Article

Restaurant Management Agreements: The Advantages and Pitfalls

With so many different styles of operation and ownership available, there is no cookie-cutter formula for restaurant formation.

Sole proprietorships, partners, concept creators and private equity investors, and corporate minichains are but a few of the varieties one can find just on one busy urban corner. Further, there are many different types of owners, from culinary professionals to ex-restaurant managers, to Mom and Pop who make delicious fried chicken at home and are told by their friends that they should start their own restaurant.

These different owners have as many different reasons for using management agreements. For example, a company may enter into a management agreement with the owner as a kind of employment agreement. The multiunit operator may form a management company as a way to streamline back-office responsibilities and expenses for those units. Additionally, owners may employ an outside, third-party management company to run various aspects of the restaurant, up to and including all operations. Management agreements are very effective tools in streamlining restaurant operations. They can cover everything from detailing responsibilities for employee matters. For simplicity's sake, we will look at the management agreement from two perspectives: in house and outside. In both cases the restaurant will be referred to as the "owner," and the management company will be the "operator."

The In-House Arrangement

For many restaurateurs, the "management fee" is viewed as a salary replacement, paid as a percentage of gross sales. Startups often budget for a management fee of anywhere between 1 and 6 percent of gross sales as a way to compensate the working owner for the time required to keep the place running. Unfortunately, they often fail to use a management agreement to spell out responsibilities for operations, payments, services, indemnities and more.

Whether you own a single unit or are running multiple units or concepts, the management company should be a separate entity from the restaurants. Especially if there are other owners in the restaurant(s), there should be a written management agreement that spells out the parties' responsibilities (specifics on some of those items are mentioned later in this article). As with any policy, the simple rule is twofold: 1. Write it down. 2. Enforce it. If the management company receives a management fee and charges the restaurant(s) for expenses it incurs on its behalf (e.g., insurance, public relations, attorney, accountant), they should be clearly designated in the agreement as operational expenses that can be charged back to the unit(s).

The last thing the owner wants is to be in a deposition testifying about the money that flowed out of the company as a "management fee" without an agreement stating terms. The next-to-last thing the owner wants is to be in a deposition testifying about why there was a management agreement in place, but no one ever followed it. In-house management agreements can be a very useful tool for the seasoned restaurateur, especially if there are multiple units in the picture. Management companies are also a useful tool in preparing for growth, and as systems become established, economies of scale make implementation across multiple units easier.

The Outside Arrangement

Mom-and-pop, second-career foodies and even chefs, beware! There is much more to the restaurant business than the myriad cooking shows would have you believe. You are far more likely to need the experience and diversity of an outside management company than owners with experience "in the business."

Dean McSherry, owner and founder of DSM Hospitality, has extensive experience working with owners. When asked about the benefits an outside management company can bring to a restaurant, McSherry said, "This arrangement can create many advantages for the owner. The management company usually comes with a team of experienced food and beverage experts that know the challenges of day-to-day restaurant life. It also should provide best business practices in accounting, payroll, insurance and human resources. Additionally, if the management company has multiple accounts, it may also have national account pricing of food, beverage, services and supplies, which can greatly enhance the profitability of the operation. Finally, it will also have access to staff and management that can best fit the type of restaurant."

That's a laundry list of benefits that should pique the interest of the inexperienced (or struggling) restaurateur. That said, to structure a mutually beneficial relationship, both the owner and operator must perform due diligence. McSherry says, "The owner must check [the operator's] references, see, feel and 'touch' other managed accounts, and perform background checks. Likewise, the operator must also underwrite the owner extensively, asking questions such as, 'Is the business model sound? What is the owner's role? How does she want to interface with the restaurant? Are they going to continue working another business? Are they adequately funded?'"

As for the amount of time necessary for a third-party management relationship to achieve its goals, McSherry says, "Any new business takes time to develop and mature, and the restaurant business is no exception. Therefore, long-term engagements are necessary for a third-party operator to have its best chance of success. For a new opening, there is usually a 'preopening phase' of 90-120 days, depending on the construction timeline. This phase usually is billed on a flat monthly rate, followed by a three-year contract to manage all aspects of the operation."

Beware the Two-headed Monster

Some owners are hell-bent on keeping a presence in the restaurant, even when they have brought a management company in to oversee operations. On that arrangement, McSherry is clear: "That is a recipe for disaster for a management company. It is difficult for staff and on-site management to answer to two bosses -- the dreaded 'two-headed monster.' If the owner wants to be in the business, then a consultative 'train the trainer' approach may be more appropriate. In this situation, the management company acts as a consultant for a set period to train the owner to be a full-time restaurateur, and then says 'goodbye, and good luck.'"

....Landlords faced with a defaulting tenant may, under certain circumstances, find it beneficial to bring a management company in to keep a restaurant space operating. Many commercial leases allow the landlord to step in and run a business in the event of tenant default...

Other candidates for using an outside management company are institutional stakeholders who may unintentionally find themselves in possession of a restaurant. Landlords faced with a defaulting tenant may, under certain circumstances, find it beneficial to bring a management company in to keep a restaurant space operating. Many commercial leases allow the landlord to step in and run a business in the event of tenant default (it could raise a host of concept-related intellectual property issues if not addressed specifically). If, for example, other tenants in a shopping center or office complex expect a restaurant nearby, or if foot traffic will be reduced by the absence of a restaurant, the landlord may contract with an outside management company to keep a space operating. They elect to generate some cash flow to replace lost rental income, often while attempting to re-lease the space.

Similarly, in the event a restaurant is placed in receivership, it is highly likely that the court-appointed receiver will not have any experience whatsoever in running a restaurant. The receiver is often faced with the task of replacing management (and key employees) that caused problems serious enough to warrant the appointment of a receiver. Outside management companies are perfect for this scenario because they are experienced and have no ties to ownership.

Fundamentals of a Sound Management Agreement

McSherry says a good management contract starts with an agreed-upon budget on which performance bonuses are based. "A good fee structure consists of a base management fee, percentage of gross sales, and a bonus based upon three to four line items (food cost, beverage cost, labor cost and net income). The contract should include proper language for termination: cause or no cause," he says.

The following is a review of critical provisions that should be included in every management agreement. It is not complete, but it covers essential items.

Terms. The cancellation and termination of these agreements must be set forth in detail. These can be very similar to regular employee agreements, with termination rights based on mutual agreement of the parties, for-cause bases for termination, and (optionally) without-cause bases for termination. Owners should ensure that if the operator has the right to terminate the agreement at will (i.e., without cause), the agreement should provide a notice provision to allow the owner time to make arrangements to step in and manage operations or find a replacement operator (e.g., 60 days notice).

..The last thing the owner wants is to be in a deposition testifying about the money that flowed out of the company as a 'management fee' without an agreement stating terms. The next-to-last thing the owner wants is to be in a deposition testifying about why there was a management agreement in place, but no one ever followed it...

Owners will want as detailed a definition of what constitutes "cause" as possible, such as theft and failure to comply with alcohol policies, but also include a "catch-all" provision that will give the owner some flexibility in terminating the operator for general lack of performance, such as "continued or repeated failure of operator to perform its duties and responsibilities pursuant to the agreement."

Payment of operator. One large difference between outside and in-house agreements is how the fee is paid, including whether on a monthly or semi-monthly basis. Some agreements pay the operator based on a straight percentage of actually monthly sales or profits. Other times it is paid on a more estimated basis, but these are almost always subject to year-end adjustments.

Payment of expenses. Preopening expenses are often determined by a preopening budget, which then are paid to the operator based upon a schedule of disbursements set forth in the agreement. Preopening needs include necessary costs for hiring, training, advertising, operations, telephone/TV, licenses and professional fees, with necessary revisions built in as operation ramps up. There may also be a fail-safe provision, whereby no charge over a certain amount can be authorized by the operator without prior approval by the owner. While the owner does not want to have to sign off on every expense that is run through the restaurant, there is a point at which the operator should be required to obtain a countersignature.

Post-opening expenses are paid out of the restaurant's operating funds. Often, however, the operator will include the restaurant in its own contract for goods or services, and reimburse itself for that expense from the restaurant's funds. For example, if an operator works with 10 different units, then rather than obtain 10 separate insurance policies the operator may procure one insurance policy (in an amount adequate to cover all units). Each unit would be a separate "named insured" on the policy, but the operator would only pay one premium. It would then charge the individual units on a pro-rata basis for their share of the insurance expense.

...If the operator is running your business and a guest files a lawsuit for slip and fall or dram shop liability, for example, the agreement should indemnify the owner for liability due to the operator's negligence....

Human resources issues. The section on the hiring and termination of restaurant employees should be carefully drafted. A good management agreement will require the operator to file detailed reports with the owner for any new hires and any terminations. Even though the employees would likely be employed by owner, the operator must be afforded some kind of control over the employees. In cases where restaurant employees are actually employees of the operator, the owner obtains the added benefit of removing itself from the payroll, termination and benefit procurement process.

Also, since many owners initially look into management companies as a mechanism by which they can provide health insurance benefits to certain employees, the owner must be confident that the operator's benefit plan complies with federal and state law, including ERISA (Employee Retirement Income Security Act). Ask the operator for written information about how any proposed plan complies with current law.

Insurance and indemnification. A critical provision is one that addresses the operator's duty to indemnify, defend and hold harmless the owner from any claims brought by guests, contractors or other parties dealing with the operator. If the operator is running your business and a guest files a lawsuit for slip and fall or dram shop liability, for example, the agreement should indemnify the owner for liability due to the operator's negligence. The indemnity, however, only has value to the extent the operator is solvent. If there is no insurance to back the indemnity, or if the owner is not identified as a named insured on the operator's policy, there may be little to no money backing the indemnity, resulting in owner exposure to claims. Operators should be required to carry all the major business coverage, including commercial general liability, alcohol (including assault and battery coverage), workers' compensation, and an umbrella policy for extraordinary claims.

Miscellaneous. Other provisions that an owner might consider adding into third-party agreements versus in-house include:

• A statement that the operator is an agent of the owner, and that the management agreement does not create a partnership or joint venture.
• A requirement of regularly scheduled meetings (e.g., monthly) between the owner and operator.
• Specifications of the terms of any discounts or "comps" for employees, managers, owners, etc.
• For restaurants in the preopening stage, a "conditions precedent" provision that makes the agreement contingent on the restaurant either fully funding with investment money or being opened.

The Upshot

For the seasoned restaurateur, an "in-house" management company might make a great deal of sense, streamline responsibilities and cut expenses. For inexperienced or overwhelmed owners, however, an outside management company might be the answer; that is, with the right management agreement in place. Get it in writing, make sure all terms are carefully contemplated, and have a lawyer familiar with these arrangements draft or at least review the final version.

Legal articles are for your general information only. Legal advice must be tailored to the circumstances of each case, and laws often change. Federal laws, the laws of each state, and often each municipality vary and each may have its own procedures and time limitations that must be followed. Confer with a lawyer in your state to assess your legal rights in a particular situation.