Nearly three years ago, I co-founded a virtual reality (VR) business with the goal of transforming an industry that my partners and I see so much potential in. Our business is a location-based entertainment center that operates something like a cross between an arcade and a bowling alley, except the entertainment is VR games. There are tens of thousands of dollars of VR equipment, a commercial kitchen, and about a dozen employees who are really what make the business function. And business was going like gangbusters until early March.
As the coronavirus spread we've been required to shut down not once, but twice. As a result, I've gotten a unique view of the challenges ahead and how businesses adapt and survive in a crisis. I am reminded of Warren Buffett's quote: "I am a better investor because I am a businessman, and a better businessman because I am an investor."
I hope I know a little more about what to expect as an investor because of my view of this crisis from inside a business being directly affected. Today, I want to share some of what I've learned with you.
Image source: Getty Images.
How a small restaurant sees a crisis
Every small business is different and will see the pandemic differently, but ours runs a lot like a restaurant from an economic standpoint, so that's the analogy I'll use here. And it's probably informative because restaurants and bars have arguably been affected more heavily than any other industry in the U.S.
For some background, restaurants are a notoriously low-margin business, and they also have very high operating leverage. There are high fixed costs, so when revenue goes up or down a little, profits go up or down a lot. This makes a crisis like the current pandemic dangerous.
First, let's take a look at three of the most successful restaurant operators in the world: Dave & Buster's Entertainment; Restaurant Brands International, with its Burger King, Tim Hortons, and Popeyes brands; and Darden Restaurants, owner of the Olive Garden, Longhorn Steakhouse, and Yard House. Of these, only Restaurant Brands has a profit margin over 10%. And that's high for a restaurant. Smaller, family owned restaurants usually run in the 2% to 3% range.
PLAY Profit Margin data by YCharts.
This is what makes even a small loss of business so dangerous for restaurants. When revenue drops, rent is still due, electricity bills need to be paid, licensing costs don't change, and there's a minimum number of employees who need to be on the clock just to have a single customer on site.
This example shows why the industry is in so much trouble. In the base case, a restaurant has $1.5 million of revenue with $10,000 in monthly rent, a 70% food margin, and the other costs I outline below. You can see that a 10% tor 20% drop in revenue is absolutely devastating to the bottom line.
| Item | Base Case | 10% Drop | 20% Drop |
|---|---|---|---|
| Revenue | $1.5 million | $1.35 million | $1.2 million |
| Rent | $120,000 | $120,000 | $120,000 |
| Other overhead | $200,000 | $200,000 | $200,000 |
| Financing costs | $80,000 | $80,000 | $80,000 |
| Food costs (30%) | $450,000 | $427,500 | $405,000 |
| Labor (25%) | $375,000 | $356,250 | $337,500 |
| Other variables (10%) | $150,000 | $135,000 | $120,000 |
| Annual profit (Loss) | $125,000 | $31,250 | ($62,500) |
| Monthly profit | $10,417 | $2,604 | ($5,208) |
Table by the author.
If we run the same numbers but assume a 50% drop in revenue, which was realistic in March and April (and in some states, again for December), the situation looks dire. Monthly losses add up to $25,833, which will put a lot of restaurants out of business quickly. Small restaurants don't run operations with hundreds of thousands of dollars on the balance sheet. Their owners are trying to pay off start-up loans and personal mortgages, and send kids to school, so there's not exactly a huge cushion to fall back on.
Thousands of restaurants, entertainment venues, and service businesses face this same challenge, and we're on month nine of the pandemic. Small businesses that can withstand a few months of reduced demand are now running on fumes. And more will be closed every day.
The impact on employees
One of the unique qualities of owning a small business is that we know the people who work for us intimately. We've broken bread together, they've met our children, we know their families, and in some cases they've uprooted their lives to personally invest in our small-business dream.
According to the U.S. Bureau of Labor Statistics, 16.3 million people work in the hospitality and leisure industry. They were the first to see hours reduced and tips drop, and they'll be the last to see wages return when the coronavirus passes. A lot of people's lives are affected, and currently there's no additional safety net for them to fall back on. For other businesses, their customers have seen their own discretionary income dry up.
If, as an example, we assume that lost pay will be $100 per week on average for all hospitality and leisure workers, the lost wages for the industry will be $1.63 billion every week. Over the course of a year, that's $84.8 billion of income. That money would have flowed through the economy for rent, groceries, clothing, entertainment, and anything else workers spend on.
The economic impact of lost wages over the next few months is going to be very real. And it'll be felt by almost every company. If the economy has a hard time jump-starting in 2021, it'll be because millions of workers have less to spend every day and will be trying just to make ends meet.
What keeps me up at night
In my case, I think we'll be able to fight through this challenge and come out a better company. We prepared early and are already working on ways to adapt that don't require a physical presence at all. But there will be a painful period for everyone in our business.
Even if the company does survive, what I worry about most is our employees. Some are part-time and will have a cushion from another place of employment, but some rely on us for their income. We've been working hard to increase pay since we opened, and now we're going backward just in order to survive.
I worry that government won't fill the right holes that small businesses are finding because of the coronavirus. Restaurants are already in a dire situation, and it's only getting worse. Shutdowns that began last week and are sure to last into 2021 aren't going to help.
Is there a light at the end of the tunnel?
What we're all holding on for is a coronavirus vaccine and some sort of return to "normal." We know that many competing restaurant and entertainment venues have closed and will never reopen. If consumer discretionary spending picks up and corporate groups have a flood of pent-up demand in 2021, will that be a windfall? It may have to be for many small businesses, particularly restaurants, to survive.
