Things to consider if you are thinking about buying a restaurant
It can take years of blood, sweat and tears to create a new restaurant from scratch. Purchasing an existing restaurant provides a turn-key established business, hopefully with “Goodwill” in spades. Goodwill is that intangible power of a successful BRAND where customers are an enthusiastic, free “Marketing Force” for the restaurant.
I’ll say it again there are so many benefits and advantages to owning your Real Estate. To control your destiny and not be at the whim and control of a landlord (Lose your Lease, you may Lose your business), to allow for future expansion, the ability to lease the property back to another operator if you no longer wish to operate the business, cash flow potential to lease out unused space, depreciation and other tax benefits, mortgages decrease while rent is a constant and most importantly to build both equity leverage and appreciation value in real estate for future projects or nest egg…
Purchasing a restaurant can be a complicated process and its easy to get excited by the flash and sizzle of it all. But remember; keep eyes wide open, know what you’re looking for, look at and evaluate several properties and above all dig deep and do your homework. You CAN buy a good operation and get a reasonably quick return on your investment with intelligent strategy and Due Diligence.
Here’s what to consider:
REASON for SELLING: It seems the obvious question but, are they just retiring, is the business failing or are there other hidden nightmares?
NOTE: Even though a place has steady customers and looks busy, DOES NOT MEAN ITS PROFITABLE!
GOODWILL: Are you buying a successful concept and if so, what is the value of this “BRAND”? Are there Media Accolades? Positive reputation and Online Reviews? Community Recognition? Is there an “Affinity” or customer loyalty program with a large core audience of regulars? Is there a large digital Data Base of customers for marketing purposes?, Does this place have sustained “Buzz”, Are the recipes valuable?, etc.. HISTORY: How long has this restaurant been in operation (generations, a few years, relatively new)? Is the current owner the founder? What is the restaurant’s story… is it strong and relevant for marketing purposes? LOCATION, LOCATION…
I can’t overemphasize the importance of the “Power of Location” (Tourist Attraction, Mall, Downtown, Suburbs, etc..) and Visibility. Valuable location, traffic and goodwill all increase Price. It goes without saying… “Buy the best location you can afford” whether you keep the existing concept or create your own.
NOTE: Traffic study counts are available from the municipal or state Department of Transportation (DOT)
BE A CUSTOMER: Study and understand the market area… what do you see? Spend time in this concept (Bar, Dining Rooms, common areas, baths) and put your guest “hat” on.
Query the patrons, assess convenience, cleanliness, ambiance, acoustics, volume of business during different dayparts and days of the week, menu and pricing, staff greetings, are the employees cheerful and well trained?, service levels, quality of the food and beverage, timing of service, additional profit centers (Retail, Live Music/Events), smiling satisfied customers, the website and marketing, proud to call this place your own?, Negative Impressions, will you change much?, etc.
CUSTOMER BASE: Demographics and psychographics. Families, singles or young professionals, etc.. Where do they come from (the neighborhood, 10 mile radius, destination traffic)? Can you effectively market to this clientele?
SIZE and SEATS: Is the size and number of seats inline with your financial projections, expenses and future goals? Is there room to expand?
NOTE: The basic financial equation is: number of seats X average table turns per day X average check per person. Your projections from this formula MUST cover your rent or mortgage, payroll/benefits, taxes and related fees, cost of goods, insurances, oil and utilities, marketing, repairs and maintenance, supplies, administrative expenses, etc..
Can your revenues cover all the above expenses Plus provide growth and a cushion against weather, economic downturns, sudden loss of business, competition, time to establish a clientele, etc..
HOURS of OPERATION: How many meals per day?, days per week? Hours?
CURB APPEAL/MAINTENANCE SCHEDULES: Has the building, furniture and fixtures been well maintained. Has the Grease Trap and Septic system been pumped (if not city sewer)
TAKE OUT BUSINESS/DELIVERY/RETAIL: Is there an existing Take-out, delivery and/or Retail Merchandise business as additional profit centers? What is the sales potential?
LIVE MUSIC/EVENTS/ENTERTAINMENT: Is there a stage for performers? Can you charge Cover? The opportunity for holiday parties, group functions and large events? Are there any zoning restrictions against live music?
WOULD YOU RENT THIS LOCATION?: Ask yourself, if this property were not for sale, would you be interested in renting it based on its condition, strengths and amenities?
PARKING: Availability and convenience to your door is Critical for restaurants relying on significant drive-by traffic.
EQUIPMENT: What equipment and small-wares, furniture and fixtures go with the business and importantly What Condition is it in (good and operable, in need of repair or near the end of useful life)? Obtain a detailed Equipment Schedule from the seller and verify each piece right down to the salt shakers. Anything missing will have to be purchased. What equipment is still needed for any changes to the concept? What value does the seller’s Attorney/CPA place on the equipment?
NOTE: This Asset Allocation value including equipment has an impact on your tax liability or benefit at year end following your purchase (Consult your CPA).
KEY MANAGEMENT, STAFF & MORALE: Identify effective managers and valuable staff. What is the chemistry between kitchen and front of house… a family or sets of cliques? Are staff happy and will they stay after the sale? Often news of a sale invokes panic and staff used to the status quo, leave for seemingly greener pastures. Prior to closing; interview leaders, sit down with staff, warmly embrace them and honestly outline your plans.
COMPETITOR ANALYSIS: What is the concentration of independent and national chain restaurants nearby (this can be a traffic draw – business brings more business)?
NEIGHBORHOOD: Safe, well-lit, pedestrians or crime, graphiti, odors and blight? Consider residential and commercial neighbor relationships.
ZONING/PERMITS & USE RESTRICTIONS: Is the liquor license transferable and affordable? Can you expand? Sign Ordinances?, Building Permits, Noise restrictions?, Dancing & Entertainment permitted? Approvals take time… make all necessary license and other permit applications asap. Make sure closing on the Purchase & Sale agreement is contingent on obtaining all necessary permits and approvals. Are there any road construction plans on your street or in the area that could affect business?
HEALTH INSPECTIONS: Inspect the last three (3) health inspection reports… note any fail issues. Any outstanding violations?
LEGAL ACTIONS/SAFETY RECORD: Have there been any customer injury or property lawsuits? Is there a clean worker’s comp claim record?
BOOKKEEPING/RECORDS: Outside service or in-house bookkeeping?
OFFICE APPEAL: Is the office organized and professional or a mess? The latter may be telling as to the restaurant’s record keeping. AUDITS: Has the business ever been audited by the IRS or state revenue department?
EMPLOYEE BENEFITS or OBLIGATIONS OUTSTANDING? EXISTING TIPPING POLICY: Servers and bar only or all front of house positions?
FIXED CONTRACTS TO HONOR (equipment that goes with the sale, credit card processing through POS system, etc..)
STORAGE: You never have as much storage as you need in restaurants? Are there lockable storage areas such as a basement, closets, separate rooms? Is the walk-in cooler and freezer space adequate for your needs and menu?
OWNER CONCESSIONS: Are there repairs or improvements that the owner will fix? Now’s the time to negotiate. NOTE: When I sold my restaurant, I rebuilt the rear entrance with a new roof, doors and interior renovation because it was needed and was the right thing to do.
Means just that… taking the necessary and thorough consideration of all the above list, as well as the all-important financial reports. NOTE: It is common in the restaurant business for financial reports to be inaccurate or unreliable. Some dishonest restaurateurs have unreported income and keep two sets of books. If so called Profits cannot be proven on a tax return, then you should not pay for those profits which cannot be validated. One Spot Check to verify income would be to compare financials and/or tax returns to monthly Sales Tax reports. I’d be curious, but chances are if the books are cooked, so are the Sales Tax reports. Its important for you to review the reports whether you understand them or not. Ask your CPA for a lesson and professional opinion on the restaurant’s statements and tax returns.
Have your CPA review:
- the restaurant’s Profit & Loss and Balance Sheets for each of the past three (3) years
- the restaurants Tax Returns for the last five (5) years
- the restaurant’s Cash Flow Statement Depreciation Schedule for both equipment and building (if owned)
In addition to Net Income or the bottom line Profit of a restaurant, the number one most telling information is the restaurant’s Cash Flow. Cash Flow is The NET amount of all inflows and outflows of cash within a business, showing its current financial viability. Positive Cash flow shows that the restaurant’s cash and liquid assets are increasing, while Negative Cash Flow means that cash and liquid assets are decreasing. Positive Cash Flow allows a restaurant to pay its expenses, cover its debts, invest in improvements, pay a return to investors/shareholders and put aside a cash cushion for future uncertainties.
A restaurant’s Cash Flow statement should show Net Income PLUS all compensation, bonuses and owner benefits including shareholder distributions not reflected on tax returns, Amortization and depreciation benefits, Bank and long term Interest payments, and all items currently paid with cash that a new owner may or may not choose to continue. The higher the Positive Cash Flow Number, the more appealing the business and the more expensive it will be to purchase.
The following example shows a strong Positive Cash Flow Restaurant:
NET INCOME $165,000
Owner Compensation and Benefits $ 85,000
Company Car, Repairs, Insurance, Gas $ 15,000
Interest Expense $ 73,000
Depreciation $ 39,000
Amortization $ 3,000
Plus Off Balance Sheet items:
Shareholder Distributions $ 25,000
Total Cash Flow $405,000
*Have your CPA review all financial statements and tax returns for accuracy and an honest assessment of the potential value of the business.
- Are Sales Growing or Flat?
- Are expenses stable or are there any dramatic variances from period to period – why?
- What is the Net Profit Percentage? Industry averages about 12 – 15 %
- What are the restaurant’s Food, Beverage & Labor Costs (AKA Prime Cost) – this should be 65% combined or less.
- Employee compensation and raise policy vs. recognition and non-monetary rewards?
The two most common restaurant valuation methods are Asset Value and Cash Flow Value.
ASSET VALUATION: If you are simply buying a closed or marginally operated restaurant in a lease space and you plan to change the concept: in effect you are only buying the equipment and the right to occupy the space. There is No Goodwill or Brand value to you the purchaser.
If Real Estate is involved then the same theory applies.. you are buying equipment, land and building only with No Goodwill Value. Years ago, I purchased a failing restaurant that owned the land and building, but there was No value to the concept to me, nor was there repeat business or marketing power. I simply purchased the property and equipment for a negotiated price.
CASH FLOW VALUATION:
Generally used to purchase a viable existing restaurant with established reputation and clientele. Here there is a value to Goodwill, equipment, supplies and inventory in addition to a possible value of land, building and Non-Compete agreement from the seller.
The typical Cash Flow Valuation formula is 2 to 3 Times Cash Flow Plus Real Estate value which is usually calculated separately.
NOTE: The Asset Allocation assigns a Value to: A) Goodwill B) Equipment, supplies and inventory C) Covenant not to compete D) Real Estate if applicable
The Allocation affects your Tax Liability or benefits for the year of purchase and should be calculated by your CPA/Attorney for optimum Tax Advantage to you. As the same holds true for the seller, the Asset Allocation becomes another point to Negotiate.
FINDING RESTAURANTS FOR SALE:
The old adage “everything’s for sale for the right price” holds true in the restaurant business. Lots of operators of successful businesses are looking for an exit-strategy for a variety of reasons… this was me once. If you are a customer and fan of a restaurant you’d like to own, meet the owner and discuss possible interest in a deal.
Check with your State Restaurant Association, Business Brokers (restaurants are popular businesses for sale and the commission is usually paid by the seller) Food Purveyors, Industry contacts and word of mouth Media (industry trades, local newspapers).
FORM NEW ENTITIES:
If you buy an existing restaurant, make absolute sure that you form an all new operating company such as an S Corp. or Limited Liability Company (LLC). If you were to keep and operate under the seller’s former organization, you could be liable for any past debts of the business, business practices, future litigation from unresolved labor issues, prior violations, etc..
Most importantly, you should set up separate companies for your restaurant to run the business only and a real estate company to own the property, equipment and other tangible assets in the building.
As cash flow builds, rents are paid monthly from the restaurant company to the real estate company for use of the space and equipment contained therein. There is simply too much liability in operating a restaurant, especially one that serves alcohol to not protect your assets and minimize what can be attached in a lawsuit.
Perhaps the #1 reason restaurant’s fail is that they are undercapitalized. Things always cost more than you think and it is impossible to anticipate your true cash needs when buying a restaurant (even more with new construction) allowing also for necessary working capital.
No matter how much you qualify for as a borrower, you should still have access to additional sources of capital and if you are just starting out, its unlikely you qualify for additional lines of credit with the bank. Consider personal credit cards. When I started two new restaurants (one new construction, the other purchasing the real estate), I was undercapitalized and it was only my personal credit cards that saw me through the short term until cash flow kicked in. In the latter case, I also needed to sell a piece of real estate after the doors opened to satisfy short-term cash needs. Be prepared for the unexpected!
The restaurant business is widely known for its challenge and high fail rate, so its no wonder banks are often reluctant to fund new restaurant ventures, as opposed to established successful operations. One benefit to Seller Financing is you’ll pledge a down payment, but in most cases won’t be required to sign a personal guarantee against your assets or pledge your house as security. The terms are usually reasonable as the seller has a strong interest in your success. The only downside is the seller, much like a bank will take back the restaurant if the payments are not made as agreed.
NOTE: Under this scenario, make sure that you hire a Title Attorney to conduct a Title Search of the property for sale to make sure there are no ownership disputes or other encumbrances.