Under a management contract, an experienced operator will take over a property (oftentimes distressed) and attempt to make it profitable. If the operator is able to generate profit, he retains a percentage of the profits for his efforts. The net proceeds from operations are then passed through to the owner.

The owner is motivated to accept the management contract relationship for the following reasons:

• If the owner is also a restaurateur, he recognizes the potential for greater profits - sometimes dramatically higher than he would be able to achieve on his own
• He avoids the responsibilities and problems of daily operations
• If the owner is not an operator, he recognizes his inability to effectively hire and direct a manager
• His potential return is higher than if he merely leased or subleased the restaurant to another operator
• If the operator improves profits substantially, the resale value of the restaurant or value of the real estate increases by healthy multiples

The restaurant management company is motivated to perform well for the following reasons:

• The higher the profit generated for the owner, the greater the reward to the operator
• The operator can expand without the need to raise a large amount of investment capital
• Success in providing profits for the owner reinforces the operator's credibility and ability to expand

Relationship Between Owner and Operator

Most restaurants have two distinct components:

1. The Operating Entity which derives revenues and incurs expenses from the sale of food and beverage, and

2. The Real Estate Entity which deals with the land, building, improvements and such related aspects as debt service, property taxes, building insurance and invested equity.

Management contract operators are concerned with the first component and owners with the second.

Typically, an owner purchases the land, building, furniture, fixtures and equipment, placing some cash down and financing the balance over a period of time. On a regular basis he pays interest and principal, property taxes, and premiums for insurance on the building and its contents. From time to time he makes capital improvements to the restaurant. The owner regards his purchase of the property and the related expenses of ownership as an investment. As such, he requires a reasonable return on that investment.

The owner contracts with the operator to run the restaurant business with the expectation the operator can generate sufficient income from the restaurant to pay the costs of operation, cover the owner's expenses of owning the property and provide a reasonable return on investment.

Under a management agreement, the owner agrees to provide working capital, bear all expenses, maintain insurance on the building and contents, and avoid any role in the restaurant operation. Among other things, the operator agrees to assume proprietary responsibility for management, handle all administrative functions, handle all cash, pay all bills, develop and execute the marketing plan, design and price the menu, plan capital improvement needs, select, train and motivate staff, maintain accurate books and records, prepare regular financial statements and prepare all sales and payroll tax reports.

The essence of the relationship is that the operator is only responsible for those revenues and expenses which pertain to the actual operation of the restaurant and over which he has control. If the operator is successful, he will generate income from the operation after management fees which will then flow to the owner.

Whether or not the income is sufficient to cover the owner's expenses and expected return on investment is another matter. Obviously, the operator has no control over how much the owner paid for the property and thus cannot be accountable for the adequacy of the income flow with respect to covering the owner's real estate investment. It is in the operator's best interests, however, to maximize profitability of the restaurant which in turn maximizes cash flow to the owner.

Management Fee Formula

Generally, management companies are paid a percentage (2-5%) of gross sales, called a Basic Management Fee (BMF) plus a percentage of the operating income (15-25%) called an Incentive Management Fee (IMF). The BMF covers the operators organizational expenses and rewards him for increasing sales. The IMF is the reward the operator receives for delivering profits to the owner. Typically, IMF accounts for about 60% of the fees received by a management company.

Pitfalls of Management Contracts

Management contracts can create problems as well as solve them. Listed below are a number of areas that can be potential causes of dissatisfaction between owners and operators:

• owners do not understand the nature of the relationship
• owners do not understand the terms of the contract
• owners attempt to interfere with the operation
• owners hesitate to make needed capital improvements
• operators do not perform as well as anticipated
• operators pad their expenses to divert assets
• operators fail to perform needed maintenance in order to increase short term profits
• operators fail to adequately promote the restaurant in order to increase short term profits
• operators favor one of their operations over another

As might be expected, there are occasionally disagreements between owners and operators as to what constitutes operating expenses as distinguished from ownership expenses. The best solution lies in a clearly worded management agreement which addresses these areas in detail and provides appropriate incentives and safeguards to all parties. Ultimately, of course, the real measure of "workability" in a management contract is reflected in the level of respect and trust between the owner and operator.

Profile of the Successful Operator

The restaurant operator who succeeds in generating a stable, consistently profitable operation generally shows the following characteristics:

• is passionately and single-mindedly focused on guest service
• thoroughly understands the aspects of the retail, manufacturing and service industries
• has a significant vision, depth of knowledge and technical competence
• demands tight controls and sound accounting practices
• requires daily information to keep on top of the operation
• responds with appropriate action in a timely manner
• knows how to develop and implement restaurant marketing plans
• is effective in the complex areas of staff training, productivity and motivation
• takes a real delight in the professional development of the restaurant's staff
• has high standards of quality and performance
• is able to deal effectively with a wide variety of unexpected challenges
• is profit-oriented and willing to spend money to make money
• maintains a perspective on the operation, its place within the market and its potential for improvement
• genuinely enjoys the restaurant business
• is able to maintain a sense of humor and positive attitude

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