. • Senior debt, which most closely resembles a commercial bank loan, generally has preference over other forms of debt and equity; it is frequently used for later-stage financing in low-risk companies, s While venture capital has traditionally focused on equity, debt instruments are increasingly being used. From the venture capitalist's point of view, senior debt is the safest form of investment, since it may have a fixed rate of return and preference over other instruments. C o m m o n stock is the riskiest instrument, since it has no specified rate of return and the lowest preference in the liquidation hierarchy. However, a fixed rate of return may not ultimately be the highest rate, because appreciated common stock may yield a higher return despite the risk. History. Individuals have invested money in business ventures for thousands of years, but organized, professionally managed investing in new companies is less than 50 years old. Georges Doriot, a professor at the Harvard Business School, and Ralph Flanders, president of the Federal Reserve Bank of Boston, are considered to have started the venture-capital community when they founded ARD in 1946. The goal of ARD was to finance companies that would license and develop commercial applications for scientific discoveries at Boston-area
universities. As a result, many of the firm's founding partners were faculty members at the Massachusetts Institute of Technology. Its most celebrated investment was in Digital Equipment Company. An investment of about $70,000 in 1957 gave the firm 77 percent of DEC'S stock, which by 1971 had increased in value by 5,000 percent. 6 ARD's success, especially in the DEC investment, set a tone and character for venture capital that lasts to this day.While the range of industries targeted has broadened and expectations for extraordinary returns have diminished, the community maintains a strong bias toward high technology and high returns. Bygrave and Timmons make a compelling argument, however, that venture capital has changed significantly since its inception.Venture capital, as practiced by Doriot and his disciples, was a long-term investment approach that focused on building value through advice and consultation. ARD concentrated on early-stage investments in new companies with superior management teams and market potential. It patiently held its investments for ten years or more. That is the original, classic approach to venture capital. Two changes occurred during the 1980s. First, venture-capital funds became increasingly dominated by institutional investors, such as pension funds and universities. The effect was an increase in the size of venture funds (resulting in larger disbursements) and a change in performance measures (resulting in less patience and a lower tolerance for risk). Second, as new techniques in finance for example, mergers and acquisitions and junk bonds-were developed, they were adapted to venture capital.
SStanley Golder,"Structuring the Financing" in Pratt's Guide to Venture Capital Sources, p. 57.
6patrick Liles, "Sustaining theVenture Capital Firm;' unpublished doctoral dissertation, Harvard Business School, 1969, p. 29.
4William D. Bygrave and Jeffry A. Timmons, Venture Capital at the Crossroads (Boston: Harvard
Business School Press, 1992), p. 11.
s2
ClIP,NELLHOTELANDRESTAURANT ADMINISTRATION QUARTERLY
A "greedier, speedier breed" of venture capitalist emerged who concentrated on "financial engineering for quick entry and exits," later-stage financing, and buyouts. 7 It is not unusual now for a venture deal to have more debt than equity or for venture capitalists to prefer well-established ventures. Bygrave and Timmons call that "merchant capital" and suggest that it has more in common with investment banking than classic venture capital. As Wall Street heated up during the 1980s, as deals grew larger, and as the holding period of investments decreased, there was more venture money chasing fewer attractive opportunities. A destructive competition developed, the quality of due diligence declined, bad deals were made, and venture-capital returns plummeted. Ironically, while merchant-capital behavior caused the crisis in venture capital, it was the reputation of classic venture practices that suffered. The poor returns were mistakenly associated with classic, early-stage, long-term investing.The result was a shortage of venture money, especially for earlystage investment, that created a "venture capital gap...for new, small and mid-sized businesses.''8 The only positive change during the 1980s was the development of niche venture funds, which specialized in particular industries or types of investing. For example, strong interest in biotechnology helped buoy the overall number of"seedstage" (the earliest stage) deals. 9 Recent developments suggest a rebound in venture-capital investing. After a steady decline from 1988 through 1991, fundraising (collecting of money by venture capitalists from investors) has been
7Bygrave and Timmons, p. 291. 8Robert A. Mamis, "Risky Business," Inc., Vol. 12, No. 3 (March 1990), p. 20. 9Bygrave and Timmons, p. 61.
increasing since 1992. In fact, activity in the first half of 1994 broke the previous record set in 1984. T h e c o m m u n i t y . Today there are more than 500 venture-capital firms in the United States, and total capital under management is nearly $40 billion. Two-thirds of those firms are headquartered in three states: California has 26 percent; NewYork, 25 percent; and Massachusetts, 15 percent. Other active communities can be found in Illinois and Texas) ° A disproportionate share of dollars disbursed go to companies in California, which receive almost five times as much as those in Massachusetts, the state with the next greatest amount. ~ Venture-capital firms stick together not only geographically but also in their investment targets. Syndicates are venture-capital firms that team up to invest in the same companies. The syndication effect can be explained by a desire to spread risk and a need to share expertise and information. Between 1982 and 1984 the National Science Foundation studied activity of 464 venture firms. 12Although less than 3 percent of them co-invested in the same companies, the number was much higher among industry and regional specialists, reaching 69 percent among the leading venture firms specializing in California high-tech companies. It has been said that 100 decision makers control the investing of the entire community. P e r f o r m a n c e and exit. Venture Economics, a private information and research company serving the venture-capital and investmentbanking communities, analyzed nearly 400 venture investments beWVenture Capitaldournal, Vol. 29, No. 3 (March 1989), p. 16. HStanley E. Pratt, "The Organized Venture Capital Community," in Pratt's Guide to Venture Capital Sources, p. 83. ~2jeffryTimmons et al., National Science Foundation, unpublished study, 1984, ISl82-13157.
tween 1969 and 1985. Less than 7 percent of them returned ten times the invested capital or more; 60 percent lost money or returned less than a bank savings account. 13 As Bygrave and Timmons say, venture capital is a business of exceptions. Classic venture-capital investing in young companies is a high-risk affair; statistically, success is improbable. To balance the large losses (possibly in the millions of dollars) on most investments, venture capitalists must occasionally make a big score. Historically they have done so with sufficient frequency and regularity to deliver industry-wide average annual percentage returns in "the teens, with occasional periods in the 20-30 percent range and rare spikes above 30 percent. ''14 During the late 1980s returns dropped to the single digits, but by 1993 they had rebounded to 18.3 percent. 15 Three factors affect the returns on venture-capital investments. First, a strong appetite for initial public offerings or acquisitions boosts performance.Venture firms provide capital and take equity in return, then wait for the company to grow and become profitable and for the stock to appreciate. They hope to cash out when the company is sold. The stronger the markets at the time of the desired initial public offering, the more likely the IPO will actually occur and the higher the price per share. In a good year a venture firm will realize gains from investments perhaps a decade old, and the returns on those investments will affect the availability of future venture funds. According to Bygrave and Timmons, "venture capital liquidity is 13Venture Performance (NewYork:Venture Economics/Securities Data Publishing, 1989), p. 5. ~4Bygrave and Timmons, p. I53. 15Jesse Reyes,"Venture Capital Returns Continue Ciimb," Venture CapitalJournal, Vol. 34, No. 8 (August-September 1994), p. 33.
June 1995 • 53
Exhibit 1
Sampling of investments in restaurant companies, 1989-94 Restaurant company
Au Bon Pain/Midwest Bertucci's Boston Chicken* Chevy's ChopChop EZ's
Java City Koo Koo Roo Levy Restaurants Outback Steakhouse Roadhouse Grill Taco Cabana
Venture,capital firm
Allstate Venture Capital US Trust Platinum Venture Partners Patricof Ventures
Consumer Venture Partners MVP Ventures Primus Venture Partners Austin Ventures Chancellor Capital Management Phillips-Smith Specialty Retailing Group InterWest Partners Casual Dining Concepts Allstate Venture Capital Kitty Hawk Capital Scimitar Development Capital South Atlantic Venture Fund Horn Venture Partners Prudential Equity Investors
* The company's name is now "Boston Market." Sources: Various issues of Venture Capital JoumaL Nation's Restaurant News, and local business joumNs.
quite sensitive to the health and vibrancy of the over-the-counter stock markets .... The ability to harvest an investment [depends] heavily on a hot new-issues market. ''16 When venture investments mature during weak markets, or when the number of potential initial public offerings exceeds the capacity of markets, exit strategies change, and acquisitions outpace initial public offerings. Even when markets are good, some venture capitalists prefer selling their investments to large corporations rather than going public.While public offerings raise large amounts of cash, securities regulations and the dynamics of the marketplace require venture firms to hold their shares for a while after the offering, rather than dump them on the open market. Furthermore, the costs of underwriting an initial public offering eat up some of the 16Bygrave and Timmons, p. 38.
54
capital. In contrast, an acquisition can provide a quick exit at a premium price) 7 Second, the earlier an investment is made in a company's life cycle, the higher the return. An analysis of 77 venture-backed initial public offerings between 1979 and 1988 looked at rates of return for different stages of investment. The average first-round investment paid 22.5 times the original principal; secondround, 10.0 times; and third-round, only 3.7 times58 That is consistent with the classic risk-and-return theory of finance: the greater the risk, the greater the potential return needed to justify the investment. Third, the greater the experience of the venture capitalist, in both venture capital and industry of spe~7For more about acquisition strategy, see: Bradford T. Hudson, "Innovation through Acquisition," Cornell Hotel and Restaurant Administration Quarterly, Vol. 35, No. 3 (June 1994), pp. 82-87. 18Bygrave and Timmons, p. 170.
I ~ N [ [ I HOTELANDRESTAURANTADMINISTRATIONQUARTERLY
cialization, the greater the return. Analysis shows that between 1975 and 1988, follow-on funds outperformed funds raised by novice venture firms. 19 Knowledge, expertise, and information are important.
The RestaurantIndustry As mentioned earlier, venture capital has traditionally been focused on high-technology opportunities. Between 1987 and 1989, 30 percent of venture-capital investments were in the computer or electronics industries, 20 percent were in biotechnology or medicine, and 13 percent were in telecommunications. Restaurants, retail, and other services made up only 16 percent. 2° Venture capital has not been a major source of restaurant financing in the past. During the 1990s, however, retail and service businesses began to receive more attention from the venture community, especially nichefund specialists. By 1993 there were at least ten firms nationwide that regularly made significant investments in retail and consumer services, and in the first half of 1993, venture firms invested more than $175 million in consumer-related companies. Leading investors include CopleyVenture Partners, First Century Partners, Frontenac Company, Phillips-Smith Specialty Retail Group, and US Venture Partners. 21 An informal survey of venture firms listed in Pratt's Guide to Venture Capital Sources reveals that of the 77 firms in the Boston area, about 20 percent include restaurants among their areas of specialization. Earlier this year Patricof and Company, a NewYork investment bank and venture-capital firm, demonstrated 19Bygrave and Timmons, p. 202. 20Venture Performance (NewYork:Venmre Economics/Securities Data Publishing, 1989). 21"Retail, Consumer Services: More Attractive, But Still Tricky," Venture CapitalJournal, VoI. 33, No. 12 (December 1993), p. 15.
its commitment to the restaurant industry by hiring Max Pine (former chief executive officer of Restaurant Associates) as a special partner. ~2 In general, venture-capital investments in restaurants have grown, and by 1993 disbursements totaled more than $75 million. 23 Examples. Cucina! Cucina! is a popular restaurant company in the Northwest. At the beginning of 1994 it owned five upscale Italiantheme casual restaurants, a quickservice concept, and a retailing division. The company had 350 employees and 1993 sales of $20 million. To fund continued growth, executives raised $5.5 million from private investors and an additional $8 million in expansion financing from a syndicate of five venturecapital firms: BancBoston Ventures, Chemical Venture Partners, Norwest Venture Partners,Weston Presidio Capital, and USVenture Partners. 24 Takeout Taxi is aVirginia-based firm that offers home delivery for more than 2,000 restaurants in 140 cities. Using a franchising strategy, the company grew from sales of $1 million in 1991 to $50 million in 1994. 25 Last year the company received $3 million in financing from NationsBancVenture Capital in exchange for 35 percent of the company's equity and a seat on the board of directors. Takeout Taxi executives deemed it critical that the company gain a national market presence quickly, and venture capital enabled it to do so. Among other things, the money will be used to attract management talent and build corporate infrastructure. 22Samuel Foster, "Patricof Hires Restaurant Specialist," Venture Capital Journal, Vol. 34, No. 4 (April 1994), p. 28. 23Venture Economics/Securities Data Publishing, unpublished data, 1994. 24M. Sharon Baker, "Cucina Backers Put $13 Million in Pot," Puget Sound BusinessJournal, Vol. 14, No. 47 (April 8, 1994), p. 1. 2S"Takeout Taxi Inks $3M Equity Financing," Nation's Restaurant News, VoI. 28, No. 29 (July 25, 1994), p. 14.
Exhibit 2
Disbursements to restaurant companies, 1984-94, by year
Year
1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994
N u m b e r of disbursements
1 3 1 4 5 6 8 5 8 22 8
Mean amount per disbursement (O00s of dollars)
$1,020 1,644 2,000 2,488 4,072 1,665 1,423 6,525 3,279 4,359 2,012
Median a m o u n t per disbursement (000s o f dollars)
,
$1,020 1,782 2,000 2,250 1,100 1,528 1,138 4,000 3,100 1,125 1,911
25 20 15 10 5 O 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994
Source: Data from Venture Economics/SecuritiesData PuNishing
The House of Blues is a restaurant-and-nightclub concept created by Isaac Tigrett, cofounder of Hard R o c k Cafes. In 1993, with one successful unit in Cambridge, Massachusetts, Tigrett sought early-stage financing to open units in N e w Orleans, Hollywood, N e w York, Chicago, and London. He raised $32 million in a private placement effort coordinated by Montgomery Securities. Investors included entertainment-industry notables such as Dan Aykroyd, Jim Belushi, and Aerosmith, and three venturecapital firms: the Aeneas Group ($15 million), US Venture Partners
($2 million), and the Platinum Group ($1 million). In addition to building new units, the money will be used to develop a House of Blues record label and a merchandising operation. 26 A sampling of other venturecapital investments in the restaurant industry during the last five years is presented in Exhibit 1. In addition, there were a number of investmentbanking transactions orchestrated by venture firms, including acquisitions of Ground R o u n d and Davco/ 26Alexandra Alger, "The Birth of the (House or') Blues," Venture Capital Journal, Vol. 33, No. 8 (August 1993), p. 28.
June1995 • 55
N u m b e r of disbursements
Stage
Early stage Seed Start-up Other Later stage Second Third Other expansion Bridge Other Leveraged buyout Acquisition Acquisition for expansion
Seed
Start-up
Other
Second
4 6 4
Mean a m o u n t per disbursement ~ (O00s of dollars)
T
Median amount per disbursement (O00s of dollars)
$1,100 1,892 1,545
$1,100 1,020 1,753
11 20 15 6
1,064 2,933 6,439 470
742 1,900 3,900 470
1 1 3
7,650 3,700 3,979
7,650 3,700 2,479
Third
Other Bridge Leveraged AcquisitionAcquisition expansion buyout forexpansion
Wendy's by CiticorpVenture Capital. 27 Transaction analysis. Venture Economics has provided detailed data for all 71 individual venturecapital transactions with 28 separate restaurant companies that occurred between January 1984 and Novem271Richard Ringer, "Restaurant Chain Agrees to Takeover" New York Times, August 24, 1994, p. C3; and John Lombardo, "Crofton-based Wendy's Franchise Going Public," Baltimore BusinessJournal, Vol. 11, No. 3 (June 18, 1993), p. 3.
56
/~R~L[ HOTELANDRESTAURANTADMI~$TRATIONQUARTERLY
ber 1994. 28The results of my analysis of those data appear in Exhibits 2 through 6. The first half of the 1990s has been an active period, with a large number of transactions and a high dollar value of disbursements (see Exhibit 2). In 1993 there were 22 transactions, almost three times the activity of the next highest year, and the median disbursement was $3 million, second only to 1991. A clear bias toward later-stage financing is evident (Exhibit 3), involving 73 percent of the transactions and significantly higher dollar values than other stages of financing. In fact, in terms of the number of transactions and the dollar values of individual transactions, 1993 was dominated by later-stage deals (see Exhibit 4). For 50 percent of the companies, the first disbursement--when the venture firm began its relationship with the company--was made during the later stages (see Exhibit 5). The most common first disbursement was a third-stage deal (21 percent), while the least common was seed-stage financing (4 percent). The first half of the 1990s has been a particularly good period for restaurant stocks and initial public offerings (notably Boston Chicken--now Boston Market-and Outback Steakhouse), and the performance of publicly traded stocks may be correlated with venture-capital disbursements (Exhibit 6). A significant increase in disbursements (1993) follows a strong showing by restaurant stocks from 1990 to '93. Similarly, a significant decrease in disbursements (1994) parallels some uncertainty about restaurant stocks in 1994. The data suggest that restaurants' venture-capital activity has in28Unfortunately, no data were available for rates of return on venture-capital investments in the restaurant industry.
Stage
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
Seed Start-up Other
0 1 0
0 0 1
0 0 0
0 0 1
0 0 1
0 1 0
0 0 0
0 0 0
1 1 0
2 0 1
1 3 0
Second Third Other expansion Bridge Other ~---Leveraged buyout Acquisition Acquisition for expansion
0 0 0 0
1 0 1 0
0 1 0 0
1 1 1 0
2 0 1 0
1 2 2 0
4 0 1 1
0 3 1 1
1 3 1 0
1 7 7 3
0 3 0 1
0 0 0
0 0 0
0 0 0
0 0 0
1 0 0
0 0 0
0 1 1
0 0 0
0 0 1
0 0 1
0 0 0
1
3
1
4
5
6
8
5
8
22
8
Total
Early stage
Later stage
Total
Stage Number of companies Early stage Seed 1 6 Start-up 5 Other 4 5 Later stage 4 Second 4 Third 6 3 Other expansion 4 Bridge 0 2 Other Leveraged buyout 1 1 Acquisition 1 0 Acquisition for expansion 2 Seed Total
Slad-up Other Second
Third
28
creased substantially since the mid1980s, especially in the past five years. The data are also generally consistent with the conclusions of Bygrave and Timmons regarding the venture-capital industry as a whole: that recent venture-capital transactions show a bias toward later-stage investing and against early-stage investing, and that the availability of venture-capital funds
11 20 15 6
71
Other Bddge Leveraged Acqui- Acquisition expansion buyout sition Iorexpansion
correlates with the strong performance of stocks and the appetite for initial public offerings. R e a s o n s t o invest. Restaurant companies have many advantages as investment targets: • They are popular in the marketplace and offer the sort of mass distribution potential normally reserved for consumer goods and entertainment products.
June 1995 • 57
• The corporate restaurant industry (especially in the upscale segments) is relatively young and fragmented, with low barriers to entry and good growth potential. • Restaurants don't have the technological risk or speed of life i.e.,
ae prodwing of ,ublic r exit for lrants ,~smulwth Lmunity mmber ies. increasure capitalists. • There are many restaurant entrepreneurs looking for money and therefore many deals from which to choose. Cautions. Despite the opportunities, many venture firms view restaurants with caution because of such negatives as the following. • Restaurants are a cash business with opportunity for fraud and theft. • Low barriers to entry make it harder to anticipate, and protect against, new entrants. • The restaurant industry generally does not have patent or other legal protection. While tradedress law is a growing field, it is still difficult to legally protect a concept. 29 • The dynamics of the industry are not well defined, and critical success factors differ for almost every operator and vary by region and segment. 29See:JeAnna Abbott and Joseph Lanza, "Trade Dress: Legal Interpretations of What Constitutes Distinctive Appearance" Cornell Hotel and Restaurant Administration Quarterly, Vol. 35, No. 1 (February 1994), pp. 53-58.
s8
CURNELLHOTELANDRESTAURANTADMINISTRATIONQUARTERLY
• Consumers o f restaurant services
are less predictable in their buying behavior than consumers of other products and services. • Because o f the human element, service businesses are more difficult to manage than product businesses. • Restaurant failure rates are high, and venture returns have been low, relative to other industries. Balancing the two. Venture capitalists and restaurant executives offer pronounced and conflicting opinions about the last four "cautions" presented (bulleted list above), and researchers point out that few o f them have been substantiated through studies. In fact, Christopher Muller of Cornell University suggests that no accurate study of restaurant-failure rates has ever been conducted! 3° I interviewed venture capitalists, investment bankers, securities analysts, commercial bankers, and restaurant executives for this article. Many of the people interviewed, including venture capitalists themselves, suggested that the venture community does not really understand the restaurant industry. Poor performance of investments may reflect unsophisticated screening criteria, poor industry knowledge, or even bad judgment, rather than a weakness in the restaurant industry itself. More than one person suggested that restaurants offer tremendous opportunity for venture firms, especially for those venture firms that specialize.
The Entrepreneur's Perspective The entrepreneuer, too, will benefit from a venture-capital relationship. Benefits. A venture-capital deal can provide quick access to a large amount of money that may be unavailable elsewhere. Even if availS°Chris Muller and Robert H.Woods, "The Real Failure Rate of Restaurants," FIU Hospitality Review, Vol. 9, No. 2 (Fall 1991), p. 60.
able, the risk profile of new companies and the duration of the investments may make the cost of other sources' capital prohibitively high. Most entrepreneurs are unaware of another major benefit: good venture capitalists add value. They act as management consultants, helping entrepreneurs grow their businesses. They can help find and recruit executives that might otherwise avoid start-ups. They can provide industry expertise and savvy on matters as diverse as average margins and preferred suppliers. They can act as sounding boards, providing an objective perspective. Having worked extensively with growing companies, they can help former corporate executives finetune the entrepreneurial culture. They can help recruit key customers. Perhaps most important, they can provide support in periods of crisis and doubt. 31 That may sound altruistic, but it's just good business. Consider the following: In a study of 120 entrepreneurs and their venture backers, researchers found agreement that venture firms contribute more than just cash. In fact, entrepreneurs rated venture capitalists higher on value-adding than did the venture capitalists themselves. A securities analyst suggested that venture capitalists help polish entrepreneurial "diamonds in the rough," and an entrepreneur confided that a venture capitalist helped him attain his goals sooner. 32 Control. Despite those important benefits, many entrepreneurs are hesitant to seek out the assistance of a venture firm for fear of losing control. They have heard stories about "vulture capitalists" meddling in operational decisions, lacking a basic understanding of the business, replacing executives capri31Bygrave and Timmons, p. 208. 32Bygrave and Timmons, p. 217.
Exhibit 6
Disbursements to restaurantcompanies compared to restaurant-stockperformance, 1990-94 400
Stock-Price
~
¢
,n ex
350
Restaurant stock . , . . f .O. . . . . -O . . . . . O values, NRN _e4" .-" eJ -O . . . . . O""" j l ~ Numberof
300 250
.~'~"
_O-'-'"
" -'q---°""
/
200 ~ *
Restaurant stock
15o
/
X disbursements
/
X \
1oo 5o
Disbursements
0,
0
June'90 Dec'90 June'91 Dec'91 June'92 Dec'92 June'93 Dec'93 June'94 Dec'94
Sources:
-"
-" Venture Economics/Securities Data Publishing
O- - - 0 S&P Analysts' Handbook, March 1995 Supplement e
(New "fork: Standard & Poor's, 1995), p. 27 ~ Various issues of Nation's RestaurantNews, Volumes 24-28 (1990-1995}
ciously, forcing the founders out, and exploiting early investors. For example, a restaurant executive who has never been in a venture deal expressed to me the opinion that venture capital is "expensive and unforgiving" and that "all other financing options should be exhausted first." While there may be some truth to some of the horror stories, such experiences seem to be in a distinct minority. All the venture capitalists I interviewed stated firmly that the last thing they want to do is manage a company, and that they will avoid an investment if they envision such involvement. They want the founders and the executives to run the business.
June1995 ° 59
On the other hand, there are times in any entrepreneurial venture when visions conflict. Most frequently, that occurs when growth accelerates and a founder feels the company slipping through his or her fingers. Marly management theorists believe that entrepreneurship and ongoing management require different skills and that there is a point where entrepreneurs are out of their depth. Eventually, founders are encouraged to scale back their role and change from managing to influencing. If that occurs, it is usually for the good of the company and the investment, including the investment of money, time, and effort by the entrepreneurs themselves. Entrepreneurs must ask this questinn'What is the value of control? 'hose who accept venture capital generally believe that one can't succeed alone, and that a smaller piece of a bigger pie will yield greater returns.
Selection Criteria ture capitalists have their ruing and selection criteria tial investments; the crite,y firm and even within t in general, venture firms :he following: tgement team with a track record and a passion industry; business plan; anization with a good internal culture; • a concept that is differentiated and relatively new, with high value-added elements that allow for aggressive price-setting (for example, cutting-edge decor or culinary sophistication); • a company that is beyond the planning and testing phases and has a proven product (in the case of restaurants, that means five or more units up and running);
.o
EBRNELLHOTELANDRESTAURANTADMINISTRATIONQUARTERLY
• rapid growth (revenues increasing at least 25 percent a year) and large potential markets (market share of at least $100 million); hence, mass-market appeal and demographic longevity (in the case of restaurants, the concept must have the potential for easy reproduction of 100 units or more); • relatively weak competitors; and • perhaps most important, good unit economics (including cash flow, earnings before interest and taxes, return on investment, internal velocity of money). For restaurants an important measure is the ratio of unit-level revenues to cash required to open a unit, sometimes calculated by ignoring overhead or adding back depreciation (venture capitalists want the ratio to exceed 0.4 or 0.5 almost immediately).
Finding a Venture Capitalist A venture-capit~l firm receives thousands of inquiries and hundreds of business plans every year. Many of the proposals are never read. O f those that are, 60 percent are rejected after the first reading, another 25 percent are rejected after a second look, and only 15 percent are investigated in detail. In the end, 5 percent are judged viable, and only 3 percent make it to the finaldeal stage. Thus, entrepreneurs seeking venture capital have a significant challenge in attaining it. 33 The timing and s@e of approach are important.Venture firms frequently work in syndicates. If an entrepreneur impresses a venture capitalist, the venture capitalist will likely share the business plan with other firms. A referred plan always receives favorable treatment. On the other hand, bad news travels fast. 33Alexander Dingee, Brian Haslett, and Leonard Smollen, "Characteristics of a Successful Entrepreneurial Management Team," in Pratt's Guide to Venture Capital Sources, p. 25.
Once rejected by one firm, a proposal has dramatically decreased odds of acceptance elsewhere. The character of venture firms differs significantly, and it is important to have a good fit. An entrepreneur should look for a venture capitalist who cares about growing a business, offers value beyond money, and has good personal chemistry with the entrepreneur. Beyond that, the firm should be in the right geographical area, be interested in financing the stage that the enterprise is in, be prepared to invest the amount of capital the enterprise needs, and specialize in the right industry. A proper fit may be as important as the price of the deal) 4 A venture capitalist to avoid is one who: • has investments that are spread too thin; • has limited experience in or understanding of operations; • has a track record of problems or frequent management shake-ups; • has an exhaustive interest in monitoring day-to-day activities; • offers financing but little else (such as consultative expertise); and • is managing one fund while trying to raise another. 35 It is possible for entrepreneurs to screen potential venture firms and approach them directly. However, because of the delicacy of the courting process, the importance of the correct fit, and the complexity of deals, that is a risky approach. For example, on the issue of control, the intricate terms and conditions of the financing agreement may be more important than the percentage of equity ownership. Instead, several investors I inter34G.Jackson Tankersly, Jr., "How to Choose a Venture Capitalist," in Pratt's Guide to Venture Capital Sources, p. 43. 3SBygrave and Timmons, p. 225.
viewed recommended getting help from a venture-capital broker or an investment banker who can act as a coach and intermediary. (An entrepreneur who gets help from an investment banker usually pays a contingent fee.) The point is, \ the manner in which an in~ vestment proposal is packaged " - , ~ and negotiated makes a difference. " ~
j
,
j r ~ ~"~%' ( I[/
~ -
Implications Venture capital involvement in ,,... the multi-unit restaurant industry is a relatively new phenomenon. For restaurant entrepreneurs, it means increasing access to the ~ money and value-adding expertise of the venture community. Long-term benefits include the linkages that venture firms can provide to investment banks and :NN the capital markets, which are ~ critical to the process of going public. It is perhaps no accident that Outback Steakhouse, which has an amazing success sto W, was venture-backed. Venture-capital involvement can be an important competitive weapon for growthoriented entrepreneurs. There are equally intriguing implications for the venture-capital community. Specialized niche funds and focused investment strategies are increasingly popular. Disbursements to restaurant companies have doubled since 1990 (compared to the 1980s) and restaurant stocks have a strong following in the investment community. In the marketplace, restaurants are "hot," with growth propelled by fundamental changes both in the industry's structure and in consumers' lifestyles. These are superior investment targets that should not be overlooked. The relationship of the venturecapital community and the restaurant industry promises an exciting future of growth and profit. CQ
!! ~\ ~,;,..~, I
June 1995 • 81