Jul 17 2007 by Jason

How Do You Value "Sweat Equity" in a New Restaurant Concept?

Every once in a while we get a question that isn’t in our specific realm of knowledge.  Yesterday we got a question about a new restaurant concept.  While VCs sometimes invest their personal money in restaurants, we don’t do these types of deals out of our funds.  Being the “full service blog” that we are, however, we tracked down the smartest restaurant consultants in the industry to guest blog today.

Laurie Aaronson and Frank Klein of AOC SF Consulting is a full-service, national consulting practice that helps restaurants form, execute and succeed.  Laurie and Frank, take it away…

Q:  My partner and I are trying to open a new restaurant concept.
We both have extensive operational background in the industry and we are
approaching potential investors by showing our sweat equity into the
deal. How can we negotiate or set a monetary value of our sweat equity
into this deal, so we can have a point of reference on how much we are
bringing into the deal and how much we are willing to give in return for
their investment? Thank you.

A:  (Laurie and Frank)  The value in sweat equity comes from the expertise and “leg work” that done by the founders that couldn’t be accomplished by the investors. 

The total value ascribed to sweat equity depends on several variables, such as the founders experience in opening restaurants, operating expertise, the other factors the founders bring to the table (such as a below market lease), the extent to which the founders will be compensated pre (pre opening management fee) and post (salary or management fee) opening, and of course, the concept itself.  

There is no formula for determining sweat equity ownership but one reference point is to determine what a consultant would cost to execute the preopening aspects of the businesses and then determine what additional assets the founders bring to the table.  A concept that may be solid but is not unique (for example, a pizzeria) adds little to no incremental value whereas an under market salary post opening and / or no pre opening compensation would increase the sweat equity percent ownership.  An extremely unique concept that could potentially attract numerous investors is going to be more advantageous for the sweat equity side.  In the end, the deal must provide an attractive potential return for the investors as well as compensate the founders for their efforts. 

While ownership is an important component of the restaurant deal, it should not be considered in a vacuum; if a founder’s goal is to maximize their ownership, the other aspects of the deal should be designed accordingly and it is important to understand that ownership is not necessarily the same thing as control (see closing paragraph) nor does it always determine how profits will be shared.

Investors will likely be turned off by deals which provide a significant percentage of cash flow to the founder before the investors capital is returned.  Therefore, it is helpful to separate percentage ownership from percentage share of distributions and utilize a different allocation of profits prior to vs. return of capital (“flip”).  If the founder’s goal is to maximize their ownership, one way to do so may be to provide a more aggressive share of distributions for investors until return of capital, which aligns investor and founder interests by providing a shorter payback period.

Just like any other transaction it ends up being what everyone can agree on without too much haggling.  The intimacy of the restaurant business mandates that “partnership” deals at least start out on a friendly basis and certainly savvy investors will have more of an understanding of what is “fair” vs. someone who is a first time investor. 

 Summary–expect to gain a decent but not aggressive salary, little to no pre opening fee, somewhere in the neighborhood of 25-50% equity, and ensure that the operating agreement keeps you in control as long as the bills are paid and no additional money is needed from the investors (unless that is part of the original deal).  But expect to give away the lion’s share of distributable cash (usually what is left over after a reserve account is kept full), until such a time as the investors are paid back.