Restaurant Lending
The restaurant industry is one of the most challenging industries to successfully finance, the sheer mention usually results in a negative response from most lenders. The odds are against any restaurant being successful. The failure rate for restaurants is 60% – 70% according to a number of studies (1) (2). As lenders we attempt to avoid business risk and only assume credit risk. Unfortunately funding a restaurant, particularly a start-up, is actually one of the greatest business risks any lender can take. Obviously, someone is making those loans. Are they successful, or are they just setting up their current employer for a future write-off? As a former commercial lender and equipment lessor, I have done my fair share of restaurant lending and have discovered a few things which may be helpful to anyone looking to fund a restaurant loan.

First, restaurant lending is too broad of a classification to provide any practical insight. Lending to an existing McDonald’s franchise is fairly easy relative to a start-up upper scale restaurant. I use the following classifications when evaluating restaurant loans:

Existing operation vs. start-up
Single Location Growth vs. Expansion
Franchise vs. Non-Franchise
Real Estate Included vs. Restaurant Only

These classifications help provide guidance on risk and structure.

General Rules:

1. Don’t make a restaurant loan unless you and your board of directors are comfortable restructuring the loan sometime in the future – I have seen very few restaurant loans that didn’t require some form of payment restructure at some time during the life of the loan. This might mean an additional loan during the slow season to fund a short-term gap or skipping a few payments during a difficult summer.

2. It seems that everyone wants to start a restaurant or bar. It is the second largest industry for small businesses. While this results in a large number of ill-qualified applicants, it makes liquidating an existing restaurant location a possibility.

3. Insist that the restaurant keeps all of its checking accounts at your bank. The best way to monitor the health of a restaurant is to review its checking account and accounts payables. Inadequate working capital quickly reveals itself in the restaurant’s checking account.

4. The owner should know how to manage the kitchen. If the owner isn’t comfortable in the kitchen, stay away. An owner who is comfortable in the kitchen can fill in for the kitchen manager or cook who misses a shift. They are also more attuned to food costs.

5. If the restaurant has liquor, management should understand local laws. Many restaurants have lost their ability to sell liquor and have faced huge fines because a server provided a drink to an underage patron. An overstocked bar takes up cash that could be used elsewhere. Management should be keenly aware of their liquor costs, as “overpours” are common and kill a bar’s profit.

6. As with any industry, the ability to catch a problem early has a huge impact on the potential losses that a lender may incur on a restaurant loan. Frequent visits are essential to staying abreast of problems. An empty restaurant on a Friday night is a red flag that should be immediately addressed. A brief question to a waiter or bartender can provide early insight on management or supplier problems.

7. Evaluate the owners’ personal financial statements. Boats, planes and fancy cars as a high percentage of total assets or on which there are payments may indicate a number of expensive hobbies and outside interests. Be very careful! You want an owner who will be totally committed to the venture.

8. Stay away from restaurants with new management that lack prior industry management experience. Management’s experience should reflect longevity at their previous positions and increasing responsibilities. The restaurant industry tends to attract many job hoppers. If there are conflicts, it is easy for an employee to move another job. As a lender I wanted someone who is committed. Be vary wary of people who say “I always wanted to own a restaurant” as they probably do not realize just how much work a restaurant can become.

9. If any ingress or egress issues arise, such as road construction, be very cautious. I have seen more than one restaurant close down because customers did not want to drive through the construction to get to the restaurant. These projects frequently have delays that can devastate a restaurant operator who is hanging on.

10. Key person life insurance can be a valuable asset particularly when one person is primarily responsible for the success of a business. If they can not assign an existing life insurance policy, they should get one for at least the amount of the loan (excluding small ticket purchases).

11. Lenders are poorly equipped to evaluate restaurant concepts. Too many bankers have been burned because they assumed that a franchise concept couldn’t lose. Stay skeptical; if a concept is impractical because of the community demographics or the failure of other similar concepts nearby it is best to skip making the loan.

12. I don’t know of any studies but in my experience the restaurant industry has a disproportionately large percentage of chemical abusers, whether alcohol or illegal substances. It is important to pay attention to the behavior your restaurant clients. I once had a client who lost some very valuable franchises due to a problem with cocaine. A negative situation can quickly spiral out of control.

13. Verify the restaurant’s hiring procedures. Hiring illegal immigrants is common in the industry and can cost the employer big fines and the possible loss of a franchise.

14. The build-out process for a new concept can be expensive and can quickly use available cash. It is important to review the experience of the people developing the concept and the build-out estimates carefully.

15. Stay away from the restaurant owner who has a second set of books. They are the ones with a wink who slyly indicate that the IRS doesn’t see everything. Their character is questionable and the tax authorities will eventually catch up with them.

16. The most important point, take a pass on a loan on which you do not feel comfortable. Just because it may qualify as an SBA loan doesn’t mean it is a good one. Save your bank and yourself the hassle of cleaning up a mess.

Existing Operations vs. Start-Ups

Start-up restaurant loans have the highest degree of business risk of practically any commercial loan. Banks are not equipped to take business risk; they are equipped to take credit risk. Accordingly, to avoid the assumption of business risk, a start-up restaurant loan should be supported by liquid collateral and a strong guarantor or an SBA guarantee. Do not rely on the value of the equipment. Do not rely on the concept! And do not rely on inexperienced management. If you do, the value of equipment will be lower than expected at the time it is liquidated; the concept will be flawed; and management will make expensive rookie mistakes.

Take outside collateral not only in the contingency the loan has to be liquidated, but also to ensure that management is committed to the venture.

1. Even with a great concept and an SBA guaranty, new restaurants are especially difficult to fund because of potential cost overruns and ramp-up time. In all these cases, it is best to include an interest-only ramp-up period for at least three months and preferably six-months. If the area is highly seasonal, either structure the loan with reduced payments during the off-season or set-up a seasonal line secured with outside collateral to fund difficult periods.

2. Existing operations are easier to evaluate. Use common sense and look carefully at cash flow/earnings and leverage. A view of the checkbook can provide insight about how much management is deducting from the business and if working capital is adequate. If management is disbursing excessive cash, then skip the loan. The bank should not be replacing capital withdrawn from the business. Personal and corporate credit bureaus should be obtained, but not overly relied upon as a number of vendors may not report negative information. Supplier checks with Sysco Foods or other major vendors are essential in determining the continuity of vendor credit. Seasonality should always be discussed.


1. Acquisition loans are far more challenging than growth loans. Acquisitions involve a change of ownership. When funding a new buyer of an existing restaurant, the lender should ensure that the seller is willing to hold a fair amount of seller financing. The greater the amount of goodwill the higher the amount of seller financing that should be required. The seller should also be willing to stay involved for a sufficiently long period to ensure orderly management transition. Not only should the new buyers have their assets committed, such as a second mortgage on their home, they should have cash invested in the transaction. Seller standby debt is not substitute for an owner’s equity investment, it is a supplement. Too often, the lender is left picking up the pieces of a failed business acquisition loan when new management is not committed because it had little real financial commitment. The buyer should always have real “skin” in the game.

2. When dealing with an acquisition loan, the lender should be aware of the reason for the sale. The lender should speak to the seller during the evaluation process and ask some of the critical questions that the buyer may overlook:
a. Why are you selling?
b. What is your relationship with your vendors?
c. What are the reasons for any negative operating trends noted on the balance sheet and income statement?
d. What type of seasonality have you noticed?
e. Who are your customers (demographics)?
f. Have you seen any trends?
g. Is the liquor license included in the purchase price?
h. Will you sign a non-compete?

Single Location Growth vs. Expansion Loans

1. Growth loans for our definition constitute the addition to an existing location or the replacement of equipment with newer equipment. In this case business risk has already been addressed. The lender can focus on traditional credit analysis in evaluating the loan request. Depending on the amount of the expansion relative to the size of the business, an SBA guaranty may not be necessary. It is important for the lender to file a general lien on business assets as well as a purchase money security interest if a specific piece of equipment is being acquired.

2. Expansion loans for our definition are used for the addition of another location. Often management wants to replicate their success in a second location. Although less risky than a start-up, it does have a number of similarities. Some of the common challenges of an expansion are:
a. Management may be stretched too thin, negatively impacting the performance of both operations;
b. The second location may cannibalize business from the original location; and
c. The concept may not be transferable as demographics and preferences may be different.

Franchise vs. Non-Franchise

Franchises have a number of advantages over non-franchises and a number of disadvantages. It is important not to be lulled into a false sense of security because you are already familiar with a successful franchise concept. It is important to review SBA failure rates for the franchise and understand the responsibilities of the franchisor and franchisee under the Franchise Disclosure Document (FDD), formerly the UFOC.

· Proven concept
· SBA history/ franchise review
· Consistency of product
· Franchise training
· Buying power (supplies & equipment)
· Advertising support
· Lender can use other locations as benchmark
· Possible replacement clients for failed operations

· Exposure to franchisor problems
· Franchise fees
· Premium cost for products vs. local purchasing
· Lack of control of advertising dollars
· Issues with one franchise location may impact others
· Lack of adaptability to local tastes/preferences

One of the advantages of a franchise loan is that there may be potential purchasers in the event that the first franchisee fails. Franchisor commitments about waiving or deferring new franchise fees and finding replacement franchisees can be extremely helpful with a looming default.

Real Estate Included vs. Restaurant Only

In some ways it is easier to fund a restaurant based real estate loan than just a restaurant. The critical factors depend on the amount of build-out required and lease cost relative to the cost of purchasing a location. The higher the lease cost and the higher the required level of build-out, the more attractive it is for the restaurant to acquire the underlying real estate. This is especially true when the cost of build-out is compared against the lease term. When making a significant investment in leasehold improvements, it is important to have a sufficiently long term to support the amortization of the improvements.

Though the price may be higher, the real estate value of a good location (note: it has to be a good location) tends to make the entire operation more valuable and therefore potential exit strategies more abundant. The second aspect to this is that when a restaurant tenant falls behind in rent, the landlord’s actions becomes critical in the lender’s decision making process. A restaurant that falls behind with its landlord may fail to inform the lender until it is too late. Then the lender may be forced to sell the equipment under a distressed liquidation scenario, even with a lessor’s agreement in place. The downside to funding the real estate also is obvious, greater lender exposure. Although adding real estate results in higher loan balances, it can reduce competition for better sites. Additionally, the longer amortization period for real estate loans (25 years) may actually improve cash flow for the restaurant when compared with the cost of rent and the amortization of a shorter term leasehold improvement loan.

Finally, a building purchase may make sense for certain franchise locations or the growth or continuity of an existing restaurant. Many restaurants have closed when their leases expired because the landlord wanted a large rent increase, sometimes as a result of the restaurant making leasehold improvements and building a customer base.