Minority investment, major returnMinority investment, major return

About three years ago, I wrote a column encouraging mature restaurant companies to provide capital to emerging brands, essentially becoming venture capitalists for promising early-stage concepts.

At the time, there were many reasons capital was more difficult for smaller enterprises to secure. Among them, the public markets had changed. Even Chili’s Grill & Bar and Outback Steakhouse, which had raised significant public equity as smaller chains when they initially went public in 1981 and 1991, respectively, would not have been as successful in 2010. The economy was at a crawl, the debt markets were nearly closed to smaller companies, and cash-flow lending — so important to many restaurant operators — was virtually nonexistent.

I argued that the strategy of mature companies providing capital to emerging concepts would benefit both entities. For the small company it would mean growth capital. And for the mature company it could provide a vehicle to maintain growth.

I also made the point that, in my opinion, the preferred form of investment was through either a minority equity position or some form of convertible debt, as opposed to buying the entire company. That approach would maintain the emerging concept’s entrepreneurial spirit, which is typically lost when a larger company takes over a smaller one.

I cited as an example when Scottsdale, Ariz.-based P.F. Chang’s China Bistro Inc. gave to True Food Kitchen in 2009 a $10 million credit facility, with the option of acquiring a 51-percent majority interest in the concept. P.F. Chang’s agreed in February 2012 to act on the option. Four-year-old True Food Kitchen, which is owned by Scottsdale-based Fox Restaurant Concepts, has since grown to six units and is poised for more growth.

Much of what was true three years ago remains true today. But have any companies followed the template laid out in that first column? The short answer is: only one of which I am aware.

In mid-March, Buffalo Wild Wings announced it had made a minority investment in PizzaRev, a three-unit fast-casual pizza chain located in Los Angeles.  Buffalo Wild Wings, a 900-unit casual-dining chain based in Minneapolis, also indicated it was looking for additional similar investments.

Only time will tell if the investment in PizzaRev augments Buffalo Wild Wings’ growth and adds to shareholder value. Although details of the exact structure of the investment are not known, I believe that there is a greater probability of success with Buffalo Wild Wings’ owning a minority rather than majority position in PizzaRev.

It is likely that PizzaRev will be able to maintain its culture more easily than if it were controlled by Buffalo Wild Wings. Over the years I have observed that the culture of the larger concept tends to take over that of the newly acquired smaller one, often resulting in the loss of the burgeoning brand’s soul and therefore some of its competitive differentiation.

PizzaRev’s founders should be in a position to prevent this from happening. And even though Buffalo Wild Wings does not have complete control, it will be able to impart discipline and professionalism in areas where earlier-stage companies are typically lacking, such as growth strategy, site selection, purchasing and training.

Meanwhile, PizzaRev’s ability to capitalize on Buffalo Wild Wings’ experience and expertise — in addition to its capital — is likely to increase the probability it will be able to grow profitably.

Ruby Tuesday’s acquisition of Lime Fresh Mexican Grill was a variation of the strategy I outlined three years ago. Ruby Tuesday originally became involved with Lime Fresh as a franchisee, building several restaurants to better understand the concept’s operations before acquiring the chain a little less than two years later.

With Ruby Tuesday having acquired complete control of Lime Fresh so early in its life cycle, it will be interesting to see if the cultural pitfall is avoided.

Based on the acquisitions of the last three years, there is limited buy-in to my suggestion of mature companies taking minority positions in emerging chains.  Nonetheless, I continue to think that it is a good strategy and preferable to outright ownership.

 Private equity investors are beginning to seek out smaller companies in which to invest, playing the roles of second- or third-round venture capitalists. While this is a good source of growth capital for the industry and could make knowledgeable industry executives accessible as board members and advisors, it is likely that many entrepreneurs would prefer to align themselves with an operating company because of the in-depth operating knowledge that would be available to them.

Restaurant operators can either choose to become involved in early-stage companies now through relatively low-risk minority investments or acquire the larger private equity-backed companies for significantly more money in the future. If I were a shareholder, I’d rather see the smaller investment now.

Steve Rockwell has 30 years of experience in the restaurant industry, including as a restaurant analyst, finance executive, investor and consultant. He is a partner in Results Thru Strategy, a consulting firm based in Charlotte, N.C., and can be reached at [email protected].