Article contributed by Lawrence A. Rosenbloom, Ellenoff Grossman & Schole LLP
The menu and décor for your dream concept is set, and then you realize: how am I going to raise money to launch my restaurant?
Here are a few important things to keep in mind when embarking on the task of seeking third party funding.
Types of third party investors (and what to expect from each)
Third party funding (excluding traditional bank loans) usually comes from two sources: friends/family and professional investors.
Very often, friends and family want to help bring your dream to reality. Others like to invest so that they can experience the cache of “owning a restaurant”. While typically friends and family money is the easiest to raise and the least expensive (in terms of preferred returns or approval rights, as discussed below), the biggest challenge with taking friends and family money is just that: ultimately if something goes wrong, you’ll have your friends and family to answer to. The problem with cache investors is that they typically are either in your hair with lots of questions on how the business is doing, or they ask for favors (like a prime reservation or free drinks or meals).
Professional investors have less emotion attached to them, but they are in it to score returns on their money, so their terms are usually harsher. Professional investors will likely ask for a preferred return on their money, meaning that they will want to see the positive cash flow from the restaurant (cash less expenses) paid to them only until they have received their investment back plus a return (usually 6-8% per year) before the owner can participate in the cash flows (remember that owner salary comes out of cash flow, so push for that).
Also, professional investors will very often insist on “major decision” approval rights that give the investor some control over the management of the restaurant, such as taking on bank debt, initiating or settling litigation, adding additional investors or selling the restaurant. Some investors will want even more approval rights, like menu changes or the hiring or firing of an executive chef. Remember: the more money an investor is investing, the less leverage a restaurant owner will have in negotiations (keep in mind the “golden rule” – he who has the gold, rules!).
Types of investments
Typically, third party investments come in three forms: debt, preferred equity and common equity.
Investors like to loan money (rather than being an equity “partner”) because debt is senior to equity in the unfortunate event of bankruptcy or liquidation. Debt usually comes with the most onerous financial and operational limitation terms. The contract for debt is a loan agreement, perhaps with a security agreement if a security interest in the assets of the restaurant is being provided.
Preferred equity affords the investor a senior return on the positive cash flow of the business. These investors get their money out before the restaurant owner, and they typically require some operational approval rights.
Common equity investors are the most owner-friendly. These are typically the “silent partners” who provide capital then receive returns side-by-side with the owner. This is usually how friends and family invest.
The type of entity you have to run the restaurant (e.g., a limited liability company or corporation) will dictate the documents needed for preferred and common equity investments (for the former, an operating agreement; for the latter a stockholders’ agreement).
What to Keep in Mind
Taking on third party funding can be stressful (as if starting a restaurant wasn’t stressful enough)! Here are some general tips to keep in mind:
Make sure you are comfortable getting in bed with the investor. When you take someone’s money, you become the steward of that investment. It is very important that you know or at least spend some time getting comfortable with the investor. It can make the good times better and the inevitable hard times easier.
Is the money really there? I’ve dealt with situations where a restaurant owner was told “oh yeah, I’m raising the money from some of my best buddies.” They made plans (entered into a lease, purchased inventory, etc.), and negotiated legal documents, only to have the money not be there at closing. If you are unsure, ask (respectfully) for confirmation that the money will be there for you.
Under promise/over deliver. No one wants to get sued by an investor, so it is critical to maintain good relations with investors from the start. The key is “under promise and over deliver” – be realistic with investors before they invest about the challenges the business will face and what might prevent investment returns (the best practice is to give investors some sort of disclosure document describing the benefits and risks of the venture). Then, after you raise the money, run the business so as to exceed the expectations you set.
Extraordinary rights buried in the agreement. Investors will often want their own lawyers to draft the key agreements, which can be long and confusing for the non-lawyer to read. Important investor rights can be buried deep within a 40 page document. Of course, you should have your own lawyer review the documents, but also make sure you read and understand what you are getting into, and don’t be afraid to ask questions.
Raising money from any kind of investor is a critical, but uncertain and even stressful, endeavor. Although the nuances may be difficult, these things will always keep you in good stead (they are the same things that go into a good restaurant) – use common sense, be honest, don’t be afraid to ask questions or get advice, and don’t be afraid to advocate for what you think is right and fair (for yourself, the restaurant and the investor).
Lawrence A. Rosenbloom, Esq. is a member of Ellenoff Grossman & Schole LLP in New York City. He is a corporate, securities and broker-dealer attorney who represents clients in all aspects of corporate and commercial law, with a particular focus on public and private equity finance, securities law compliance, mergers and acquisitions and broker-dealer regulation. During his career, he has developed significant experience in the life sciences and real estate sectors (including representations of restaurant owners and investors). Mr. Rosenbloom’s experience includes representation of issuers of securities as well as investors, underwriters and placement agents in connection with both public and private offerings of equity and debt securities in the mergers and acquisitions area. He can be reached by phone at 212-370-1300 or by email at firstname.lastname@example.org