The three primary areas buyers focus on in doing their analysis to determine if the restaurant, bar or club opportunity is the right one for them is as follows: a. Price Valuation, b. Location Overview and c. Lease Terms. In this article I will discuss Price Valuation and Location Overview and in the next edition I will discuss Lease Terms.
A buyer evaluates the price of the business to determine if it is reasonable based on a couple different methods.
Assets in Place Method of Valuation – If the business is not making money or is marginally profitable this is called the Assets in Place purchase. With these types of purchases the buyer is usually interested in the fixtures and equipment, lease, leasehold improvements and any licenses that go with the business and they are not normally interested in the name and menu of the business. The buyers for this type of business have their own menu and concept in mind. The criteria for pricing the Assets in Place business is the ratio between the sales price and sales.
For example if is a business is generating $500,000 in yearly sales and the sales price is $125,000 -the sales price is approximately twenty five percent (25%) of the yearly sales. ($500,000 yearly sales x 25% = $125,000 sales price), My experience in selling these types of businesses, which is the majority of the businesses I sell, is that businesses doing $350,000 in yearly sales or less sell on an average of thirty five percent (35%) of yearly sales. For example if a business in doing $300,000 in yearly sales the average sales price is approximately $105,000 ($300,000 yearly sales x 35% = $105,000 sales price). Businesses doing $350,000 to $1 Million in yearly sales sell at an average of twenty five percent (25%) of yearly sales. For example if a business is doing $750,000 in yearly sales then the sales price will be approximately $187,500 ($750,000 yearly sales x 25% = $187,500 sale price). Businesses doing $1 Million to $2 Million in yearly sales are selling at an average of seventeen percent (17%) of yearly sales. For example if a business is doing $1.5 Million in yearly sales it will sell for approximately $255,000 sales price ($1.5 Million yearly sales x 17% = $255,000 sales price). My experience in selling businesses doing $2 Million or more in yearly sales is that they sell for approximately fifteen percent (15%) of yearly sales. For example if a business is doing $2.5 Million in yearly sales it will sell for approximately $375,000 ($2.5 Million yearly sales x 15% = $375,000 sales price).
When buyers are eyeballing buying opportunities they are not necessarily familiar with the ratios indicated above but if they have been in the market long enough they develop an innate sense of value based upon how the subject business they are evaluating compares to other comparable businesses for sale.
Going Concern Method of Valuation – The Going Concern Method normally means that the business is making money and when the buyer purchases a going concern business they usually want to operate the business the same way the seller did and maintain the name, menu, operating systems and personnel in place. With this method the lease, leasehold improvements, fixtures and equipment, name, menu, concept, goodwill and cash flow are all included as part of the sale. The primary valuation method used for a Going Concern Valuation is the yearly adjusted cash flow method which is also referred to as discretionary earnings. This means that the net profit on the tax return or on the year-to-date income and expense statement is adjusted by adding back the following items to the net income: one working owners salary and payroll taxes, any personal expenses the owner is charging the business (food for consumption at home, life, health and disability insurance premiums, auto expense, entertainment and vacation expense, etc.), depreciation, interest and amortization expense on any loans the buyer will not be assuming and net operating loss carry forward charges if any. Additionally any extraordinary expense and or non-reoccurring expenses such as extra legal or accounting bills related to a particular lawsuit or unusual situation would be added back to the net income too.
Once the yearly adjusted cash flow is determined a sales price multiplier will be used to determine the value of the business. The sales price multiplier for independently owned, non-chain, non franchised food service operations will vary from one to three times yearly adjusted cash flow depending on the risk factors and other factors listed below.
The risk factor is determined by the following criteria: 1) the degree of difficulty in operating the business, i.e. an espresso operation has a low degree of difficulty as it is an easy operation to run but an upscale dinner house operation has a high degree of difficulty because it requires a high degree of expertise and sophistication to run this type of business successfully and 2) how long the business has been in operation and the past history of the business in terms of profitability and sales growth. A business with an easy to operate format coupled with a well-seasoned profitable earnings history will utilize a higher sales price multiplier versus a business with a high degree of difficulty without a track record.
The other factors which determine the sale price multiplier are as follows: 1) the lease value, (whether the lease is at market, below market or above market and the length of the lease),
2) the potential upside of the business (i.e. a business currently serves dinner only and has only a beer and wine license and there is potential for a strong lunch and/or brunch business and hard liquor sales) and 3) the future growth opportunities of a particular location (i.e. if there are some major new development(s) that will add new potential customers to the area without a lot of extraordinary new competition).
An example of a Going Concern Valuation is indicated as follows. If the yearly adjusted cash flow of the business is $75,000 and the multiple to be used is 2.5, the value of the business would be calculated as indicated : $75,000 (yearly adjusted cash flow) multiplied by 2.5 (the appropriate multiplier to be used based on the facts discussed above) which equals $187,500 ($75,000 adjusted cash flow times 2.5 = $187,500 sales price).
You may have heard the saying that the three most important ingredients for a successful business are location, location and location. Obviously there are other factors which are very important as well which are discussed in this article and elsewhere but you cannot compromise on location. Choosing the right restaurant location is one of the most important factors in contributing to ones success in the business. The restaurant business is very challenging to be successful in and having a strong location will enhance your chances for success. The key factors to consider in choosing the proper location which are discussed in detail below are as follows: 1. built out market, 2. stable demographics, 3. growth potential, 4. diversified clientele, 5. strong visibility and easy access, 6. heavy pedestrian and vehicular traffic, 7. major market generators in the area, 8. rent affordability and 9. trade area draw.
- Built out market – You want to locate in an area that has combination of commercial businesses and residential population built out. If you locate to an area with a lot of open space you will be vulnerable to have new head on competition versus being in an area that is already is built out.
- Stable demographics – Having a solid demographic base of long term well educated residents grounded with a strong commercial base of businesses and office tenants in the area is important.
- Growth potential – Although you want to be in a well built out area it is always helpful to be in an area where there is opportunity for existing commercial businesses to expand.
- Diversified clientele – It is helpful to have a mix of residents, commercial activity including retail businesses and offices buildings as well as hospitals, schools and religious institutions in the area.
- Strong visibility and easy access – Strong visibility means that the business is easily visible to pedestrian and vehicular traffic and easy access means it is easy to get to the location by either foot traffic or vehicular traffic.
- Heavy pedestrian and vehicular traffic – With these two qualities the business will have more exposure and have a greater opportunity to increase sales.
- Major market generators – Strong traffic generators include hospitals, theaters, colleges, shopping centers and tourist attractions.
- Rent Affordability – This means that you can afford the rent you will be paying. Frequently operators pay more rent then they should and this can contribute to them going out of business. Restaurant operators should not pay more than 6% to 8% of their sales in rent. This 6% to 8% factor also includes any additional costs you may be paying the landlord which may include real estate taxes, fire insurance and CAM charges (common area maintenance costs) which include security, gardening, common area utilities and maintenance costs, etc. This means that if you are doing $600,000 in yearly sales your rent should be no more than $48,000 ($600,000 sales x 8% = $48,000) in yearly rent.
- Trade Area Draw – This is the distance an average customer will travel to come to your restaurant. Most neighborhood restaurants draw customers from a one mile radius of the site. Outstanding planned dining restaurants such as the French Laundry in Yountville, Michael Mina and Gary Danko restaurants in San Francisco may draw customers from hundreds of miles away.
The price of the business, location of the business and the lease terms (which will be discussed in the next edition) are the three most important variables a buyer will evaluate to determine if the business is right for them. If you are considering selling your business it is important to consider these items in determining how marketable your business will be and consult with a professional like Restaurant Realty Company to give you an unbiased assessment.
The lease terms will be discussed in PART II – CLICK HERE