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Legal Guidelines: Opening a Restaurant

Aug. 28, 2013

Opening a restaurant is your dream, but it can easily turn into a nightmare. This Article identifies some of the key legal steps to building that dream and some the common mistakes that can turn your project south.

1. Prepare a Business Plan. Have a well thought out business model and plan. A good business plan should cause you to critically analyze each stage of your business, from legal formation to serving your first dish, and will allow you to put your best foot forward when approaching investors, lenders and landlords.

What to do: Be realistic when calculating the total cash necessary for starting your business and calculating your financial projections. Many founders fail to consider all of the costs involved before serving your first dish, such as the total cost of the build-out, fixtures, equipment, insurance, permits, license fees, starting inventory, accounting, engineering, legal and architectural services. If you plan to build or retrofit an existing restaurant, find out whether zoning laws impose any conditions or restrictions such as seismic upgrades, installation of fire suppressant systems or a change of use. Starting the project undercapitalized is a common mistake. You may hum along in the beginning, but you will undoubtedly lose steam before the open. The last thing you want is your contractor filing a lien and walking off the job before your doors are open.

2. Negotiating the Commercial Lease. Once you have found your ideal location, it’s time to negotiate favorable lease terms with your potential landlord.

What to Do: If you still need capital to start you business, consider starting with a letter of intent that sets out all of the major business terms that are particularly important for your operations and overall business model. You want to establish the lease term, options to renew, price per square foot, triple net and other costs, escape provisions, tenant improvements, etc. Get as much pre-approved by the landlord as possible. You will also want to subject execution of the lease to certain contingences, such as approval of licenses and permits and obtaining necessary capital. It is extremely risky to sign a lease before your dream is fully capitalized. Ideally, you will obtain necessary funding during the letter of intent stage.

3. Decide the Legal Structure for Your Business. Most restaurants form a Limited Liability Company (LLC). It protects your personal assets from any liability that the business incurs. If you plan to open multiple locations, you can set up a separate LLC for each location (only an individual restaurant’s assets will be at risk in the event of a lawsuit). Structuring as a Corporation also provides liability protection, but corporations are more complex to run because they require a board of directors, shareholder meetings, and other administrative extras.

What to Do: Consult with a lawyer and accountant about the best option before registering your business with the Secretary of State.

4. Hire an Architect/Engineer/General Contractor. The architect is responsible for designing and drawing up the blueprints for your restaurant. The engineer is responsible for reviewing the blueprints to make sure the building will meet local building codes and is structurally sound. The general contractor is the person who builds your restaurant from the ground up pursuant to the architectural and engineering plans. The combined services of all three are pivotal in obtaining the health permit and certificate of occupancy necessary to open your doors.

What to Do: In order for a construction project to obtain the required permits from the local authorities, several rounds of inspections need to take place throughout its execution. It requires that construction, alterations or repairs comply with the building codes, zoning regulations and contract specifications. In addition to the required inspections needed to complete a project, the inspectors also take a closer look at the capacity of the staff. In short, hire a reputable contractor with extensive restaurant experience. The planning of any project requires extensive communication by the restaurant general contractor with all parties involved in order to ensure a clear understanding of the goals set and the means in which to achieve them. Time lines need to be set, materials data need to be approved, and contracts need to be in place. Make sure that you require change orders to be documented in writing and signed by you and the GC.

5. Obtain The Necessary License to Legally Operate Your Business. Obtain your Federal Tax ID Number, Washington State Master Business License, city business licenses and Washington State Liquor License.

What to Do: Before you apply for the WSLCB, you need to have a signed letter of intent or commercial lease in the name of the Licensee. You also need to have confirmed investors and the amount each is investing. Each investor will have to complete and sign a source of funds document stating how much they are investing and the source of funds. If they own more than 10%, they will have to complete a personal history statement and have criminal background checked. Not having this information will delay your application or have it dismissed outright.

6. Insurance. Restaurants are exposed on many fronts and can be vulnerable to injuries, medical expenses, and lawsuits. Insurance to consider includes property insurance, general liability insurance, and liquor liability insurance. Washington State requires that any establishments holding a liquor license must carry liquor liability as part of their insurance. Washington State also requires you to carry workers compensation insurance.

What to Do: Make sure your policy covers employment practices liability (EPL). Many restaurant owners and managers don’t really understand what EPL is and the broad range of issues it encompasses. Employment practices liability insurance provides businesses and employees with coverage for claims made against them that can happen as a result of wrongful employment practices including: discrimination; harassment; retaliation; termination, constructive discharge; failure to hire, supervise and demote; and personal injury resulting from infliction of emotional distress and humiliation, defamation and invasion of privacy. Restaurants and bars, including mom-and-pop operations, can be at risk for EPLI claims, which could result in total devastation for the small business owner.

7. Prepare your Company’s Operating Agreement. An operating agreement is an agreement among limited liability company ("LLC") Members governing the LLC's business, and Member's financial and managerial rights and duties.

What to Do: Consult with a lawyer and accountant when drafting this agreement. Most restaurants are manager-managed LLCs, meaning as the founder, you have the right to run the day to day business without the investing Member’s involvement. Typically, Members can only vote on major decisions that can harm them financially. Many founders fail to have an Operating Agreement or fail to accurately define how certain key decisions are made therein. For example, what if the Company needs more money? Can additional units be sold? If so, who gets diluted? Without an agreement that defines key terms and major decisions, you could find yourself stuck in a deadlock with upset investing members that can bring operations to a screeching halt.

8. Capitalization. You have several options on how to obtain the necessary capital to start your business.

SBA. If you are capitalizing using part SBA-guaranteed loan and part equity, SBA terms typically require the loan amount to be matched by equity investments. In other words, if you are looking for a $100,000 loan, you will also need to find $100,000 in private equity investments. An SBA-approved lender will also most likely retain a perfected first security interest in all business assets of the Company including but not limited to accounts receivable, inventory, furniture, fixtures, equipment and general intangibles. As additional collateral they may also require a mortgage on any real property you own. The benefit to an SBA-guaranteed loan is that you will be able to retain a larger percentage of ownership in your business.

Equity Financing; Accredited v. Non-Accredited Investors. There are complex securities issues involved in selling private stock that is not registered with the Securities Exchange Commission. Accredited investors are individuals and institutions that the SEC considers sophisticated and financially savvy enough to look out for their own interests in an investment deal.

Debt Financing. Instead of selling ownership in the business, you may obtain loans from private investors with an agreed upon return. The same rule regarding accredited and non-accredited investors also applies here.

What to do: Find Accredited Investors. The major downside of seeking non-accredited investors is the extensive disclosure requirements imposed by the Securities and Exchange Commission and state securities regulators. The amount of paperwork you must complete approaches that of a full SEC registration, making the process and legal cost unwieldy for most private companies. Furthermore, the fact that these investors will have lower net worth or income than accredited investors means that the money they are investing makes up a greater percentage of their overall livelihood. They will tend to guard their investments more carefully and be more litigious in the case that your restaurant does poorly. If you do not follow proper disclosure requirements with non-accredited investors, they may sue you to get their investment back. An attorney can help you obtain an exemption to offer and sell Membership Units and therefore better safeguard you from liability down the road.

9. Key-Employee incentives: Will you offer equity to key Employees? If you have key managers, you may want them vested in the net profit that results from their labor.

What to do. If you plan to issue employee incentive units, don’t just give away the equity in your business. The employee units should be subject to forfeiture or vesting over time.

10. Finalize your investor package.

  • Business Plan

  • PPM (if selling to non-accredited investors)

  • Subscription Agreement

  • Investor Suitability Questionnaire

  • Operating Agreement

11. Execute Lease: Once you are fully capitalized and your contingencies are satisfied, its time to execute your lease.

What to Do: Most commercial leases will require that you personally guaranty the lease. In other words, if your restaurant fails you will be liable for the lease obligations for the remainder of the term. There are multiple ways that you can protect yourself against a personal guarantee. You can be creative. There are no rules, only a principle. That principle is that the more confidence a tenant can engender in its landlord, the less concern there is for a guaranty. The following are some brief examples. 1) Make sure you are able to sublet or assign the lease. 2) Have the guaranty expire after so many years of running a profitable business. 3) Negotiate a “burn down” clause. This reduces your overall liability the longer you are a profitable paying tenant. The longer you “behave,” the lower the amount you will need to stand behind. 4) Negotiate a “Good Guy” guaranty. A Good Guy guaranty basically provides that you will pay a certain monetary penalty to terminate the lease within a certain amount of time. For example, you can evoke the Good Guy guaranty, and thereby break the lease, within the first two years of the term if you pay x amount of dollars or x many months of rent.

Opening a restaurant is hard work. The above examples are not necessarily a step by step guaranty for making your dream a success. Rather, they are tips learned from the trenches and designed to help you ask the right questions during the critical stages of building your dream.