Why Restaurants Fail and How That Affects a Sale
August 2022
The story of the failure of restaurants seems to be a riveting and well-discussed topic. Any cursory web search will render hair-raising statistics of the failure rates (often broken down by restaurant closures within 1, 3 and/or 5 years of operation after opening). Equally, if not more interesting than the failure rate, is the reason behind restaurant failures and here is where things get really puzzling; no two lists are the same and each list maker seems confident in their assumptions.
I have a story I love about this topic of why restaurants fail. When I was teaching restaurant management courses, I would have my friends and colleagues, industry experts, come in as guest speakers. Whenever I would have Tom Barnett speak, (The person I credit with my restaurant ownership success) the students would always ask him: “What is the most important thing for restaurant success?” Which is another way of asking: “Why do restaurants fail?” Tom spoke five or six times over the years. One thing I noticed about his response to the question was…his answer always changed. I thought that was great, because I don’t think there is one over-arching reason the restaurants fail. I think there are several reasons. Sometimes a restaurant will fail because of a combination of things or because of one big misstep, but that one big misstep doesn’t account for why most restaurants fail.
Since this is not that lives in any central location, the lists are qualitative and subjective. Today I’m going to discuss five reasons that I see on most every list plus one reason I see as a common culprit that only applies to states with retail sales tax.
Here is my list of the top five reasons restaurants fail:
- Location
- Under Capitalization
- Lack of experience
- Margins (COGs, Labor and Occupancy Costs)
- Inconsistency
Plus
- Retail Sales Tax
Location
This feels like an old-school, worn-out reason for restaurant failure. I’ve seen restaurants located in the craziest spots succeed. Sure, there are basic location factors to consider depending on the restaurant type. If it’s a fast-food restaurant, it needs to be in a densely populated area with easy access from all traffic directions and the site must allow for a drive-through window. That stuff is somewhat obvious. In the NorthBay some of our busiest, most successful restaurants are located in out-of the way places. I put my restaurant in a free-standing building that had been originally designed for a…Kentucky fried chicken. When I took occupancy, before I’d open the doors, more than one local stopped into to tell me it was an awful location. One person went so far as to tell me it was “cursed”.
Under-capitalization (or lack of working capital)
When I opened my restaurant, Tom Barnett told me that in his experience new operators with a lot of working capital would throw money at financial problems rather than fix the problems. He advised me not to secure a lot of working capital. Which was fortunate for me because I think I had about $10,000 in the bank when I opened. That’s right, not enough money to order a week’s worth of food and alcohol and make payroll. Scary, I know, but it was all I had. That’s the thing about restaurant owners: we have a high tolerance for risk.
I think throwing money at cost over-runs or operational inefficiencies are what account for the 5-year spread in failure rates.
Lack of Experience
I agree with this one, but, again, it’s not the whole story. Most of my clients are first-time restaurant owners.
- FOH or BOH experience
- Management experience
Or
- Money
If you lack experience in a certain area: financial statements, employee management and HR, operating procedures, hire a consultant to help get things into place. It is money well spent.
Margins (COGs, Labor and Occupancy Costs)
There is no mystery about margins in the restaurant industry. They are standard depending on the type (Quick Service, Fast Casual, Fine Dining, etc). Due to robust POS systems, operators can keep an eye on the cost of goods sold (COGs) and labor daily. Knowing what levers to pull is paramount in restaurant success. If COGs and labor are too high, then more than likely, the prices are too low. Because the industry is so competitive, most operators are very hesitant to raise prices. In our region, independently owned restaurants will often add a surcharge to guests’ bills and explain the surcharge on the menu.
Occupancy cost
I find this to be a huge culprit in the failure of restaurant and I talk about with clients all the time. In fact, for every buyer I represent, I build a spreadsheet that details the gross sales need to support the occupancy costs (I use rent + NNN). I’ve spoken about this a lot throughout the series, but I specifically address in the December 2021 blog post and the Deep Dish Live episode XIV: Restaurant Leases 1.0: How Much Rent Is Too Much Rent? Basically, occupancy costs, the fixed costs required to occupy the space can make or break a restaurant. A wildly successful restaurant can fail if the rents are too high.
Inconsistency
In Tom’s view, this seemed to be the number one reason restaurants would fail
And finally…
Retail Sales Tax
I find this to be the sleeper wave that can take down a restaurant. If a restaurant doesn’t keep a separate bank account to deposit retail sales tax received from their customers, then operators run the risk of treating this “pass-through” tax as income. I’ve seen very popular, busy restaurants fail because they treated the sales tax as income and (in the start-up phase when things are crazy and a lot of money is needed) spent the money, got behind on sales tax payments, started accruing large fines and could not recover. Ultimately, they had to close which was very confusing to everyone except the owners.
So how does these affect the sale of a restaurant? If you’re a restaurant owner, is there anything you can do differently based on the list above?
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Ryn Longmaid is a restaurant broker and consultant at Santa Rosa Business & Commercial in the San Francisco NorthBay and the host and founder of the Facebook Live Series, Deep Dish: discussions on the business of restaurants for restaurateurs, restaurant buyers and sellers and the restaurant curious.
As well as being a licensed real estate broker, Ryn is a CBB with the California Association of Business Brokers (CABB), a CBI with the IBBA and she holds an MBA in Sustainable Business Management. In addition to being a proficient business broker, Ryn has over 20 years’ experience in the restaurant, hospitality, and food industries. She has served as the executive chef for Amy’s Kitchen, personal chef to actor Don Johnson, she founded and operated a successful and longstanding restaurant. She has also held teaching posts in restaurant management at the Art Institute-San Francisco and The Culinary Institute of America-Greystone.