Toast: The Restaurant Operating System - [Business Breakdowns, EP.119]

0:03This is Business Breakdowns. Business Breakdowns is a series of conversations with investors and operators diving deep into a single business. For each business, we explore its history, its business model, its competitive advantages, and what makes it tick. We believe every business has lessons and secrets that investors and operators can learn from. and we are here to bring them to you. To find more episodes of Breakdowns, check out joincolossus .com. All opinions expressed by hosts and podcast guests are solely their own opinions. Hosts, podcast guests, their employers or affiliates may maintain positions in the securities discussed in this podcast.

0:45This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. This is Zach Buss, an investor at Irenic Capital. And today we're breaking down the vertical market software business, Toast. Toast is a software platform built specifically for restaurants. Their operating system gives restaurateurs all the tools they need to serve customers from taking orders to allocating shifts. It was founded in 2011 and went public a decade later. And today it's used by nearly 80 ,000 restaurants across the United States. To break down Toast, I'm joined by Will Schreiber, the co -founder and CEO of Bottle, an e -commerce platform built for subscription businesses.

1:29We cover the different ways that Toast minimizes the complexities of operating a restaurant, how their deep vertical focus has helped them out -compete Square, and how much room there is for potential growth. Please enjoy this breakdown of Toast. All right, Will, I'm super excited to have you on to break down Toast. I know you and I can kind of nerd out on the economics of these types of businesses for hours and for the benefit of the audience, this should be a great conversation. So maybe just to kind of kick things off, a basic overview of what Toast is and what they built over the last decade, I think would be a super helpful place to start.

2:07Thanks, Zach. Appreciate you having me on. Toast is a point of sale, specifically a restaurant point of sale, targeting non -enterprise, think independent and small chain restaurants. When you hand your waiter a card at a local restaurant, odds are they're swiping it at a Toast terminal if you're in the US. Same goes for tapping your card or phone at one of those black boxes at Dos Toros or Fast Casual Restaurant or when your waiter brings over a handheld tablet table side to take your order or swipe your card. Toast is charging your card, sending an order to the kitchen, displaying it for the chefs to cook the food and ultimately transferring money to the restaurant.

2:45And before Toast, restaurants would use on -prem point of sales like Aloha and NCR to do this. And the real breakthrough of Toast was not just cleaning up the UX, but actually taking that point of sale software and putting it in the cloud, which opened up APIs and new services to be layered on top of the traditional point of sale. So things like online ordering. I'm sure you've been on a lot of websites with the little orange Toast icon in the corner. That's Toast's full online storefront offering where restaurants can take orders directly. They also power payroll and can track inventory and extend financing and let you book reservations, which is a new Toast product.

3:27And they also let third -party services integrate with the API. So people like DoorDash can pipe orders directly into the Toast point of sale so that they can fire in the kitchen properly and the food can be ready for the courier to come pick up. And that's how I've come in contact with Toast at Bottle. We power subscription businesses. A lot of times those are local bakeries and donut shops and bagel shops, meal prep companies. And when they have toast as a point of sale, it's a relief because we can take orders, place on a bottle store and pipe it directly to their in -store toast point of sale.

4:04So toast isn't just a way to take payment. They position themselves as the operating system, I like to say the brain, of restaurant businesses, mostly in the US. So I think it would be striking to a lot of the audience if they saw the tech stack within independent restaurant or you work with a lot of SMBs. Can you just discuss a bit about how the founders saw the opportunity here? In my experiences, if you ever look at point of sale systems or the number of companies that still operate with paper, it's striking. And I just assume that there are certain parallels where they saw the opportunity with Toast.

4:44Yeah, I actually love their origin story. It's one of those where there was a previous company where a bunch of founders met and built an awesome product and then got together and did it again. And that started a company called Indeka, which was a database search engine for Fortune 500 companies to operate online retail searches. That company was run by this guy, Steve Papa. They sold it to Oracle for over a billion dollars. A couple years after that sale, three of the top engineers that had worked for Steve had left and were looking to start a company. And as three young, really talented engineers, that was Steve Prudett, Amun Narang, and Jonathan Grimm.

5:29They had an idea to take payment through an app while you're sitting at a restaurant. So basically, I want to order my own food and I want to pay for it from my phone. I sort of joke that I feel like every young engineer has three app ideas, a personal CRM, a note -taking tool, and a mobile order app idea. I'm guilty of that. But their first idea was to take this mobile payment from a phone and not have to talk to a human and just pay for your order from your phone. And what I really like about listening to their founding story is they actually had originally thought of being a point of sale, but thought that that would be too hard.

6:08And so they decided to build this mobile order app around the dawn of mobile and the iPhone. Within six months, built that product. Six months later, realized, you know what? No one really wants to use it. It's hard for restaurants. People can't get the tickets to the kitchen. People are on these old school NCR, Aloha, on -prem point of sales. We can't even get our tickets into the kitchen. and they pivoted and said, why don't we just build the point of sale after all? And they went and six months later had built the point of sale and found their first customer and a family member of an early employee.

6:44The other thing I really like about the story is they tried to raise money initially from great investors. So Steve Papa had introduced them to a bunch of people who had backed Indeka and everyone turned them down. They gave every reason in the book as to why selling to restaurants was a terrible idea. The phone number is publicly listed. They get so much outbound sales calls. It's a low -margin business. They aren't tech savvy. And Steve ended up saying, you know what, I'll find you guys. Gave them a few tranches of money and got them going down the path of building this point of sale. And they launched with one restaurant and within three months had 20 signed up to use the product.

7:25And the way the founders describe it, just had really deep and clear product market fit basically the moment they launched the actual point of sale product. I understand that you have experience trying to sell software products into small businesses. When you look at the value proposition here, what was that sales process like? How do you convince a business that's running on some antiquated software or NCR system to change over to leading -age tech and the warts that come with it? Great question. I would be very rich if I knew the answer. I think that the value prop of Toast has changed over time.

8:05What we think of Toast now as why you would sign up is more driven by omni -channel. I'm trying to sell pickup delivery. I'm trying to sell in -store. I'm trying to sell online. I need one system to kind of manage all of those orders so it makes sense to have a cloud -based point of sale. But when they started Toast and what got people's attention was far more remedial than that. They would talk to restaurant managers and people would be scared to fire up the point of sale at the beginning of dinner service because it was a command that they had to enter in a terminal. They would launch an MS -DOS -based point of sale program.

8:42It would crash mid -service. They were scared to touch it or do anything with it. And something really interesting that I heard one of the founders say was they knew they had product market fit based on people willing to give them their time or prospects give them their time. So they would approach restaurants and try to pitch them on, hey, you should let your customer place an order from a phone. People would book a call two weeks, three weeks out. But if they went to a restaurant manager and said, let's talk about your point of sale, people would clear the calendar, talk for an hour, two hour, three hours about how bad their point of sale was.

9:17So what they ended up doing is really intense door -to -door sales with restaurant managers knowing that the point of sale was such a scary pain point for each manager that they were able to get people's attention by walking into the restaurant and talking about the heart of the business, which is the point of sale system, and how painful it was to operate in this bad software. I should say that buyer is very not tech savvy and the product was tech intensive. You had to launch it from a computer terminal. If you think about the complication of running a restaurant, the fact that there are so many entrepreneurs that take on this challenge is kind of striking, right?

9:56I mean, you have to do inventory management, you have to raise capital, payroll, point of sale, work capital management, CapEx budgeting, you're managing labor scheduling, you're managing a kitchen with orders that ebb and flow. You have to think that there's a ton of opportunity to improve efficiency and productivity via technology. But I guess the industry has kind of been slow to change in some ways. Candidly, I don't even have a good appreciation for what a point of sale system does in a restaurant other than the fact that I order the food online and I come pick it up and swipe my card or I sit down and order it and they hand me a receipt and I hand them my card and they bring it back to me.

10:37What exactly are these systems kind of solving for in terms of their value proposition to the typical customer? The complexity of these products is so intense that the founders themselves didn't want to build the point of sale. They were just going to build the online ordering tool. So it is very daunting. And the reason it's daunting is because of how many stakeholders there are. Your buyer isn't actually using the product day to day. They're the manager of the restaurant. Then you have host and hostesses who are managing table SKUs, who's sitting where, when those tables are going to free up.

11:12You have menu management, what products are available, what products are going to be available for how long, what products are available in the coming days versus today. You have to price all of those products appropriately. You then have a wait staff. That's another stakeholder. They have to be happy with the system. Your manager of the restaurant is constantly dealing with staffing issues. So they have people leave. They have new employees. They have to train all of those employees on the system. Your customers come in, they place an order, but they want no cheese on this hamburger. So it has to handle that variant.

11:49And that's the tip of the iceberg. We all know it gets crazy from there. People want to pay with cash, with card, with debit card. They want to split it. There's gift cards. So there's the whole payment piece, which is really complex. And then there's the kitchen. So you have to take all of that orchestration. Who's at what table? Who's placing what order? Who's putting the order in? What exactly is the order? Are those products available? How are we going to keep track of all the variants? And you ultimately have to get that on a ticket, print it in the right order, back in the kitchen for the chefs to actually make the food the right way.

12:22That is the high level, all the stakeholders involved in just the point of sale piece before you even get to, okay, there's pickup delivery orders. Okay, there's online orders. Okay, we're going to do payroll through the system. We're going to track inventory. So it's certainly very complicated. Every developer thinks that building an e -commerce system can't be that hard. But the moment one person asks, and I add catch up to that, your brain just starts to break. And if you look at the Toast API, you have a deep appreciation for how complex things get in restaurants. The amount of variation required at every step is pretty hard to fathom.

13:04So I think later in the conversation, I definitely want to get into A, what the API ecosystem looks like for this type of addressable market. What's talking to what, where different competitors sit in the stack, and what's important. And then the other thing is, there's this debate amongst investors, whether this is a fintech, whether this is a point of sale business, what really is it? So I want to explore the fintech angle as well, but maybe just to get a better appreciation for how the business makes money at the basic level. Can we just take a restaurant and maybe walk us through the revenue model of each potential transaction that they're working through?

13:42Yeah, absolutely. So the average restaurant to talk about one on Toast will do about 100 ,000 a month in sales. And so let's think about it as one restaurant. I go to Toast and I know that I need to take orders. I want to turn on delivery. I want to take online orders, and I need something for my staff to input orders. Just the software for that is going to cost anywhere from free up to $170 a month for my location. We'll circle back on the free in a bit because it plays into, I think, the product strategy of Toast and where they've been able to win. That's the standard SaaS fee that gives you that operating system where you can manage your orders, manage your menu, your operating hours, all the information that goes into the business.

14:32The second piece of it is you actually have to take payment, which requires some sort of terminal. We're all familiar now with the square stands, the toast terminals. So the hardware restaurants have to buy themselves. And that's typically anything from a stand at a fast casual restaurant with a screen that can flip around and people can leave a tip and the person's inputting the order that goes to the kitchen, down to handheld devices that waiters can carry around in a restaurant and tap to add things to orders. These terminals will cost anywhere from a few hundred bucks for the more handheld terminals or even less for just the simple black card reader, all the way up to nearly $1 ,000 for the more complicated and complex full point of sale.

15:18What's important to note, which I'm sure we'll touch on later, is that Toast is not making money on the hardware. They're just trying to neutralize the cost the best that they can. The main way they make money after the SaaS fee is transaction volume. So once you have purchased the hardware and you're paying the SaaS fee, your customers are paying you as a restaurant. And typically about 2 .6 % to 2 .7 % of every transaction gets held back by Toast. So on a $100 transaction, $260, $270 is staying with Toast. Of that, there's interchange, there's bank fees. So the credit cards and credit card companies, banks, processors, or whatnot, take the majority of that money, usually about $2 to $2 .10 -ish of the $260 that's held back on a $100 order.

16:12They're typically keeping about 200 basis points, which leaves toast with 50 basis points spread on average for all card payments that run through toast. There is a distinction of card present and card not present. So rates are lower for restaurants when you take payment in -store versus online. And generally, if you look at the toast earnings, their take rate peaked and the net payment profitability peaked when COVID was happening and things skewed heavily online, they were able to charge more for those transactions and take a higher take rate. Whereas in -store, they get about 50 basis points or less depending on the negotiation of the restaurant.

16:53So when it's all said and done, a typical restaurant will do 100 ,000 in payment volume a month. About 2 ,600 of that is held back by Toast as payment fees. And then of that, Toast receives anywhere from 500 to 800 bucks. of that kind of payment volume, and then plus a SaaS fee of $170 a month. And so if I kind of think about revenue per customer and how that back solves into acquiring customers, is there a certain level with which you need to be operating from a revenue perspective for it to be worth it for them to go and acquire that restaurant? And does that limit their addressable market? Yes, I think Toast intentionally limits their market through pricing to target real businesses doing real revenue.

17:40The average toast merchant is doing 100 ,000 a month in transaction volume for a little over a million a year. And that's really pretty good. That's pretty big, especially when you contrast it to one of their biggest competitors, Square. Over 60 % of Square sellers process 125 ,000 a year or less. The average Square seller is doing in the low hundreds of thousands annually in transaction volume. And the reason for this is pricing. If you're a chef opening a food truck and you go to Square's website, you can get a reader for 50 bucks or less. You can open an online store and start taking payments in person and partner with delivery providers all for free, no monthly fee.

18:19And even the plus plan on Square, which gets you more industry -specific features, is only $30 a month. Whereas if you go to the Toast website, the hardware is a little more expensive. The core plan starts at 70 a month, but you really need the 160 a month plan to have Toast online ordering to have Toast delivery services and things like that. So it's definitely cheaper at the lowest end for vendors to start on Square. Well, when you go out though and talk to operators and ask why'd you switch to Toast, nearly everyone says cost. And this is because Toast usually offers about a 30 basis point break on transaction volume over Square.

19:00So if you're a business and you do the math, you're trying to make up for the 160 a month service fee that Toast has that Square doesn't, it's gonna take about $43 ,000 a month in revenue at the lower transaction rate in order to make up for that 160 bucks. So from a pricing perspective, Toast is really targeting businesses doing at least a half a million a year in revenue and up from a pricing competitive standpoint. And again, I think this is Toast really dialing in their ICP. They want restaurants that are real businesses doing real volume. They offer support. They want to be known for having good support and they need real revenue guarantees to do that.

19:40And I think that's why Toast's really cheap plan, which is there to compete at the lowest end, which is $0 a month in free hardware. That comes with a two -year contract guarantee and promises of higher take rates because Toast just knows that those vendors are going to be harder to work with and they need real revenue to provide the support that they want to support all of their merchants with. And so we talked about the challenges and the opportunity and take rates and fees. But in order to even run a business like this, not only do you have to build great software, but also great hardware. How were they able to blend those two somewhat distinct skills?

20:23And I know you're coming at it from the perspective of building software. I can't imagine how hard it would be to then have to build the hardware that is needed to run your software. Talk more about the hardware and software ecosystem that they've implemented. One of the most impressive things about Toast is they truly were deeply technical from the beginning. Founded by these three engineers, all MIT graduates, and they really went at the heart of a lot of the technical problems involved in this. It is not easy to build hardware that works with software and vice versa. Toast made one key bet early on that I think paid off, which is back when they were getting started in 2011, 2012, they decided to build custom point -of -sale software on the Android operating system, whereas a lot of their competitors were just building apps for the iOS ecosystem where you'd hope a restaurant would buy a full iPad to run your point -of -sale.

21:18And the Toast decision was, we're going to build with Android. that'll give us the ability to build more custom hardware because we can go install the Android operating system on custom hardware and run our own app. So that was a technical bet and decision that they made early on that really paid off. And they were able to build these payment terminals and point of sale systems on top of Android and integrate them with their point of sale. I think that back to the complexity of how many stakeholders there are between the manager, the waiters, the kitchen staff, the hostess, the printer in the kitchen, the display system for chefs, the online ordering.

22:00This is part of the moat that Toast has. To think about trying to compete at this level with this amount of complexity with all the different hardware that's available is extremely daunting. There was an interesting interview where one of the founders was talking about how hard it was just to make sure the hardware worked in restaurants. You forget, like if the restaurant has a patio, well, they didn't put Wi -Fi out there yet. And so they actually can't use Toast or your hardware until they install Wi -Fi and then the Wi -Fi might go out. And now the tablet doesn't work. And now the restaurant's really upset because they're losing orders of business.

22:40And I think one thing that really helped Toast grow in the beginning was a commitment to customer success and onboarding, where they, for very low prices, would do deep handholding and installation and migration work for their customers to get them off of on -prem point of sales and to adopt what's ultimately more complex in terms of how many things can go wrong. The internet can go down. Terminals can die. The battery might go out on a handheld. They might not have been charged overnight. There's just way more surface area for things to go wrong, which I think is a bigger testament to how amazing it is that it all works well.

23:22If you kind of think about like the product roadmap, they're effectively creating this ecosystem that pains me to use the terminology. But there does seem like there's some sort of network effect here in that if your restaurant is using toast and toast talks to your food distributor and the payment processors and your banks, and there's working capital and financing benefits, the more and more the layer on actually can justify a pretty significant acquisition cost upfront, just given that opportunity. How ultimately does the company's economic model look? I understand how they generate revenue, but what is the margin profile of everything they're potentially selling into the restaurant?

24:04look like or ultimately look like when they reach what we could call more of a steady state? What's most interesting of what you said before we dive into the full numbers is you would expect, in my opinion, decreasing acquisition costs over time. My perspective, especially with talking to so many vendors who use Toast is Toast has won. And the people who aren't on Toast are aware of it. If they aren't on it already, they're thinking about switching to it. there isn't really an alternative. If you're a restaurant, it's going to be toast in a head -to -head competition, again, because of the product complexity.

24:39At the same time, in the most recent quarter and kind of annual update, the acquisition costs are going up. Maybe there's international expansion or something going on that isn't fleshed out in the data. So in terms of how toast makes money, they're a lot bigger business than I think most people give them credit for. So this year, they're on track to surpass $100 billion in gross payment volume over the course of the year will probably touch close to $110 billion in GPB. That will drive nearly $4 billion. They're estimating about $3 .7 billion in revenue for Toast. Now, that's not all software revenue.

25:15It's easy to think, well, Toast, a software company, amazing margins, but only 13 % of that revenue is SaaS -driven, true recurring payments revenue. 82 % of it is payments revenue. So as discussed previously, they're withholding 2 .6%, 2 .7 % of all the transactions that flow through Toast, but they're only keeping about 50 basis points of that. So they have roughly 20 % to 23 % gross margin profile on the payments revenue stream, which is 82 % of their revenue profile. And then the remaining 5 % is the hardware and services businesses, which again are loss leaders. They lose money on hardware in every report.

26:02And it seems like using it to try to lower the friction as much as possible to get you on to a toast reader. It's in a lot of ways, the modern Keurig. They want you to have the hardware for as cheap as they can afford so that you start processing payments and making money for them. It's atypical to see software -oriented businesses with a low 20 % gross margin. But if I look at what's titled subscription services, financial tech, and hardware, and then how that consolidates into the margin profile of the business, what exactly should I think about from a revenue recognition perspective? You certainly cannot compare it to other SaaS companies.

26:43The purity of revenue here compared to something like Salesforce is not there. If we think about the $3 .7 billion projected annual revenue in this coming year, 13 % of that is just pure SaaS with 70 % gross margins. As they say, that's the monthly fee, the $60 a month, $170 a month fee that people are paying. So then the bulk of toast revenue, 82 % of their recognized revenue is transaction revenue. Right now, it's holding steady at about 23 % gross margins on the transaction revenue. which isn't bad and is pretty similar to Shopify's ShopPay gross margin profile. But because the bulk of host revenue is transaction revenue, the margins on the $3 .7 billion are well below 50%.