By Jordan Myers, Alston & Bird
The framework for defining EBITDA in middle-market credit agreements is often portable from one industry to another. But the one-size-fits-all approach does not work for the restaurant industry.
In credit agreements, understanding industry-specific adjustments is critical to effectively negotiating EBITDA and related definitions and achieving fair outcomes for borrowers and lenders.
Restaurant borrowers focus on EBITDA adjustments that normalize financial performance for industry-specific expenses and certain actions that are supportable and likely to continuously benefit business operations.
Lenders on the other hand want to limit adjustments that artificially inflate EBITDA and erode protections for creditors.
EBITDA adjustments ultimately influence numerous provisions in credit agreements, including:
- leverage-ratio and fixed-charge-coverage ratio covenants;
- incurrence tests that must be satisfied before certain actions are taken, such as debt incurrences and permitted acquisitions; and
- various basket thresholds that are determined by reference to EBITDA.
This article provides an overview of several restaurant-specific EBITDA adjustments that are commonly seen in middle-market credit agreements.
Expenses prior to opening restaurants
Restaurant borrowers invest heavily in new locations. A portion of the expenses associated with opening new restaurants — pre-opening expenses — are commonly added back to EBITDA. These can include feasibility, training, accounting, legal and travel expenses, among others.
Pre-opening expenses often are defined by reference to FASB Accounting Standards Codification 720-15.
This section provides guidance on activities within the scope of start-up costs and excludes various costs, including the cost of acquiring or constructing long-lived assets.
Depending on credit quality and deal size, this addback may be subject to a cap (likely a per-location dollar cap) and/or a timing component (e.g., only expenses incurred within 30/60/90 days of opening may be added back).
Run-rate adjustments for new restaurants
Next, restaurant borrowers typically seek run-rate EBITDA credit for restaurant locations that have been open for less than a defined period, typically 12 months. The borrower is given credit on a pro forma basis, as if the restaurant had been open for the entire reporting period even if it had not been.
This adjustment nets the actual EBITDA the new restaurant location generated during the reporting period and is frequently subject to a cap — either dollar-based per restaurant and/or a percentage threshold of EBITDA.
Run-rate adjustments for remodeled restaurants
Restaurants are frequently remodeled, either to comport with requirements of a franchise agreement or to track trends in a competitive market.
Borrowers commonly seek to achieve run-rate EBITDA credit for restaurants closed (or partly closed) during the remodeling period to normalize EBITDA when operations are interrupted.
The specified amount added to EBITDA may be defined by general reference to an amount that is factually supportable and certified by the borrower.
Or it may be calculated by specific reference to either:
- a per-day EBITDA average for the 12 months immediately preceding the remodel (which is then added back on a per-day basis for the closure period); or
- the historical EBITDA figures for the exact period in the prior year. (For example, if the restaurant is closed due to remodeling from Jan. 1, 2019, through March 31, 2019, the borrower would receive an EBITDA adjustment based on same-store EBITDA for Jan. 1, 2018, through March 31, 2018.)
In any event, this adjustment is frequently capped the same way run-rate adjustments for new restaurants are capped.
New product or technology initiatives
Food delivery is disrupting the restaurant industry, and investments in delivery services and infrastructure, as well as point-of-sale and other technology and new-product initiatives, are critical to the success of restaurants.
Specific addbacks tied to losses associated with these investments are frequently included in the EBITDA definition. These adjustments, when included, are often subject to dollar-cap and/or timing restrictions similar to other adjustments.
Finally, given the significant rent expense associated with restaurants, many credit agreements provide for an adjustment equal to the difference between GAAP rent and actual cash rent.
When such amount is positive, this adjustment allows the borrower to add back the non-cash portion of rent that results from the use of straight-line rent accounting.
Last year was robust for restaurant M&A activity, which is expected to continue in 2019. The EBITDA definition in restaurant credit facilities will remain a primary topic of discussion among borrowers and lenders in the industry.
A thorough understanding of the nuances of the definition is a prerequisite to a successful outcome for all parties.
Jordan Myers is a partner at Alston & Bird LLP, focused on representing commercial banks, alternative lenders, PE funds, and corporate borrowers in secured lending transactions, particularly in the restaurant and retail industries. He can be reached at email@example.com.