7 Key Areas to Evaluate Before Buying a Restaurant
When it comes to buying a restaurant, it’s important to evaluate it carefully. A posh restaurant with a steady stream of customers may turn out to be a lemon. On the contrary, a hole in the wall eatery on the far edge of town may turn out to be your diamond in the rough. Below is our breakdown:
1. The location should work to the restaurant’s advantage.
Location is one of the most important factors in making or breaking a great business. The same holds true for restaurants. Yet, what serves as an ideal gas station location may not serve well at all for a restaurant. The restaurant business is very challenging and a strong location can have a huge impact on its ability to be successful.
Key characteristics to look for in an ideal restaurant location:
- Easy access and visibility. A restaurant should be highly visible and easy to locate. It should be easily accessible from for cars with ample parking driving down the road or pedestrians on the sidewalk.
- Built out and developed area. The restaurant should be located in an area with a combination of commercial businesses and residential population built out. Restaurants located in wide open spaces risk being faced with new competition.
- Diversified mix of customers. A restaurant should be located within a diversified community with a mixed clientele of local residents, office workers, students, tourists, or even government workers.
- High trafficked area. A busy neighborhood street or main thoroughfare that attracts pedestrians and shoppers offers additional exposure.
- Solid demographic. The location should have a strong demographic makeup of long term, well-educated residents, as well as an established commercial base of businesses and offices.
- Opportunity for Growth. There should be room for expansion and growth. Even in areas that are already primarily built out, there should be some potential for new businesses to move in or existing ones to expand.
- Strong anchor establishments. One or more traffic generators should be within close proximity, such as a movie theater, shopping center, university, hospital or tourist attraction. Avoid areas with limited hours of operation, such as office parks.
2. The rent should be affordable. Rent affordability rule of thumb.
Many restaurants fail because they simply cannot afford the rent they are paying. The owner miscalculates the restaurant’s operating costs and the amount of sales it must take in to cover those costs and still turn a profit. They don’t factor in many of the additional costs associated with the property’s upkeep and maintenance.
A general rule thumb is that restaurant operators should pay no more than 6%-8% of their sales in rent. This percentage also includes any additional costs associated related to real estate taxes, insurance and maintenance costs, such as gardening, repairs, pest control and security. In other words, if your restaurant is bringing in $400,000 per year in sales, then your rent should be no more than $24,000 to $32,000 per year.
3. Terms of the lease should be spelled out.
In some cases, the landlord may be willing to transfer the existing lease to the new owner. If this is not the case, you should always confirm with the landlord that they are willing to assign a new lease to your restaurant business. They may require a new application and an advance of rent in escrow.
In either case, your minimum base term should be 5 to 10 years, with 1-2 or 5 year extension options. Any increases should be clearly spelled out in terms of annual increases for a minimum of 10 years. Otherwise, your landlord may make a fair market adjustment to your lease that is beyond your means.
4. All assets and equipment should be in working condition.
If you are evaluating a restaurant for sale, chances are, a large part of the price will be based on the furniture, fixtures and equipment — especially in an asset sale.In an asset sale, you are simply purchasing assets, such as appliances, tableware, furniture and point of sale equipment. If this is the case, evaluate these assets carefully and find out as much as you can about them.Typical questions to ask the owner may include:
- How well (or poorly) does the equipment work?
- How old is the equipment?
- What is the life expectancy of the machinery?
- When was it last serviced or repaired?
- Is it under any type of warranty?
If you’ll be spending the bulk of the purchase price on equipment, you’ll definitely want to make sure that you are getting what you paid for. If not, you should be ready to negotiate accordingly when it comes to purchase price.
5. Any risks or liabilities in operating the business.
There are a number of external factors that could affect restaurant operations after you purchase it. For this reason, it’s important to understand any local ordinances that could change zoning or impose costly requirements on a restaurant business. Examples of this may include updating ventilation or drainage systems.
Also, you should inspect operating risks like potential illegal activity. Are there unreported cash sales or payments being made to employees or vendors under the table? Are there any health code or safety violations? Often times, business owners cut corners to save money on operating costs.
Consider any skilled labor that may be required in order to operate the restaurant. Will it be easy to find someone who knows coffee bean roasting or beer brewing? What happens if you can’t find this skilled labor?
Your goal is to find out if there are any liabilities or, if there is anything that could negatively impact the operations of your business. You should be made aware of any responsibilities you will be taking on once you assume ownership of the business.
6. Goodwill or intangibles that add value to the business.
Also known as goodwill, intangible assets are things that might be difficult to quantify but still add value to the business. Goodwill may represent the restaurant’s reputation, popularity or even iconic status as a tourist attraction. The restaurant may be very well known with a strong online presence and many positive reviews.
If the restaurant sale is a going concern transaction, the new owner usually intends to operate the restaurant under the same name, with the same menu and concept. These sorts of intangible assets can be very valuable to the next owner.
In many circumstances, the seller may try to inflate the value of the goodwill, but this is only one aspect of restaurant’s value. The restaurant’s business financials and other factors need to be considered in determining its fair market value.
7. Profitability and future earnings potential.
When determining a restaurant’s profitability and future earnings potential, first you need to evaluate its financial statements, including income and expenses to arrive at current profits. Next, you should look at any potential to increase income and reduce costs. You should also consider how current and future market conditions could affect the price of food, labor and other expenses crucial to operations.
Furthermore, restaurant’s income statements should show an upward trend in sales over a period of time. If sales are declining, it may not necessarily be a reason to abandon the deal. However, it may be a cause for concern and should be addressed before you dive deeper into the next steps of the transaction.
Before you consider buying a restaurant, each of these key areas should be carefully evaluated. As with any business, it’s important to conduct some sort of preliminary due diligence to better determine its potential value and whether or not the opportunity is right for you.