Finance | June 2017 | By Kevin Hardy

What Restaurants Need to Know about True Unit Economics

A lesson in the nuances of unit economics can help restaurants better gauge the health of their system.
CFO Dominik Stein says VERTS focuses on the bottom line rather than topline sales. verts / Jessica Attie
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When investors are ready to sink their cash into up-and-coming brands, they love to find unique concepts with passionate fans, enthusiasm from franchisees, and a differentiated product offering. But little will weigh as heavily as the bottom line, says Tom Wells, vice president at BIP Capital, the venture capital firm that owns Tropical Smoothie Café and Tin Drum Asian Kitchen.

In reviewing unit economics, Wells sees the most important calculus as whether franchisees are thriving or not.

“What does it cost someone to open a new location all in, and how quickly are they able to make back that cost? We try to look for concepts that have a potential for a three-year or better payback,” Wells says. Ultimately, BIP Capital asks if franchisees make money and if those profits are compelling them to open new locations. If the franchisees do well financially, the brand will be fine, he says.

Restaurateurs throw around the term “unit economics” frequently, but it can mean different things to different operators. For example, Wells believes metrics like average-unit volume (AUV) can be misleading. At Tropical Smoothie, some of the most profitable stores are in smaller markets where competition is more limited than in bustling metros. And with lower investments (about $325,000 for a 1,600–1,800-square-foot store), franchisees can make their money back quicker than at bigger concepts with a higher price tag.

“It’s hard to fixate just on AUV because there are so many components to whether or not that franchisee’s going to make a profit,” Wells says. “What I love is that … in a more densely populated market, our franchisee can do a higher volume and make good money. But also, they can go into a tertiary market where the volume isn’t as high and make a good profit.”

A sophisticated understanding of unit economics can help refine individual store performance. In some cases, above-average performance for a new Tropical Smoothie store has pointed to a franchisee’s deep investment in pre-open marketing. Other times, poor results have implied a poor location or a lack of marketing. Regardless, Wells says, the data is worthless unless action is taken. For BIP Capital, the goal is to diagnose any potential problem with a franchisee, but to also glean insights from the best-performing operators.

Dominik Stein, CFO and cofounder of Texas-based VERTS Mediterranean Grill, a 28-unit chain of all corporate stores, says unit economics isn’t just the realm of top-level management. The performance data of each store is important for all employees to understand. But at VERTS, managers are only held responsible for things they can control, like food costs, labor hours, and sales.

“That’s a big opportunity and a big advantage we have over other companies. We keep things very simple; we don’t overcomplicate things,” he says. “The visibility is only possible if it’s easy to understand for the team members.”

The manager incentive program at VERTS doesn’t take into account factors like real estate costs or regional variations in wages—things that local store managers have little influence over. Stein says this hands-on approach means managers are incentivized by the factors they can control.

He believes too many brands over-emphasize topline revenues in weighing the health of each store. “The most important thing is always profitably, bottom line,” he says. “I think many companies underestimate that, because they always look at topline sales and don’t look at the bottom line. For us, $1 million in sales at a restaurant that’s highly profitable is so much better than a restaurant with $2 million in sales that isn’t profitable.”

Last July, Original ChopShop’s “compelling unit economics” were cited by North Carolina–based Hargett Hunter Capital Partners when the firm announced it had acquired a majority stake in the Phoenix-based fast casual that serves juices, salads, and other healthy dishes.

Hargett Hunter managing partner Jason Morgan says the firm seeks concepts with strong unit economics, but also looks for areas where those numbers can be improved. Likewise, in evaluating a multiunit concept, he doesn’t get caught up in the finances of just the highest performers.

“I like to look at the average—the stores that are in the mean, and those that are performing the poorest. If the poorest performing stores still have a strong AUV, that’s OK,” says Morgan, the former CFO of Zöes Kitchen. “I think what happens a lot of the time is people get focused on the most successful stores, and those stores sway what they think it can be going forward.”

Investors crave reliability in unit economics, but Jeff Brock, another managing partner at Hargett Hunter, says a level of variation is acceptable, so long as it can be explained by the market.

“It’s easier when all stores in multiple markets are performing very similarly and you don’t have too much variability,” he says. “But you can feel comfortable with the variation if you understand why.”

Regardless of which metrics operators and investors rely on when examining unit economics, it can sometimes be difficult to get on the same page, Brock says. At larger companies, crafty financial reporting can downplay expenses, while at smaller concepts, the books may lack detail.

“You really have to be able to peel back the onion and make sure you can verify what you’re looking at,” Brock says.

This story originally appeared in QSR's June 2017 issue with the title "Building Blocks."