For years, it has been a foregone conclusion, when you get into the restaurant business, hours are going to be long and margins are going to be tight. But does it have to be this way?
First, lets explore the prevailing wisdom when it comes to restaurants. Operating a restaurant involves a delicate balance of cost management and revenue generation. Restaurant profit margins are notoriously tight, typically ranging from as low as 3% for full-service restaurants to about 9% for fast-food establishments (Restaurant365) (WebstaurantStore). This narrow profitability is due to several factors, primarily the cost of goods sold (COGS) and labor, both of which can vary significantly depending on the location and type of restaurant.
Breaking Down Costs: Goods and Labor
The cost of goods sold (COGS) includes all the expenses directly involved in the production of the dishes served, such as food ingredients and beverages. Labor costs, on the other hand, cover wages, benefits, and other compensation paid to staff. In different states, labor costs can significantly affect profit margins due to varying minimum wage laws and the availability of skilled labor. For example, a state with a higher minimum wage might lead to higher operational costs, thereby squeezing the profit margins even further.
In most great restaurants, they are able to keep COGS + Labor (also known as Prime costs) in the 60-65% range. In the best they are in the area of 50% - 55%. Some restaurants are in the 70-75% range. These don't last long.
Evolving Business Models to Boost Profits
To combat these financial pressures, many restaurants are evolving their business models to find new revenue streams and enhance profitability:
Diversification of Services: Some restaurants have expanded their services to include catering, online deliveries, and even meal kits, which help to increase sales volume without significantly increasing overhead costs (Sage).
Technology Integration: Implementing advanced POS systems and using data analytics for better inventory and menu management can reduce waste and optimize pricing strategies (Restaurant365).
Dynamic Pricing: High-end restaurants, in particular, are experimenting with dynamic pricing models where menu prices vary based on demand, day of the week, or season (DoorDash).
Loyalty Programs and Promotions: Establishing loyalty programs can enhance customer retention and increase average spend per visit, thus boosting overall margins.
Case Studies and Success Stories
Several successful restaurants have demonstrated the effectiveness of these strategies. For instance, fast-casual chains like Chipotle and Panera have leveraged economies of scale and efficient supply chain management to maintain profit margins despite high labor costs (Owner.com). Additionally, innovative fine dining restaurants have adopted premium pricing strategies that reflect the exclusivity and unique dining experiences they offer, thus allowing them to sustain higher profit margins (DoorDash).
Here's a breakdown of average profit margins for different types of restaurants:
Type of Restaurant | Average Profit Margin |
Independent Full-Service Restaurants | 3-5% |
Fast Food Restaurants | 6-9% |
High-End Restaurants | 6-15% depending on the specific business model and market conditions |
Full-service restaurants, which offer comprehensive table service, generally see profit margins in the range of 3-5%. These types of restaurants have higher labor and operational costs due to their extensive customer service and dining experience (Restaurant365).
Fast food restaurants, characterized by quick service and lower labor costs due to more standardized and pre-prepared food options, typically enjoy profit margins of 6-9%. Their efficiency and high-volume sales contribute to these relatively higher margins (Restaurant365) (WebstaurantStore).
High-end restaurants can have varying profit margins, usually between 6-15%. This range is broader due to the diversity within the category, from fine dining establishments with extensive and costly menus to those that might operate with more efficient cost structures (Sage).
If you are a restauranteur that wants to eventually exit your business for a healthy profit after your investment and toil, here are some multiple averages for a service business that we were able to find through a simple Chat GPT prompt.
The valuation multiples for restaurants in the U.S. have shown some variability over the past decade, reflecting changes in market conditions and industry trends from 2014 to 2024. Here's a broad overview based on the data gathered:
Revenue Multiples: The revenue multiples for restaurants have generally ranged around 0.32x to 0.48x. This multiple is crucial for understanding the market value of a restaurant relative to its total sales (Peak Business Valuation).
EBITDA Multiples: More commonly used, EBITDA multiples have varied more significantly, typically seen in the range of 2.80x to 3.65x for average scenarios. This metric is vital for investors as it excludes non-operating expenses, providing a clearer picture of a restaurant's operational profitability (Peak Business Valuation).
SDE Multiples: For smaller or individually owned restaurants, Seller’s Discretionary Earnings (SDE) multiples are often applied, ranging from 2.14x to 2.96x. This multiple is particularly relevant for valuing small to medium-sized restaurants (Peak Business Valuation).
So what does this mean for a restaurant that does $2 million in annual sales with a 6% - 15% EBITDA margin of ($120,000 - $300,000 EBITDA).
This would mean a purchasing company (if one existed) for this business would purchase the business at between: $336,000 to a high end of $1,095,000.
That is not a bad exit, but after capital gains, paying off any debt, profit sharing plans, a nice house and a vacation, it doesn't amount to much. Let's say it took you 10 years to build that business, that is no more than $100,000 a year in enterprise value created assuming the highest possible scenario here.
Contrast this to technology / subscription software companies. Here is the average multiple on subscription technology companies over the same time period. Again, I did a quick Chat GPT prompt to get this data, it can be fact checked if you like, but I'm sure it's within a few french fries of accurate.
Restaurant Businesses: The average revenue multiples for restaurants have been relatively modest, ranging from 0.32x to 0.48x. EBITDA multiples are generally higher, ranging from 2.80x to 3.65x, reflecting the operational profitability of these establishments (Peak Business Valuation).
Consumer Marketplaces: Valuation multiples for consumer marketplaces, particularly those at scale, have been higher. These businesses have been valued around 1x their annualized Gross Merchandise Volume (GMV), which often translates to about 6-8x annual revenue for leading category marketplaces. This is due to their operational leverage and the scalability of their platforms (Version One).
Subscription Software Companies (SaaS): SaaS companies have experienced even higher valuation multiples due to their scalable business models and recurring revenue streams. Revenue multiples have varied widely, with a median of around 5x to 7x, but can peak much higher depending on growth rates, market leadership, and sector. EBITDA multiples have similarly been high, reflecting the premium investors place on the future cash flows these companies can generate. The median EBITDA multiple was found to be around 16.5x, with top performers in the sector achieving multiples as high as 32.6x (Aventis Advisors).
Comparing the two models
These multiples for software and marketplace businesses range in the 12 times to 18 times, to as much as 50 times as valuable for these business. This means, if over time you spent 10 years building a software business to $2 Million in revenue vs your restaurant, you could be looking at a $12 million to $16 million exit. This is quite a bit different then the $300,000 to $1 million exit with the restaurant's existing business model. Compare it on a 10 year basis to enterprise value created and on average you created $1.2 to $1.6 million a year in enterprise value vs the $100K or so a year you created with the standard restaurant model.
But how can 1 or a few restaurants create a sustainable subscription business?
This is a tough questions. There are reasons people pay $15 a month for netflix, they can watch an endless supply of content, anywhere, anytime. But for a single restaurant or small restaurant group, it is difficult to conceive of a subscription business that many people would actually find value in, plus, your margins are so low to begin with, it would be highly risky to eat them up with a big discount membership program. Prices, labor and other market factors are too volatile. So it seems, there must not be any room for innovation, right?
Wrong.
PassPass is literally revolutionizing our business. It's not hyperbole. We are a seasonal restaurant. Last year, we took home about $30,000 in profit. With PassPass, our goal is to sign up 2,000 members over the next 2 years. This would bring us another $60,000 a year in revenue, and it's all profit. Its a total game changer - Joe, GM The Lumberyard Pub
Lets examine what a $2 million restaurant looks with incorporating PassPass.
At an average of ticket of $50 this equates to 40,000 tickets. Assuming this business has 25% repeat customers, this would be 30,000 unique customers.
At a 5% conversion rate of these customers into PassPass subscribers over 3 years, this would equate to 2,000 members a year (6,000 in total). members. At a $2.50 per month revenue share ($30 per year), this equates to $15,000 a month ($180,000 annual) in revenue with near 100% gross profit margins.
At a revenue multiple on recurring revenue of 3X, in the process of selling this business, it would increase the enterprise value of the restaurant to $540,000 to $2,700,000 (plus the value of the service business of $336,000 to $1,095,000.
By implementing a subscription business model and leveraging the core business to persuade subscribers to register for the PassPass program, this business went from a low end of $336,000 exit to a low end of $876,000 to a high end of $3,795,000.
Analyzed another way, what if the core business was a $5 Million business? What if you have 2 restaurants? 5 restaurants? With PassPass, leveraging your core business to build an adjacent subscription, tech based business is a no brainer. Because it's a new concept, there will be early adopters and those that resist change. But those that do not eventually adopt a modern solution to growing sustainable revenues, will be more susceptible to the whims of the marketplace and broader macro economy. And certainly, will not be the beneficiary of the types of exits that people who put their time, energy, investment and passion into better business models with higher multiple upside.
Conclusion:
With all this being said. I personally think the case is clear here. Business owners need to rethink their businesses. Is it better to sell a cheeseburger for $15 and make $1.50 profit? Or is it better to sell the burger for a $5 discount, to earn $30 in profit over the next 20-30 year?
The choice can be pretty simple if you understand the numbers.
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