Growing the right wayGrowing the right way

Steve

New unit development was for decades the driving force of growth at restaurant companies. That growth attracted human capital and provided career opportunities, allowing those who once labored in restaurants to work their way to top spots within organizations. It also provided certain economies of scale, such as in purchasing and marketing. 


Early in the history of chain development, market conditions also accommodated the addition of new restaurants, with demand for eating out growing more rapidly than the supply. Returns on new restaurants were strong, further supporting growth through building new units.


But the environment has changed. As the industry has become more competitive and consumer demand has slowed, returns on new restaurants have come under pressure, increasing the risk of new unit development. What has not changed is the entrepreneur’s strong desire to grow. Growth continues to have all the prior benefits of opportunity, economies of scale and the potential to create wealth.


Unfortunately, in some entrepreneurs’ minds growth has the additional benefit of providing incremental cash flow to correct past mistakes. The cash flow from opening a new restaurant, the reasoning goes, will support the losses from earlier restaurants.


While there is a chance that this strategy of “growth to correct the problems of the past” can be successful, it is highly risky, especially in an era of increased competition and declining returns on capital. Growth requires resources, both human and capital. When a company is focused on growth, its resources, usually finite, are divided, making it very difficult to focus adequately on either existing operations or new units.


Because a new restaurant is exciting, it often gets a disproportionate allocation of resources at the expense of the existing operations, creating a situation where the existing restaurants are not able to receive the investment necessary to achieve their full potential. Small chains are most vulnerable to this cycle, but larger ones, even some public ones, have succumbed to this thinking.


To avoid expansion for the wrong reasons, companies should make sure they have the following characteristics:


First, existing operations should be strong, profitable, consistently meet or exceed operating standards and provide a return on investment that exceeds the company’s cost of capital. Financial reporting and operating systems should be timely and provide a true insight on the operations and profitability of each restaurant. Cash in the bank every night does not necessarily support investment in a new restaurant.


Second, the company should have the human capital to support growth. It is easy to underestimate the time and resources required to open a new restaurant, and the diversion from existing operations it can cause. Ideally, a company should have a dedicated team for new restaurant development that is separate from the team that operates existing units. Smaller companies cannot support such a team, making it all the more imperative that existing operations are sound.


And third, a company needs the financial capital to fund its growth. Capital should be available before a lease or purchase agreement is signed. If the money is not available, funding can be a major distraction that takes focus away from operating the core business. If cash flows from existing restaurants are insufficient to fund development, the company could come under extreme financial distress.


Two words encompass the above and sum up what a company needs to expand properly: focus and discipline. Focus is essential because management must have the human resources to manage existing operations at a very high level and support the simultaneous development and operation of new restaurants.


Discipline must be present in several ways. For example, there must be the discipline to objectively evaluate the business to be sure operations are strong, and the human and financial resources are available.


In addition, assuming all the resources are available to support growth, management must develop and execute a disciplined growth strategy. That strategy should include return-on-capital hurdles, as well as general and specific location parameters — for instance, how and where to expand, targeting both geographies and specific demographics.


Opportunity — as in, “The landlord approached us and will give us a large tenant improvement allowance, so it is too good a deal to pass up” — should not drive the decision if the location does not fit other elements of the strategy. In other words, the strategy should determine the location; the location should not determine the strategy. Management must also have the discipline to stay focused.


New unit growth can be fun and provide an outward appearance of success that is irresistible to many operators. However, it is also difficult to execute and eats up valuable resources. Over the long run, focusing on existing restaurants and assuring they are operating optimally prior to adding new units will create more value than expanding before all the supporting pieces are in place. 


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].

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