Lousy Incentives In The Restaurant Business

What an understanding of incentives can do for you, through the lens of one industry that we're all familiar with.


This is a companion discussion topic for the original entry at https://commoncog.com/the-restaurant-business-seen-through-the-lens-of-incentives/

This reminded me of a story I read a year or two ago about prepaying for inventory in the restaurant industry…which it turns out I read here

Related, though - I think often about the strange real estate factors that are at play in the restaurant business. We had a cute little restaurant down the street from us for many years that existed only because they were in an old shopping mall that had not yet been redeveloped…and when redevelopment time came, they were unable to find a new place where they could afford the rent. There are a handful of similar interesting restaurants near us now that continue to exist only because their occupants purchased the land at a time when the neighborhood was much less desirable; the prices we pay at the restaurant are effectively subsidized by the restaurant owners, who could probably make more by either selling the property outright or renting it to a less interesting business.

(I read an article some time back that I can’t locate…but it made the case that much of New York’s “interesting restaurant scene” is subsidized by wealthy investment managers who want to be the sort of people who “own a restaurant” but who aren’t invested in making the enterprise sustainable for more than a few years.)

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Oh, absolutely!

Tren Griffin has this thing where he says that restaurants are at the mercy of their landlords, and he uses the term ‘wholesale transfer pricing power’ (another John Malonism) to describe this dynamic.

Wholesale transfer pricing = the bargaining power of company A that supplies a unique product XYZ to Company B which may enable company A to take the profits of company B by increasing the wholesale price of XYZ.

As an example, John Malone made himself rich by owning the cable systems and saying to new channels, “I will be glad to give you distribution on our cable system as long as you issue us AB% of the equity in your company.” The wholesale transfer price of getting distribution on his cable systems was AB% of the equity. On the flip side, John Malone always made sure there were at least two suppliers of set-top boxes for his cable business so he was not on the ugly side of wholesale transfer pricing.

(…) As an other example, the owners of Wild Ginger started their wonderful restaurant in a rented space on Western Avenue in Seattle. The restaurant was a huge success. When lease renewal time came up for Wild Ginger the landlord wanted a massive rent increase. The ability of the landlord to demand that increase is wholesale pricing power. It was not absolute, but wholesale transfer pricing power in that case was significant. The owners of Wild Ginger had a lot of brand and other value tied up in that location. The rent increase request was so big that the Wild Ginger owners brought in up investors and bought their new building in a new location and did the huge investment required to refurbish it. The restaurant owners had to completely change their business model by bringing in the outside money from investors. The owners of Wild Ginger are is now in the restaurant business and the real estate business. The whole thing was kicked off by the wholesale providing power of the original landlord. Another restaurant moved into the old Wild Ginger space on Western Avenue and went bust, probably because the rent was too high compared to the many other restaurants in Seattle. Now that restaurant space on Western Avenue sits empty.

The full article is found here:

Interesting article. I was working in a very similar space in 2018 with my startup. We had an ordering system which would allow people not to wait in line.

One of the counter-incentives we saw at first is that some places do like the line, as it is a free advertisement. Some of them were already at max throughput, so they had no incentive to adopt us.

But the place with piloted with was interested in improving efficiency and throughput. It was a food truck, and using the cashier to help with food prep was a win.

We did have to integrate with their paper ticketing workflow initially, by printing our own tickets with a similar format, which was an interesting hack for adoption.

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That reminded me of this article from seven years ago: After 20 Years, Starbucks Is Feeling the Pressure of New York Rents - Eater NY

I’m now questioning my assumptions about the value of businesses owning their own land. I’ve believed that this was a waste - that in most cases, speculating on real estate is a distraction, except in cases where it’s core to a company’s value proposition. But vulnerability to rent escalation is a heck of a weakness. I wonder if there’s some sort of novel financial structure that could be applied here - to give the restaurants rent stability without also having to be land owners.

(Related: a beloved local fast food franchise has been caught up in this sort of drama for the past fifteen years or so. They had a right of first refusal that they planned to exercise, but their municipality encouraged them to instead work out a sale-and-lease agreement with a developer…who then went bankrupt during the 2008 financial crisis. That voided the new agreement and the eventual purchaser had no interest in resurrecting it. Community appeals did lead to a resolution…but the franchise is a lot more vulnerable than it had been, and has had an especially rocky time these past two years.)

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There’s certainly something interesting about the interplay between real estate and the restaurant business. I’m sure you’ve heard of the saying “McDonalds is in the real estate business, not the restaurant business” — and the incentive structure and wholesale pricing power nature of the real estate underpinning the restaurant business is probably what led it to evolve to its current model. (Explainer articles here and here).

From the second link:

In 1956, Ray met a man named Harry J. Sonneborn, who gave him a simple idea that would help him accelerate the growth of McDonald’s across the country: Own the real estate that future franchises would be built on.

In this new arrangement, which is now popularly known as the Sonneborn model, McDonald’s would buy the land franchises were to run their outlet on at long-term fixed interest rates and lease it the franchise owner at a markup. The genius of the Sonneburn financial model was that McDonald’s would earn royalty fees from franchisees and collect rent, as well as keep adding real estate assets to its portfolio. After McDonald’s switched to the Sonneborn model in 1958, the company added 68 locations in a year.

In other words, one way of looking at McDonalds is that it is a real estate company that just happens to guarantee occupancy by renting to its franchisees.

I loved this article. I really loved your description of just how long it takes to deeply understand your user and their incentives, as well as the evident joy of realizing that you’ve finally gotten that tiny nugget of information that helps you crack it

I’m running into a similar situation in my current role at a (US-based) health insurance startup. Health insurance in the US is really funky because you’re essentially running an n-sided marketplace (in the nfx sense) between Patients/Members; Doctors (or consortiums of doctors—aka Provider Groups or Hospitals); and digital health startups (e.g. One Medical, Ro, etc). Deeply understanding the motives of each is something that I think we’re just barely scratching the surface of

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