Lending to Restaurants: Despite Their Reputation, Restaurants Can Be an Acceptable Credit Risk If Lenders Perform Initial and Ongoing Due Diligence

Article excerpt

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The restaurant industry plays an important part in the American lifestyle and is a key component of the U.S. economy. According to the National Restaurant Association, the typical adult in the United States visits a restaurant 5.8 times a week. (1) And approximately 44% of adult Americans believe that restaurants are "an essential part" of their lifestyle. (2)

Despite the importance of restaurants, lending to them is often perceived as a risky endeavor. Yet, a new restaurant's failure rate during its first three years of operation is the same as the average for all industries, according to data from the U.S. Bureau of Labor Statistics. (3)

This article discusses factors to investigate when lending to a restaurant--specifically, the qualitative factors that influence the success or failure of a restaurant, the quantitative measures that indicate whether a restaurant is financially healthy, and how guarantees and collateral should be evaluated. If done prudently, lending to a restaurant can be an acceptable credit risk.

Qualitative Factors

In 2005, researchers from the Ohio State University and California State Polytechnic University, Pomona conducted a study on why restaurants fail. (4) The study identified characteristics shared by successful restaurants and those common to failed restaurants.

Key Concept and Strategy

According to the study, the most distinguishing characteristic separating successful restaurants from failed restaurants was having a "clear concept that drives all activities" and "goes beyond the type of food served." Successful restaurant owners had "a well-defined concept that not only provided a food product but also included an operating philosophy, which encompassed business operations as well as employee and customer relations." Meanwhile, owners of failed restaurants "could only describe the food and could not expand their description of [their] concept beyond food production .... They would state that their concept was 'vegetarian food' or 'Alaskan seafood.'"

While a clear concept is essential, the study concluded that having a well-defined strategy--in marketing and pricing, for example--was not critical to a restaurant's success. The researchers observed that "some of the most successful [restaurants] did not have a well-defined strategy .... Some of the restaurant owners who had been extraordinarily successful were 'going with the flow.'" On the other hand, the study noted that some restaurateurs failed despite having well-defined strategies.

Work-Life Balance and Energy Levels

Because of the immense time commitment required to run a successful restaurant, the study concluded that the work-life balance of the owner and key managers is one of the most important determinants of a restaurant's success. Successful restaurateurs were single, divorced, or good at balancing their family and work lives. Conversely, owners of failed restaurants were no longer willing to make the family sacrifices.

The researchers observed that successful restaurateurs "had a passion for business and high energy levels," whereas owners of failed restaurants "lacked the high energy levels necessary to motivate themselves and their employees." During their interviews with the researchers, every failed restaurant owner cited the "burden of the immense time commitment required for a restaurant" as a factor in their establishment's failure.

Marketing and Advertising

In terms of marketing, the study concluded that successful restaurateurs considered public relations, community involvement, and customer relations important to their success. On the other hand, it found that successful restaurateurs shared a strong belief in not advertising and not using promotions. One successful restaurateur commented, "If you have to give something away, then you shouldn't be in business."

Successful restaurateurs also said that having a defined target market was not critical to their success. …