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Buying a Restaurant – What You Need To Know

If you've spent anytime at all looking at restaurant for sale listings, you probably realize that there are more restaurants listed than any other type of business. The question is whether this a good or bad thing? There's really two ways to approach it: the optimist will say that there's a great market when the time comes to sell; while the pessimist will want to know why all of these people are selling their business? Actually, they're both right.

On the positive side, good restaurants, just like any other solid business, will sell quickly; especially in the current market with so many people looking to buy a restaurant. On the other hand, the failure rate amongst restaurants is so staggering that many people simply want to get rid of them before they become another statistic. With this in mind, there are a number of critical issues you need to be aware of so that you're certain when you buy a restaurant, it will be successful with you as the owner

The Lease

Unless a restaurant has a long established, storied history, most often the location will play a significant role in its success. Traffic can be driven by its proximity to office workers, a movie theatre, a mall, or a thoroughfare. Whatever the reason one can see that location is crucial and this is directly related to the lease in place.

More and more landlords are being cautious or downright difficult when it comes to assigning a lease to a new restaurant business buyer. Some flatly refuse an assignment unless the buyer has prior experience in this field. Or, they may require the former owner to remain on the lease (very difficult to convince them to do so), or they may insist that the buyer puts up a significant advance of the rent into escrow.

With these potential challenges, it is recommended that you address the lease portion of the deal as soon as possible with the seller. It is imperative that any purchase contract contains language (a condition/contingency) whereby the deal is contingent upon you the buyer getting the lease assigned or a new lease in place that is satisfactory to you. Once you have a deal in place, you'll want to arrange to meet with the landlord. The seller may require you to complete your financial review first which is understandable however; your best strategy is to convey to the seller that if the landlord will not assign or enter a new lease, the sooner everyone knows, the better it will be. Plus, the seller will surely want to understand the landlord's position for any future prospective buyers.

Insofar as terms and conditions, obviously you'll want a long-term lease including options. Anything less than five years is not recommended.

Valuating a Restaurant Business for Sale

There are two main methods for valuing a restaurant: 'Asset-Based' or Seller's Discretionary Cash Flow' (Owner's Benefit) multiple formula. The Asset-Based method is appropriate for an unprofitable or closed location where you are simply purchasing the equipment in place either from the owner, or maybe even the landlord. Get a reasonable valuation done on the equipment and make an offer.

For an ongoing location, a multiple of the Owner's Benefit (a.k.a Seller's Discretionary Cash Flow) is the way to go. This figure is achieved by totaling the owner salary + perks + net income (on the tax return) + depreciation + interest expense (see additional articles in the Buyer Resource section on valuations). A multiple is then attached to this figure.

As a very general rule, here are some multiples to consider:

  • Full Service Restaurants: 2 - 3 times Owner Benefit Figure
  • Self Service: 1- 2 times Owner Benefit Figure

You should also consider the hours of operation when valuing a restaurant. As an example, an owner operated location that is open five days a week for breakfast and lunch that makes $100,000 year is certainly worth more than one that is open 7 days, serving three meals and makes $120,000 where the seller works 80 hours/week. Wouldn't you agree?

In the past, there was a very general rule used to value different restaurants depending on the number of meals days it was open each week. It is by no means the ideal valuation method but again, valuation is an art, not a science and so here is another barometer for you (although we especially do not like the fact that it uses revenue as a basis we prefer profit!):

  • Five days a week: 70% of Gross Annual Revenue
  • Six days a week: 60% of Gross Annual Revenue
  • Seven days a week: 50% of Gross Annual Revenue

Regardless of the method, keep in mind that you may need to reduce the Owner's Benefit figure that you are using as a basis of your multiple to factor in any anticipated capital expenditures (i.e. equipment) that you will need to make shortly after you take over the business.

Dealing with Cash Sales Unreported Income

While the industry has got better, there is still a tremendous amount of unreported income in the restaurant industry. The problem of course is that sellers expect to get paid for their total profit, yet often times they cannot even prove it. My attitude has always been: if they cannot prove it; you cannot pay for it. Furthermore; they can't expect to have it both ways: if they've been cheating the government for years and benefiting tax-wise, they cannot reap the benefits a second time in the sales price of the business.

Now it is possible to reconstruct the financial picture of unreported income based upon supplier invoices, hourly wages, the seller's personal records, etc. Nevertheless, the onus is on the seller (not you) to do so. The three questions you need to ask the seller are:

  1. Can you prove the numbers?
  2. How are you going to do it?
  3. Are you willing to?

Costs

Food and labor costs are the key considerations in a restaurant business. Costs will vary based upon the type of restaurant whether full service, fast food, and when a large percentage of liquor sales are involved. Again, do your homework. As a very general rule, the combined total of food costs, labor and rent should not exceed 65% of the total revenue. If you violate this rule, you run the risk of operating in the red, which could lead to the eventual closing of your doors.

It is widely believed that a typical breakdown should be:

  • Food Costs: 32 - 33%
  • Labor: 22 - 25%
  • Rent: 6 - 10%

The ideal range when combining these three components should be between 64 - 66%

Due Diligence

Conducting a due diligence review of a restaurant is a comprehensive undertaking. There's a lot to review, and a short time to do it. There are over 125 items that need to be investigated. Allow yourself enough time to perform this critical stage when buying a restaurant. List out everything you need to do, and keep an ongoing checklist. At the end of this article there's a recommended resource that includes a 125 point due diligence checklist and guide you may wish to review.

Other Issues

  • Unless you're an expert, take the time to have the equipment evaluated by a professional. In most major cities, a local restaurant supply store will be able to provide you with a referral. The good news about restaurant equipment is that if you do need to repair or even replace it, there's a huge marked for used equipment at substantial savings.
  • Health department regulations and compliance will form a key part of your investigation. Check public records for any prior infractions, and have the "representations and warranty" sections of the purchase include a clause that there were no prior health violations that may have resulted fines, temporary closure, etc. You may also want to check the online archives of the local paper since they'll usually report on these health issues. As you know, people want to eat in a clean environment. If there were any health issues, it is almost guaranteed that the public was made aware of them and there's no faster way to put yourself out of business then a published report in a local paper that your establishment is bug infested, or in default of health or safety regulations.

So there you have it. Buying a restaurant can be very exciting. Lots of people have built tremendous restaurant businesses. However; there is a lot to consider. Make sure that you educate yourself properly, especially if buying a restaurant is new to you. After all, you want to buy and build a successful operation and not allow yourself to become another statistic.

About the Author

Richard Parker, President of Diomo Corporation

Richard Parker is President of Diomo Corporation – The Business Buyer Resource Center™ (www.diomo.com) and has personally purchased eleven businesses since 1990. He is the author of the most widely used reference resources and strategy guides for buying a business for sale - the How To Buy A Good Business At A Great Price© series. His materials are used by prospective business buyers in over 80 countries.

The recommendations of reading, reference materials or links mentioned, are for general informational purposes only. The materials are intended as a public service and are not a substitute for obtaining professional advice from a qualified firm, person or corporation. Consult the appropriate professional advisor for complete and up-to-the-minute information. These materials do not constitute the rendering of any legal or professional services.

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