Why do most Restaurant Businesses fail?

If I ask you whether you want to have your restaurant, you will say YES is very high.

Everyone wants to have their restaurant. Isn't it?

There is a generally a fascination towards restaurant business irrespective to wherever you are in the world. The company or restaurant seems pretty easy as the general argument is there is a demand for food, so the business should work.

Fine. Makes sense. However, it's not that easy.

According to a report, 60% of restaurants shut down within the first year of operations, and up to 80% of restaurants close their operations in the first five years. No matter how lucrative the restaurant business seems from afar, running a restaurant business is an arduous task. These figures may make you think, ‘Why Restaurants Fail’ that too ever so often. Lack of proper information about what the industry entails ultimately leads restaurants to their failure. In this scenario, information is the key area you need to focus on. Most restaurateurs do not even know that they are doing something wrong until it is too late.

Often, the No. 1 reason is simply location — and the general lack of self-awareness that you have no business actually being in that location.

Unfortunately, that hip new part of town with cool shops and lots of foot traffic also comes with a price tag. And while it might be nice to sell meatballs right in the heart of everything, those meatballs had better be spectacular. Because the landlord doesn’t care if it’s your grandmother’s recipe. The landlord cares about rent — specifically that you pay it.

There’s also a very modern concern: technology.

It used to be that a restaurant could open fairly quietly. You had time to work out the menu and staffing issues, relative obscurity to find your voice and style, and months of experience to adequately adjust the flow and feel of the front and back of the house.

Now, you’re one bad lasagna away from wallowing in the depths of Yelp hell. And in a world where buzz is everything, nothing spells trouble like the buzz of bad service and dodgy lasagna

So what works then?

Glad you asked. The answer lies in Franchises.

Let's look at some numbers.

Here's a broad overview of the USA restaurant industry. The data suggests that,

Many people are employed in this industry, and a lot of these units cannot scale.

Restaurant Industry Facts at a Glance

• $659 billion: Restaurant industry sales in 2020, down $240 billion from expected levels

• 12.5 million: Restaurant industry employees at the end of 2020, down 3.1 million from expected levels

110,000: Restaurant locations that are temporarily or permanently closed

• 9 in 10 restaurants have fewer than 50 employees

• 7 in 10 restaurants are single-unit operations

• 8 in 10 restaurant owners started their industry careers in entry-lével positions

• 9 in 10 restaurant managers started in entry-level positions

Restaurants employ more minority managers than any other industry

So what's happening here?

Think of a restaurant; what levers of growth do they have?

Time? - Limited inventory - 7 days/at best 24 hrs

People? - customers will have limited appetite, so the average bill at any given point per customer won't change much unless the prices are increased

Prices? - can't increase much as customers will shy away

Size of the restaurant? - sure, a bigger place can accommodate more people during peak hours, but then rentals will be extremely high

This is what we call a classic Operating Leverage business. Heavy fixed cost business. Costs won't move much even if the business is high or low.

So then what's left?

Do more business with lesser space/cost - more takeaways/deliveries can achieve this.

Leverage the brand - allow others to put capital and you lend your brand name and take a cut for it (royalty).

Does this work?

Sort of.

I am not saying that a company that owns all restaurant locations can't scale; they can sort out the supply chain issues and have a brand name.

However, if the company has a brand and decides to go with the franchise option, it is generally safer + scalable.

The below data will make it clear.

What can we infer?

Margins are less if the company operates most of the stores - the case being Chipotle and Starbucks.

To have a global presence, the franchise model is the fastest model to achieve scale.

But is that it? No. there's more to it.

Let's see the final set of data.

Final Takeaways

The restaurant business is a tricky business. Unless the company has good capital, the growth is going to be extremely tricky.

A franchise is a way to diversify risk - margins may not change, but the risk will certainly go away and can be scaled faster. The company needs a brand name + can be scales fasted in terms of # of store presence.

If you have a brand like McD, you can command a premium (look at net margins), but that may not translate to share price.

You can have a brand like Chipotle - still opening more than 150+ own stores in the USA (compared to Domino's and McD - less than 20 new stores), and generating profits + returns for shareholders.

Brands like Domino's doing wonders in International markets :)

I hope this helps anyone who is reading this.

Shoutout to Parth Parikh for most of the inspiration for this article.

Until Next time.