Private Equity Restaurant Investment: Preparation Strategies For Success

Preparing for a private equity investment in a restaurant is a complex process that requires a significant commitment of resources. It involves a range of considerations, from legal and financial regulations to strategic planning and due diligence. Here are some key steps to help restaurant owners and operators navigate this process:

- Understand the regulatory landscape: The sale of securities is highly regulated, and it's important to be aware of state and federal securities laws. Seek guidance from legal professionals experienced in private offerings to ensure compliance and avoid potential pitfalls.

- Form and structure your entity: Determine the legal and tax structure of your business, selecting the appropriate business entity type (corporation, LLC, LP, etc.) and establishing clear foundational documents that specify decision-making processes, capital contributions, and profit and loss allocation.

- Protect your intellectual property: Clarify the scope of the investment, distinguishing between investments in individual restaurant units and the broader concept or brand. Consider creating a separate entity to own the intellectual property, such as trademarks and recipes, to maintain control over your concept.

- Develop a comprehensive business plan: Investors want to understand what they are investing in. Prepare a detailed business plan that communicates the opportunity, anticipated return on investment, and how the funds will be utilised.

- Identify the right investors: Look for investors whose values, goals, and beliefs align with those of your restaurant. Consider their experience in the foodservice industry, the size and outcome of their previous investments, and their strategic orientation.

- Prepare due diligence materials: Conduct an in-depth study of your restaurant's financial, legal, commercial, and operational status. Identify any red flags that could impact the transaction and develop a clear understanding of your restaurant's value.

- Engage advisors and intermediaries: Consider working with sell-side advisors or investment bankers who have expertise in the foodservice industry. They can guide you through the process, provide valuable connections, and help streamline negotiations.

- Define deal breakers: Know your non-negotiables before entering into discussions with potential investors. This may include the minimum acceptable enterprise value, the role of key players, and other essential factors.

- Prepare for post-investment changes: Selling to private equity often leads to significant disruptions and changes in your business. Be prepared for potential restructuring, cost-cutting measures, and the implementation of specialised expertise to maximise the value of the company.

Understand the legal and logistical pitfalls of raising investment capital

Raising investment capital can be a complex and challenging process, and it's important to be aware of the potential legal and logistical pitfalls. Here are some key considerations to help you understand and navigate these pitfalls when seeking private equity investment for your restaurant:

• Securities Laws and Regulations: The sale of securities (taking investment money to run a venture and pay profits) is highly regulated. In the US, the Securities Act of 1933 requires any offer to sell securities to be registered with the SEC or meet an exemption. Failure to comply with securities laws can have significant consequences. It is crucial to consult with an attorney experienced in private offerings to ensure you navigate these regulations effectively.
• Accredited Investors: Ideally, you will sell securities to "accredited" or "sophisticated" investors. Accredited investors meet specific criteria indicating financial wherewithal, such as a net worth of $1,000,000 (excluding their primary residence) or a certain level of gross income. Selling securities to unsophisticated investors is not recommended, as they are more likely to be taken advantage of.
• Form and Structure Your Entity: Consider the legal and tax structure of your business entity. Choose the appropriate type of entity (corporation, limited liability company, limited partnership, etc.) and establish foundational documents that outline how your business will operate, including decision-making processes, capital contributions, and profit and loss allocation.
• Friends and Family: Approaching friends and family for investment does not exempt you from federal or state securities laws. Properly document these transactions to comply with regulations and protect both the investors and your company. Treat friends and family as you would any other investor to maintain control over your business and avoid potential issues.
• Tax Structure: Understand the tax implications of your entity structure. There are two main types of entity taxation: corporate and pass-through. Corporate taxation, where the entity is taxed as a C-corporation, requires annual tax returns and has restrictions on profit allocation. Pass-through taxation, on the other hand, passes profits and losses directly to the entity's owners.
• Intellectual Property: When raising equity, clarify whether investors are investing in a specific unit or the entire concept, including future growth. Create a separate company to own the intellectual property (logo, trademarks, recipes, trade secrets) to maintain control over the concept.
• Equity Structure: Build an equity structure that aligns with the founders' desires and expectations. Consider separating equity into voting interest and financial interest, allowing for creative investment deals. Consult with a CPA and an experienced business finance and formation attorney to structure ownership interests effectively.
• Disclosure and Transparency: Provide a substantive disclosure document to every investor. This document should include specific disclosures, such as the investment amount, equity exchange, investment proceeds, and anticipated return on investment. Ensure that all information is accurate, reasonable, and not misleading.
• Working Capital: Don't underestimate the working capital needed to operate your restaurant. Include sufficient working capital in your initial capital projections to cover expenses during the stabilization period, as you may experience spotty cash flow and limited assets.
• Partnerships: If forming business partnerships, ensure good partnership agreements are in place. Address operational questions, profit and loss allocations, and investor repayment terms from the outset to avoid potential issues down the line.

Know the rules and regulations around selling securities

Before selling securities, it is important to understand the rules and regulations that govern such transactions. In the United States, the sale of securities is primarily regulated by the Securities and Exchange Commission (SEC), which was established by the Securities Exchange Act of 1934. The SEC has oversight, regulatory authority, and disciplinary power over the securities industry, including brokerage firms, transfer agents, and securities organisations.

One of the key requirements for companies offering securities to the public is to register the securities with the SEC. This ensures that investors receive adequate information to make informed investment decisions. However, certain exemptions from registration exist under the Securities Act of 1933 and its Regulation D, which allow companies to sell securities privately without SEC registration. These exemptions include private equity, venture capital, high-yield bonds, and investment-grade debt.

When selling securities, it is important to comply with the antifraud provisions of federal securities laws, which prohibit false or misleading statements about the company and the securities offered. Criminal, civil, and administrative proceedings can be initiated by the government, and private parties can also take legal action under certain securities laws.

It is worth noting that private placements, or unregistered offerings, are often used by companies to raise funds from investors. While this provides an opportunity for investors to participate in private equity and private debt securities, it also carries a higher risk of loss. Investors should carefully review the offering materials, ask educated questions, and understand the risks involved before investing in private placements.

To summarise, when preparing for a private equity restaurant investment, it is crucial to familiarise yourself with the rules and regulations surrounding the sale of securities. This includes understanding the role of the SEC, complying with registration requirements or exemptions, adhering to antifraud provisions, and being cautious when considering private placements.

Form and structure your entity

Forming and structuring your entity is a critical decision when creating a business and should be one of the first steps when preparing for private equity investment. There are two elements to consider: the legal structure and the tax structure.

Legal Structure

The legal structure of your business entity includes the type of entity you select (e.g., corporation, limited liability company (LLC), limited partnership (LP), etc.) and the foundational documents that outline how your business will run. Regardless of the type of entity chosen, it is crucial to specify decision-making control, capital contributions, and any special agreements regarding profit and loss allocation in your foundational documents.

Tax Structure

The tax structure primarily focuses on how the entity is taxed. There are two types of entity taxation: corporate and pass-through.

Corporate Taxation

Corporate taxation, where the entity is taxed as a C-Corporation, requires annual corporate tax returns to be filed with the IRS and most state taxing authorities. Owners (shareholders) are taxed when profits are distributed, and there are several formalities to adhere to, such as annual board of director and shareholder meetings, to maintain liability protection. Allocating profits and losses in ratios different from ownership percentages can be challenging. Due to these factors, independent restaurant companies seeking investors typically avoid C-Corporations.

Pass-Through Taxation

Pass-through taxation occurs when an entity does not pay corporate tax, and profits and losses are passed through to its owners, such as LLC members or partners in a limited partnership. While LLCs and partnerships can elect to be taxed as corporations, there are usually few reasons to do so.

Considerations for Investment

When seeking investment, it is essential to be aware of the limitations of certain tax statuses. For example, S-Corporation (S-Corp) tax status restricts an entity to a single class of investors, limiting the ability to provide investors with different voting or distribution rights. Additionally, S-Corps can only accept investments from individuals, excluding many large investors that use entity investment vehicles.

The selection of the appropriate entity structure is crucial and should be approached with the assistance of both an accountant and an attorney. While creating an LLC through a secretary of state website may seem simple, there are numerous issues to consider based on your goals and prospective investors.

Protect your intellectual property

Protecting your intellectual property is a critical aspect of preparing for a private equity restaurant investment. Here are some detailed instructions to help you safeguard your restaurant's intellectual property:

Understand the Types of Intellectual Property in the Restaurant Industry:

Firstly, it's essential to recognize the different types of intellectual property that are specific to the restaurant industry:

• Trademarks: These protect the names, logos, and brands associated with your restaurant and its menu items. For example, New York chef Dominique Ansell trademarked the name "Cronut" for his unique pastry creation, preventing others from using the same name.
• Copyrights: These safeguard original works of authorship, including menu designs, marketing materials, websites, blogs, and website content.
• Trade Secrets: Recipes, customer and vendor lists, and unique kitchen processes can be protected as trade secrets. It's crucial to maintain confidentiality and have employees sign nondisclosure agreements.
• Patents: While more challenging to obtain, patents can protect unique inventions or processes in the food industry.

Identify and Prioritize Your Intellectual Property:

Take an inventory of all the intellectual property associated with your restaurant. This includes tangible and intangible assets, such as recipes, brand names, customer experience elements, and any unique processes or inventions. Prioritize the intellectual property that is most valuable and distinctive to your restaurant.

Consult with Legal Professionals:

Engage the services of a lawyer or legal team specializing in intellectual property law, particularly in the restaurant industry. They can guide you through the complex process of protecting your intellectual property and ensure that you have the necessary registrations, trademarks, copyrights, and agreements in place.

Implement Confidentiality and Non-Disclosure Agreements:

As mentioned, trade secrets are a crucial aspect of intellectual property in the restaurant industry. To protect recipes, customer lists, and kitchen processes, ensure that all employees, contractors, and vendors sign comprehensive nondisclosure and confidentiality agreements. These agreements should clearly outline the expectation of secrecy and the potential consequences of disclosure.

Monitor and Enforce Your Intellectual Property Rights:

Stay vigilant in monitoring and enforcing your intellectual property rights. Regularly review your trademarks, copyrights, and trade secrets to ensure they are up to date and continue to provide the necessary protection. If you become aware of any infringements or potential violations, take prompt legal action to protect your rights.

Consider the Impact of Private Equity Investment on Your Intellectual Property:

When preparing for a private equity restaurant investment, be mindful of how this may impact your intellectual property. Ensure that any agreements or contracts with the private equity firm acknowledge and respect your intellectual property rights. Additionally, consider the potential for future changes in ownership or management and how this could affect your ability to maintain control over your intellectual property.

By following these steps, you can effectively protect your restaurant's intellectual property before and after a private equity investment. This will help safeguard your unique offerings, brand reputation, and competitive edge in the market.

Prepare a substantive disclosure document

A substantive disclosure document is a crucial aspect of seeking private equity investment, as it provides investors with detailed information about the company's performance, position, and cash flows. This document should be carefully crafted in collaboration with legal and financial experts to ensure compliance with securities laws and to protect yourself from potential litigation. Here are some key considerations for preparing a substantive disclosure document:

• The "Ask" and the "Return": Clearly communicate the amount of investment you are seeking and the corresponding equity offered in exchange. Include a minimum investment amount, considering that small denominations can attract a larger number of investors.
• Investment Proceeds: Outline how the investment funds will be utilised, providing a detailed and verified budget. Ensure that the budget information includes all costs associated with the project and disclose any fees, payments, or salaries that will be paid to individuals linked to the business.
• Anticipated Return on Investment: Describe the expected return on investment for investors, including any accelerated profit distributions, preferred returns, or investor discounts.
• Company and Project Information: Provide comprehensive information about the company, including the founders' background, financial history, and treatment of intellectual property.
• Real Estate and Demographic Criteria: Share your desired criteria for the restaurant's location, taking into account real estate and demographic factors.
• Warranties and Disclaimers: Include relevant warranties and disclaimers to manage expectations and mitigate potential risks.
• Investor Suitability: Assess the suitability of potential investors, considering factors such as their financial wherewithal and sophistication.
• Limits on Investor Participation and Resale: Clearly define any limitations on investor participation and their ability to resell their interests.
• Risk Factors: Identify and disclose potential risks that could impact the company's performance, including external factors specific to your industry or location.
• Dependencies and Assumptions: Explain the factors and assumptions that your financial projections and budget are based on, providing transparency and context for investors.

Remember that the disclosure document should be a truthful and comprehensive representation of your business and the investment opportunity. It is essential to seek legal advice to ensure compliance with federal and state securities regulations and to tailor the document to your specific circumstances.

Frequently asked questions