Restaurant Example Using Waterfall Framework

Symon He
A free video tutorial from Symon He
Author | Investor | Entrepreneur | Stanford MBA
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Lecture description

Restaurant example using waterfall framework.

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03:57:45 of on-demand video • Updated June 2020

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English [Auto] Boo boo boo boo boo boo boo boo boo. Hey everyone in this lecture I'm going to go over how to use a waterfall structure for a hypothetical restaurant startup. Now you can adapt this waterfall framework for pretty much any business as long as you have a grasp of the cash flows. So I mean surely what it will look like right now what you're looking at on the screen here is the sample project worksheet that is provided for in the waterfall model that you have. All right now I just all I did was made some adjustments here. OK. So I'm going to assume that this is for a start up restaurant that has a certain startup costs half a million dollars and it's just going to be cash wrong. I'm taking out all debt. So basically I just modified what we had in the original model to some economics that would reflect say a restaurant startup. OK. So let's figure out what that would look like and how you would go about doing something like that. Now remember all of the waterfalls us structures are the worksheets they all flow from the cash flow line that was on row 26 so at the end of the day the only thing that feeds into those calculations is going to be this row what ever you put above it were however you want to add to it. It won't affect that as long as you change this ROE. Then it would change all of the calculations in the back so basically you can create any kind of business here up here. It could be a restaurant Servi could be a yoga studio it could be a laundromat it could be a food truck whatever it is that you're starting you need to be able to create the business model performance here. Right. Because every business can be different. And I'm not going to be able to go through every prophetical small business so that you'll get the idea once we go through this example. All right. So let's start with sales. Every small business they start of they are going to do you're going to have some sales options. OK. So for this restaurant what I'm assuming here is that in the first year it's going to do 650000 sales it's kind of its first year. It takes a while for the community to know of its existence it might take a while for the Yelpers to find it. You know first here is kind of a learning year for a new restaurant so I'm going to assume that it's going to take a year it's going to get to the second year before it really starts to get its footing. And then afterwards what I'm assuming after the second year is that every year afterwards it's sales going to stable and grow at about 3 percent a year. Okay. Just keep up with the cost of goods and inflation as it goes up. Now for a restaurant restaurants often run promotions and sometimes they might have refunds. OK. So what I'm going to assume here for the promotions is that it spends about 5 percent of its budget every year and give you running promotions that keep me coupons. It could be you know buy buy something get something half off kind of deal could be Restaurant Week whatever. Whatever promotions it's running where it's taking some kind of a discount off of its menu pricing. All right. So that's what that line is. And then I'm going to assume that there's going to be some customers or they're going to get that are going not going to be happy with either service or the food or both and that in order to avoid negative review on Yelp they're going to give some refund. OK so I'm going to assume at about 3 percent of its annual revenues will go towards refunds. OK. Now once we factor all that in what we end up having here is a net revenue. So this is revenue after promotions and refunds. Okay. Now after that we're going to have costs for running a business right especially your restaurant you're getting the waiters you're getting the cooks you're going to need different kinds of labor. They're going to have different hours maybe a store general manager who's managing everybody doing all the scheduling doing all the training might get paid more. It's going to be benefits. So I'm kind of lumping them all in right now for you as a business owner if you want a more accurate projection you need to break down these cost items into bigger into smaller line. So labor you might break it down between salaried labor and hourly labor you might break it down between managerial and non managerial labor whereas maybe you know managerial labor maybe a significantly higher rate hourly rate than the minimum wage whereas the hourly associates are going to get something like minimum wage or a little bit more than that. Right. But if you have different tiers of employees or associates at different levels of wages you want to break those down if you want a more accurate projection. Same thing for all the other categories going to break you do kind of lumped up numbers here so that we you get the gist of these examples so also for a restaurant there's going to be food costs or food related costs. Right. When you serve a plate to somebody there's there's actual food that's on there. There's also also potentially if you are doing to go or if you're kind of more of a to go place you have packaging. You have you may even have to go utensils you have sauce you have things that are related to delivering that one plate that somebody ordered. OK you got condiments as well. So all of those can get rolled up into food costs things that are directly related to the ordering of food. OK. Now I'm thinking of a kind of a fast food sort of like borderline fast food fast casual type of place so that you know where there are costs of goods food is not that high. So if you're kind of in the industry fast casual will range anywhere from 28 to 35 percent in terms of food costs. But if it's like fast food it can. You can go down to the low 20s potentially depending on what you're serving. I'm going to assume this is kind of more like fast food. But the first year they're not very good yet. They may have a lot of waste. For instance they're not they're not utilizing all of their goods. They don't know how to store it properly so they're actually losing some food costs to spoilage. And so the first year instead of instead of 25 percent food cost rate they're at 30 percent because there's still kind of learning how to be efficient and with their food costs. OK. And the same thing with labor is it's not going to be they're not going to be as effective as the first year they're going to be over hiring because you know in the first year you rather be over deployed in terms of having people working in a restaurant and not having enough people that you know if you have a lot of a long line there. People have a bad experience they never come back. Right. So it's what a lot of new restaurants do is initially they kind of overstaffed just to make sure that they don't give a bad experience and then they start to pare down and they pare down just enough so that the customers can't perceive the difference. But then the restaurant starts to say because you know sometimes you get to know when your peak hours are going to be. And then after that you know how to adjust your hours accordingly. So we're going to assume that the second year to become more efficient are going to go from 45 percent labor costs to 35 percent labor costs. Okay utilities and rent and utilities bills will change very much so it utilities maybe goes up a little bit if your sales go up. You have to use a little bit more fire electricity being in and what kind of equipment you're using or you know if you're turning on the heat or the AC Moore but otherwise rent is rent you know whether whether your reference for or not you're paying the same amount of rent. OK. So for the rent for the rainy Tillie's we can assume that it's just going to grow 3 percent a year afterwards. Okay. And there's other expenses other expenses to capture everything else you may have marketing expenses you may have like uniforms training things and insurance other things. Okay. So that's what I'm going to assume a 7 percent of the sales each year will go towards all other expenses. Okay. All right. Next what we have is this not net net revenue model let's call it gross profit. Okay. And then we have sales proceeds. And let's assume that they're not depreciating anything right now so we're going to assume that what we have here is going to be the cash flow not not not the best assumption here. What we normally have is you're investing 500000 into the startup costs some of it's going to go towards equipment and will be depreciated. So those right now I'm going to assume that depreciation is lumped up in these expenses. Okay. So this is gross profit here becomes the actual cash flow. All right. And then what I did here for Road 26 is just to make this cash flow equal to that calculate cash flow. So $500000 start up costs Okay this could be to secure the lease to do the build out and fixtures and Boulby all the equipment from a restaurant that failed beforehand. Get it for pennies for the dollar and and then start making some money from the sales of the restaurant. So based on our assumptions first year over deploying labor wasting food okay and not doing not marketing very well and still kind of ramping up business first year they're going to operate at a loss and a lot of restaurants do that in the first year it takes it takes time to really build up their sales. But we're assuming that this restaurant is going to really find its footing. A second and third years and then kind of stabilize that make in a little over 100 grand in profits every year. Now this profit is cash that is distributable This is after everything this is what we're calling distributable cash flow is what's going to flow into your waterfall framework. OK. So when you what you want. You don't want to just put profit into the into the waterfall framework. That's that's perfect for tax purposes. But if you want to know what's actually going to go in the pocket for all of the members involved you want to look at distributable cash and distribute little cash is not always the same as net profits. OK. Because for instance depreciation is something that knocks on the profits and will lower your taxable profits. But it's not a cash event so it actually doesn't do anything the cash you still have the cash to be able to distribute. So you want to use that distributable cash flows to feed into your or the waterfall framework. All right. So what we just did I give you a really simple model here to estimate what a hypothetical restaurant might look like. OK. And then I just fed it into the line. It is good on here highlighting what I just highlighted here. This could be any business that you model for yourself. And if you're starting into business going into venture with some business owners if none of your co-founders if nobody knows how to make a simple perform over the business especially a traditional business that you that you're getting into you're not ready to start the business. That's you know it's my opinion you need to be able to understand the economics of your business of the business that you're you're about to invest time and money to go into. So be able to generate something that is more complicated more more sophisticated more detailed than what I've done here. That's just for demonstration purposes. So when you're able to do that feed that line and the cash flow into row 26. And if you use this model you can easily add add more columns OK and if you need if you're building out your model we're involves the worksheets find it doesn't matter just feed it back into this role here to this worksheet. OK. And once you have that and once it feeds into this line you can use any of the calculations sheets they're pretty much all the same except they're just preset to show you what it would look like if it were two tier three tier or fourth year. OK. Or if there's a waterfall or so in this case let's take a look at this three co-founders. Let's say they all invest the same amount of of of the investment. Thirty three point three three percent. OK. And so they all have the same investment. And if there's no waterfall where the Alice here the the main founder is doing putting in more work with us she's not putting in more sweat equity than others. Everybody's getting the same return on their money right. So that's the case for them to qualify warfighting you see what that will look like based on the assumptions that are made for my hypothetical restaurant. That's pretty pretty good return. Twenty percent a year and the cash multiples five point three cents for every dollar they put in they can expect to get over $5 back over the course of the life of the project. Now you can do the same here and we can look at the two tier. Now here you see these these are the preferred return and the split. You can change that to whatever you like. OK. This is a more risky venture. Maybe maybe the preferred return is 12 percent. OK. And instead of a 65 35 split maybe it's 70 to 30 houses and doing all that much. Maybe did deserve first restaurant and she's not that experienced or she can't really negotiate terms that are in her favor as well. So she's only getting 70 30 split and we'll see that all of these here. I've kind of defaulted to feed from the previous one so you can see what it would look like except we should change the preferred returns to be the same. And once you do that you can get a better sense of how they compare. If you go to the summary page now we're not using the last two founders line so that's why they have all these errors because they didn't index anything. So there's no calculations there. Right well we'll see here that in the two three and four here because this restaurant actually does really well and it's giving good returns that you saw that and the no waterfall cases returning almost 20 percent to the investor. So if you provide any kind of waterfall work with hurdles well below the nineteen point five percent and with some kind of catch up Alice is going to do really well for her sweat equity. Okay. So this this lecture here was just to show you that you can use this waterfall framework for pretty much for any type of business as long as you're able to model out the performance for your business startup. Okay. Now if you're look you're looking at any kind of traditional business startup you're going to be able to Mahto out the cash flows for that business and you'll be able to feed it in and then utilize this waterfall framework. Thanks Bobo.