For aspiring restaurateurs hoping to make their brick-and-mortar dreams come true, funding their projects can be a daunting challenge. Traditional bank loans are the most common methods for financing a restaurant project and often feature the most amenable repayment options. Still, because many banks view restaurants as high-risk projects, “they tend to have very rigid parameters on who they will lend to, how much debt you can get, [and] what the terms of that debt is,” says Erik Herrmann, partner and head of the investment group for CapitalSpring, a private equity firm that regularly lends to restaurant concepts.
If a bank loan proves to be a less-than-ideal funding path, restaurant groups have other possible avenues to explore. We asked Herrmann to talk us through the world of alternative funding, and here’s what we learned.
What is alternative funding?
Bank loans, while the most conventional form of financing for restaurant projects, come with both rigid requirements and rigid repayment structures. Herrmann tells us that restaurant groups in need of more flexible loan terms may struggle with bank loans because “banks have heavy amortization requirements.”
Amortization refers to the process of covering both the principal of a loan and the corresponding interest through regular payments made over time, and Herrmann says that amortization structures can be “a real constraint on [a restaurant’s] cash flow.”
So what alternatives are available to hospitality groups who would prefer to avoid standard bank loans?
Popular possibilities include term loans; Small Business Administration loans; lines of credit offered through online-only lenders; merchant cash advances that provide restaurants with short-term lump sum loans that they can repay through a daily or weekly cut of their future credit card sales; private equity lending; individual peer-to-peer investors; and crowdfunding through platforms like Kickstarter.
In addition to more gentle amortization terms (Herrmann says that “amoritization light” structures offered by alternative lenders can “cut down from paying up to 15% down to 1% to unlock a huge amount of cash flow”), alternative lenders might introduce options like “pay-in-kind” interest features, through which restaurants can defer their interest payments and allow them to accrue until the loan matures and they’re in a more stable financial position for repayment.
Which types of hospitality businesses could benefit from alternative funding?
Alternative funding can be an attractive proposition for restaurant concepts dealing with a number of different situations.
For example, a new single-location venue might not have the credit rating or financial documentation to qualify for a traditional bank loan, and an alternative lender could offer more flexible terms. Also, because alternative lending generally takes less time than standard bank loan applications, businesses in need of quick cash can benefit from these accelerated time lines.
But why would fast cash be necessary for restaurant groups? Herrmann floats a couple of possibilities: “Maybe they have a big acquisition they want to do, and they need a bunch of capital to come in and support new location development. Or maybe they want to buy out a partner, and they need capital to do so.”
Of course, it’s important to consider that the convenience and flexibility of alternative lending comes with consequences. Alternative funding generally features much higher interest rates than typical bank loans, so while they could give a fledgling restaurant the startup capital it needs to get off the ground, paying back that money plus interest may be a greater burden than the restaurant can realistically shoulder.
Herrmann says that alternative lending through online banks and private equity firms generally makes more sense for larger restaurant groups, as individual restaurants may benefit more from “local community banks,” which can both offer lower rates and give new businesses guidance on how to thrive in their neighborhoods. But crowdfunding can be a viable path for single-location eateries, especially those with compelling stories that can attract small-scale investors.
As for private equity firms and direct lending, these alternatives fall into a category of straightforward investing, which removes some of the bureaucratic red tape involved with bank loans. But restaurateurs must consider the fact that taking on an investor, whether that be an individual or a firm, means that they’re no longer the sole owner of their business. Profits must be shared, responsibilities must be divided, and setbacks must be accounted for. Whether this makes sense for your restaurant concept depends on your goals and your desire for autonomy, but if you’re determined to remain the sole owner of your hospitality project, explore online banks and lines of credit or stick with the tried-and-true funding method of a brick-and-mortar bank loan.
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