The Importance of Aligning Business Models To Employees and Markets

Adaptation is the key to the digital economy - and the consumer expectations that have arisen in other markets as a result. JL

Kwokchain reports:

Why do some companies seem to run better than others, and why can’t others replicate them? As the cost of forming startups decreases and capital availability increases we see a proliferation of options for consumers. Market supply fragmentation provides users with more options and shifts leverage towards demand. As the structures of markets change, the optimal business models change with them. Business models are how we align and reconcile the markets needs with the cost and human capital to provide them. Investing in employees is an asymmetric strategy aligning incentives and business models to thrive
Danny Meyer opened Union Square Cafe in 1985. Since then, his Union Square Hospitality Group (USHG) has expanded to nearly 20 restaurants, encompassing Michelin-starred fine dining at The Modern to casual barbecue at Blue Smoke. The USHG empire also spawned Shake Shack, now publicly traded with a market cap of almost two billion dollars and more than 200 locations. In his business memoir Setting the Table, Meyer attributes his outsized success to an uncompromising focus on employees that leads to differentiated service.
If Danny Meyer’s employee-first approach is so effective, why haven’t we seen more restaurant groups adopting it faster? Or even more service-first approaches?
This is an important question to ask, because it’s the question we keep asking ourselves in tech too. Why do some companies seem to run better than others, and why can’t others replicate them as well? Why do companies do well in their industries whether Fortnite in gaming, or Airtable, Figma, and Notion in productivity? Perhaps answering this for restaurants will shed light on it in tech.

Structurally supporting service

It’s tempting to think USHG’s approach hasn’t become common because owners and employees don’t care about service. While this may be true of some, it seems unlikely across the service industry.
Instead, to riff on Hanlon’s Razor, “never attribute to stupidity or malice that which can be adequately explained by structural alignment of incentives.” Providing a high level of service is a choice that must be supported by your business model. Few can afford the investment. But for those that can the dividends are significant.

Investing in your employees is expensive

[Thesis: turnover makes it hard to invest in training, which is a prerequisite for service]
The constraints of most restaurants’ businesses make it hard to replicate employee-first approaches. Most restaurants don’t have the employee retention or capital to improve their service significantly. The economics of their business don’t allow them to invest more in service.
When Danny Meyer says customer service is important, a prerequisite of this is being able to hire high-quality people and invest significantly in training them. And most restaurants simply can’t afford to do that.
Kenji Lopez-Alt (author of The Food Lab) has a great interview on the Freakonomics Podcast about the challenges of opening Wursthall, the restaurant he co-founded. In it he spoke about the difficulty of hiring, training, and retaining great talent:

“Finding good people is by far the hardest thing…finding great people is very hard. Even finding remotely reliable people. Even before we opened, when we were training staff, we must have lost probably 50%. 50% turnover over the course of a few weeks. Which is not abnormal.”

Imagine a startup with 50% churn. What could they even do? Forget how high the cost of recruiting might become. It would be impossible to invest in training employees, much less to maintain any standard of service. With an employee half-life of weeks, none of this is possible.
For many restaurants it’s prohibitively expensive to train employees for months. They don’t retain most employees long enough to justify the costs. According to an industry expert who’s run chains at both the fine dining and fast casual ends of the spectrum, employee churn rates at restaurants can range from 50% annually at fine dining restaurants to 70% at causal places and 110% at fast casual chains. At those attrition rates, the employees are more likely than not to be gone by the time training is done. And since employees don’t view most restaurants or chains as a place for their long-term careers, the more you train employees and help them build experience and skills, the sooner they will leave.
Could any restaurant take the leap of faith and invest in their employees? Perhaps, but it’s a risky bet. It takes significant capital to do this, with no immediate payoff. And the cost are deeper than training: if you say customer service matters, then compensation and bonus structure must reflect that.

The farm club model of talent retention

[Thesis: providing advancement opportunities is one way of combating turnover]
USHG is a constellation of very different restaurants and chains. At one end it has michelin star fine dining restaurants like The Modern and Gramercy Tavern. While at the other end it has the large chain Shake Shack. And many restaurants in between those two ends of the spectrum of pricing and scale.
Unlike many restaurant groups, this variety means Union Square Hospitality Group can hire people early in their careers–and plan for them to advance their careers from within USHG.
You can start working at Shake Shack, and then move on to managing their own Shake Shack or working in one of USHG’s more upscale restaurants. This is true both on the business or chef sides of the business.
If you do well you could go on to run a restaurant in USHG’s portfolio. Or if you wanted to open your own restaurant, you could open one with Danny Meyer as part of USHG–or start your own restaurant and have USHG as an early investor. In fact, another possibility is what the three michelin star restaurant 11 Madison Park did. It was a USHG restaurant that they sold to its general manager and head chef, who’d both worked at USHG for years.
By having a portfolio of restaurants at different scales and price points, employees are able grow their careers while staying in the family. And USHG is able to have high retention and invest more in its employees.

Back of the House is another prominent restaurant group, founded in San Francisco by Adriano Paganini in 2009. Its portfolio includes ten casual to mid-level restaurants, ranging from Belgian brasseries to Argentinian Steakhouses. And like the Union Square Hospitality Group, it also has fast casual chains, including a successful burger chain, Super Duper. Perhaps, most importantly Back of the House also has taken a farm club approach to growing talent to fuel their expansion:

The last big piece of the pie for Paganini is the big working family he’s assembled over the past two decades. If you take stock of Back of the House’s upper management, you’ll find that many staffers here began as waiters and line cooks. Director of operations Jessica Spencer-Flores got her start as a server at Starbelly. Luis Flores, general manager of Uno Dos Tacos and his first own full-service restaurant Flores, was a manager at the very first location, in the Castro, of Super Duper Burger. Giovanni Joris, a former server at Lolinda, is now GM at A Mano. And Patricio “Pato” Duffoo, who started with Back of the House as the sous chef at Starbelly, is now the executive chef of Barvale.
“This is what excites me—I see them grow and get better and smarter,” says the boss. “We share a philosophy for providing customers with good value, and it’s easy to see consistency across all our restaurants because it’s what we all believe. It’s not manufactured or forced.”

By having all these avenues to accommodate the career growth of its employees, groups like USHG and Back of the House have lower employee churn. This allows them to invest more in training their employees because they know they will be able to reap the benefits of their investment over a longer period of time. Long term, the amount invested in employees is dictated by the return captured by the company — similar to LTV/CAC and payback periods in the realm of user acquisition. These restaurant groups have found a better way to extend theirs.
This business model has an advantage in attracting talent that compounds. As these restaurant groups are able to get higher returns from their employees and thus provide larger career growth for them, they can attract stronger prospective employees who might not have considered hospitality before due to the limited career growth opportunities. And this talent loop is particularly brutal on competitors, because talented employees at other restaurants that don’t have similar growth opportunities will have an incentive to leave and join one of their portfolio of restaurants. In this way, those who do not have business models built for employee career growth will increasingly find it difficult to hire and retain great talent.

Why did the service focused model succeed now?

All of this explains why Danny Meyer’s model for USHG has advantages, but why did it particularly show up when it did?
While I wouldn’t go so far as to say it *wasn’t* possible to do a similar strategy before. I think there are many trends that point to why we will increasingly see more restaurant groups converge on this approach. There are macro tailwinds that USHG rode. And they are identical to many of the tailwinds hitting tech as well.

The Internet has radically raised the bar for in-person service

The world is becoming increasingly demand driven. Consumers have more and better choices. And have become far more informed and educated about their options too.
There used to be a paucity of options, so just being in a neighborhood could drive demand. However, as the world urbanizes and transportation gets better, consumers have an abundance of options–and being a place consumers want to come back to becomes more important.
And due to the internet consumers have more ways to help them decide what are the best restaurants to go to. While before there were only a few ways to hear about restaurants, now there is Yelp, many food blogs, and all of your friends on social media.
Before, many restaurants could expect one time customers from those who happened to be in close proximity and needed a place to eat. Like the classic Times Square restaurant that caters only to tourists in the area who will never be back again.
Now restaurants are increasingly competing for informed consumers who deliberately choose where to go (or go to again). They are aided by sites like Yelp, that aggregate ratings and reviews of prior diners–making the experience of each customer matter more. The bad experience of one customer can deter many future ones if they leave a bad review. And similarly the small details that make the night of customers can now spread in their reviews to many others.
These shifts to the demand side of the industry have made restaurants care more about quality of service. Customers are able to go anywhere they want, so great restaurants are better able to retain customers. But customers also hold these restaurants to a higher bar.
The market has reacted to this by rewarding restaurants that are focused on service. Danny Meyer and USHG model are well suited to this shift in the hospitality market. The business model is more aligned than traditional restaurants with a market that prioritizes higher quality of service and customer and employee retention.
And while it started with social. It won’t end there. With social media, it’s not just service that gets noticed. Instagram has driven the rise in importance of ambiance and aesthetic to restaurants. How well your decor and food photographs impacts how far it can spread socially. Restaurants used to hate diners taking photos of their food–now they realize there’s no better acquisition channel. There are many places that are almost entirely built around getting social distribution. In the early days creations like Dominique Ansel’s Cronut would get discussed on social media, but now there are many places that not only make unique creations–but optimize them for Instagram distribution. Like black ice cream or rainbow grilled cheese.
As the internet reaches each aspect of restaurants it makes them matter more. And this will restructure what it takes to be a successful restaurant.

Shifts in market dynamics cause new business models to flourish

Changing market dynamics, business models, and the resulting features of these companies are all tied together. Business models like USHG enable restaurants to invest more than others in service, not just talk about it. Structural changes in the demand side of the restaurant industry ripple downstream into the flourishing of new business models.
This is identical to what we see all over tech today. As the structures of markets change, the optimal business models change with them. Business models are how we align and reconcile the markets needs with the cost and human capital required to provide them. Alignment of markets and the costs to serve them is core. And as either side changes, so to do the business models that are dominant.

Case Study: Gaming (Fortnite)

Fortnite and the evolution of gaming is a good example of this. Why has Fortnite, a multiplayer-first battle royal game risen to be the most successful game–and could this have been predicted?
Gaming, like all industries, is shaped by its structure. Over the last decade fast, consistent internet connections have become ubiquitous for all gamers. This change has swept through all aspects of gaming in ways most players don’t appreciate.
In a pre-internet gaming world, it is hard to update games over-the-air (OTA). This means that all games need to be shipped with assumption that the company won’t be able to improve it further, which makes the process much less iterative than we’ve come to expect in tech.
This structure causes games to monetize via upfront game purchases. Since they can’t update or improve the game after it is bought, and often don’t have any way to maintain contact with the customer, it’s very hard to justify trying to get customers to make recurring payments. With ubiquitous internet connectivity, companies are able to keep working on their games. It’s more similar to how a tech company keeps iterating on its product, than like making and releasing a movie. And as companies keep adding value to their games, the best games can start to charge users recurring subscriptions.
But over the last few years, a different aspect of ubiquitous internet connectivity has shifted the gaming industry. Gaming has shifted from primarily singleplayer to multiplayer-only games. Multiplayer only games didn’t used to be possible. There weren’t enough players with good enough internet access. But it has now become widely available. And as more games introduced multiplayer and started to understand the dynamics of it, the utility of the top games shifted from aspects like plot or the single-player campaign, and shifted to the multiplayer experience.
But this shift to multiplayer driving the utility of games means that gaming has become fundamentally network effect driven. The utility of a game is driven by how robust its active user base is. With scale there are more games, better matching, higher likelihood of playing with your friends, etc.
So the business model of games has shifted to match this. If you’re optimizing for maximal active players and retention, then having people pay upfront, or even pay a monthly subscription, limits your user base considerably. Instead, it’s better to have your game be free to play, and monetize via optional in-game purchases. This wouldn’t even be possible in a world with physical distribution. But digital distribution has zero marginal cost and makes it viable. Fortnite used this business model change to great effect against PUBG, which charged an upfront purchase fee.
Fortnite is the culmination of these structural shifts. But the shifts to gaming haven’t ended. And the evolution will continue.

Case Study: Productivity Tools (Airtable, Figma, Notion)

These trends aren’t unique to gaming. These same second order impacts of ubiquitous internet connectivity are hitting other industries in exactly the same way.
Take the wave of productivity products that are raising at huge valuation multiples in the last year, like Airtable and Figma. And the more waiting in the wings like Notion.
Their successes have much in common with Fortnite’s rise. As these tools become online-first it’s allowed them to be collaborative-first. The utility for them is increasingly driven by the network effects of collaboration within your teams–outweighing any other features they may not have compared to legacy products.
Similarly, by being browser based distribution and onboarding become super frictionless. When I send you designs in Figma you can see them immediately. With software like Photoshop the recipient would need to download, install, and sign up for Photoshop before they could see (much less interact) with the designs. And they use a freemium approach and pricing model that wasn’t possible before. This pricing model is also key because it builds the network effects of the product in a bottoms up, product driven approach–that makes enterprise sales to those companies far more effective. And more importantly improves the sales velocity significantly.
If there were a particular area of tech most similar to USHG, it’d be the rise in startups focusing on retention and increasing share of customer wallet. As customers become more cognizant of their options and switching costs go down, companies that provide the best service are able to better compete for customers and then absorb more of their spend.
As the cost of forming startups decreases and capital availability increases we see a proliferation of options for consumers in any given category. This market supply fragmentation provides users with more options–and shifts leverage in the market towards demand.
Similarly, this increased competition makes acquisition more efficient and competitive for startups. In order to maintain an edge, companies need a proprietary advantage such as better retention or monetization to be able to compete long term. For example, this is the trend we see in direct to consumer ecommerce. Originally as new paid acquisition channels like Facebook expanded, companies could easily enter the market with little competition. But as it became easy for many companies to start and use these same channels the acquisition costs rose. Only companies that have better retention or monetization are able to maintain their spend and even outspend and force out their competitors. This has driven the rise of new business model types like subscription ecommerce.
But at a more general level, whether the shift from enterprise to SaaS or the shift from listings to marketplaces to vertically integrated services. Our business models change as a function of the structure of their markets.

Summary

So why have restaurateurs like Danny Meyer and Adriano Paganini been able to succeed where others have struggled? Certainly one part is their personal conviction in customer service. It’s allowed them to bet on investing in customer service where others wouldn’t–even before it’s proven to be correct. But adoption of this model by others has been relatively slow despite its success, so passion for service is unlikely to be solely sufficient.
Investing in employees is an asymmetric strategy for companies with the best retention and employee appeal.
Union Square Hospitality Group and Back of the House have not just realized that service is important and that requires investing in and retaining employees. They’ve structured their business models around being able to invest in employees.
Instead of hoping they can out execute, they’ve understood the changing underlying structures of their markets, and aligned incentives and business models to thrive in them.
This isn’t unique to restaurants. It’s in gaming and productivity. And every other industry.
When we understand the structural shifts in our industries we can understand the second order impacts of them that ripple down to the business models and companies that thrive. And many of them rhyme more than we think.