Restaurant Valuation – Post-Pandemic Update
You may not be interested in selling your restaurant any time in the near future. And that’s fine. But life happens. You do not have complete control over the timing of significant events, including the need to sell or at least value your business.
An accurate valuation is required not only for carefully planned business sales, but also in the wake of unexpected events. These include execution of a buy and sell agreement to reassign shares of the company if a partner dies or otherwise leaves the business. A valuation of the business as marital property might be required in a divorce proceeding. Or you might be presented with an unexpected offer to purchase your business that could be too good to pass.
What’s It Worth to You Now? Factors influencing restaurant value in the current market.
If you plan to transfer all or some of your interests to family members during your lifetime or in your estate plan, the value of your business can have tax ramifications. You are in a better position if you have taken the time to carefully assess the value of your business before these situations arise.
Be aware that there are highly trained professionals who specialize in valuation of closely held businesses who can assist owners in determining the “fair market value” of their enterprises. You would be well-advised to hire a business valuation consultant when contemplating any transfer of ownership of your business.
Restaurant Valuation in the Current Market
The hackneyed real estate phrase “location, location, location”, meaning that a property’s location is the most important aspect of its value, applies to businesses, as well. And not just in terms of the part of town in which a restaurant is located. For a number of reasons, some restaurant markets are “hotter” than others.
As the “work from home” trend continues post-pandemic, Northeast and West Coast cities with high costs of living are losing residents to emerging-growth regions with milder winters in the Southwest and Southeast. Among the first steps to predict the potential value of your business is to assess the growth of the restaurant market in your backyard.
Marilyn Schlossbach, an Asbury, New Jersey-based restaurateur, caterer, chef and chocolatier whose properties include Langosta Lounge, The Sparrow at WCP, and Chinese Fish House, says she looks at the demographics of the consumer base. For example, you want to know if the median age of the area is skewed toward younger or older patrons. Are you in a college town or in an upscale suburb with established homeowners?
“I look at the traffic patterns,” says Schlossbach. “I look at the needs of the community. The numbers are very important, but so are the intricacies of the location.” To these factors that help determine value, she adds access to workforce and affordable housing for the workers.
Fred Parrish, president and CEO of The Profit Beacon, a financial forecasting software company, says that in the Dallas, Texas region, Covid has not had an effect on restaurant valuations. “However, it’s quite possible that other parts of the country could have an entirely different dynamic.”
Indeed, in his market, Michael Bissanti, founder of the Cambridge Restaurant Project consultancy in Boston, Massachusetts has observed “demand for restaurants is lower due to labor shortages and increased cost of goods sold. I recently found a landlord with an empty restaurant, and he just handed me the keys; no upfront cost.”
The independent restaurant market has changed significantly, even in the past 10 years when concepts and cuisines fell into uniform categories. With the increasing food sophistication of consumers and the explosion of off-premises dining, prospective buyers are launching a variety of concepts, particularly in small footprint layouts.
“Covid has upped the value of location features. Now, having an outside area for dining, pick-up windows, curbside parking for pick-ups, a staging space for high-volume deliveries and shipping, and the ability to get a liquor license for take-out booze plays a key factor.”
“If I’m opening a taco joint and you are selling your pizza concept, sales won’t really matter as much since you are going after a new market segment.” In that case, the buyer is looking for a location, and possibly tapping into the previous owner’s market. However, prospective buyers can’t be assured the going concern of the business will translate into success for them.
As you are likely aware, many new operators from casual to fine-dining want to offer off-premises dining as a significant percentage of sales. Your previously lackluster strip mall lease address might have increased appeal due to its ease of parking for delivery drivers and take-out customers.
“While leasehold has always been a key factor in valuations for length of lease and cost of occupancy, Covid has upped the value of location features,” says Arlene Spiegel, president of Arlene Spiegel & Associates in New York City. “Now, having an outside area for dining, pick-up windows, curbside parking for pick-ups, a staging space for high-volume deliveries and shipping, and the ability to get a liquor license for take-out booze plays a key factor.”
Perhaps as never before, it is critical to match your business with a buyer who sees the most value in your facility. You have to treat nearly every independent restaurant as a unique enterprise that will appeal to a specific type of buyer. The trick is finding them. And this is where a restaurant broker can really be a great help. As Bissanti notes, prospective buyers have a variety of plans. “Are they going to gut-renovate or are they looking for a turnkey operation?”
The value of a going-concern restaurant is often based upon the stability of the business and the ability to manage profits, says Ken Heck, the managing partner in Chinglish, a kosher restaurant in the upscale Summerlin section of Las Vegas, Nevada. If a buyer is looking for a turnkey operation, they want to be assured the business will be able to prosper with owner transition.
“Before you sell, it’s a good idea to lock in your chefs, recipes and key employees,” says Heck. “It ensures the new owners will be able to continue and then make adjustments after the transition.” Sellers often need a reality check. Business owners in every industry believe their business is worth much more than a buyer is willing to pay. “Owners have a hard time looking past the amount of money, time and sweat they put into creating a business,” says Heck. Unfortunately, that means nothing to the buyer.
Shanny Covey, the owner and chief executive officer of Luna Red, Novo Restaurant & Lounge, Mint + Craft and Robin’s restaurants in California, says she includes equipment, improvements, location, age of the building, signage and sales volume in the value of the restaurant, “as well as the lease and having good operating systems and a solid, loyal team.”
With labor shortages, buyers need to be assured they will be able to adequately staff the restaurant. If you have a general manager with a loyal following of employees, you might want to bring them into the conversation with the buyer to negotiate the terms of their employment going forward.
According to Steve Zimmerman, president, CEO, principal broker and founder of the Restaurant Realty Company, a useful valuation method used for going concern sales is the seller’s discretionary earnings (SDE) method. This, he explains, means that the net profit is adjusted by expensing the following items against sales, to determine a truly accurate net income, taking into considering expenses that might not be reflected on the profit-and-loss statement.
- Working owners’ salaries.
- Any personal expenses the owner is charging the business (for instance, food for consumption at home; life, health and disability insurance premiums; auto expense; entertainment and vacation expense).
- Interest expense on any loans.
- Net operating loss carry-forward charges, if any other expenses are personal and will not be applicable to the buyer.
Any extraordinary expenses and/or non-recurring expenses such as additional legal or accounting bills related to a lawsuit or unusual situation would be expensed against sales, as well, to determine an accurate net income. Once the sellers’ discretionary earnings are determined, a sales price multiplier will be used to determine the value of the business.
Another valuation rule of thumb is using price multiples, which base the value of the business on a multiple of its potential earnings. “The sales price multiplier for independently owned, non-chain, non-franchised foodservice operations will vary from one to three times yearly adjusted cash flow,” says Zimmerman, adding it can depend on certain risk factors noted below:
- The degree of difficulty in operating the business. For example, an espresso operation has a low degree of difficulty since 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.”
- How long the business has been in operation and its history 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,” Zimmerman says.
- The lease value. Whether the lease is at, below or above market, and the length of the lease. • The potential upside of the business. For instance, Zimmerman posits, a business “currently serves dinner only, has only a beer and wine license, and there is or a strong lunch and/or brunch business and liquor sales.”
- The future growth opportunities of a particular location. “For example,” says Zimmerman, “if there is some major new development that will add new potential customers to the area without a lot of extraordinary new competition.”
When selling a going concern rather than a shuttered operation where you are selling the assets and location, you are selling sales and profits. “The facilities are less important,” explains Mark Bires, the owner of Jerry’s Sandwiches in Chicago, Illinois. When selling just the facilities, Bires says it is a function of location and the quality of the build-out.
“If the condition is ratty, or the buyer just wants a complete redo no matter, then they are just buying the location and the hard aspects of the build-out like plumbing lines, electrical lines, etc. All the rest of your design will likely go to the dumpster. If you have a longer-term, favorable assumable lease, then that will add to the value.”
One tactic to increase a restaurant’s value as a going concern is investing in technology, says George Huger, the owner of the Southern Inn Restaurant in Lexington, Virginia. “Establish a strong online presence with a social media following. Establish off-premise/carry-out sales.”
Increasing value also means driving sales, controlling costs and making facility improvements, says Bissanti. “If you want to sell, spend the next six months to a year improving the financial performance of your business and make needed repairs so you can get maximum value. But again, it will depend on finding the right buyer.”
What’s the Story?
Nearly every restaurateur who has navigated successfully through the pandemic has a story of their white-knuckle voyage. And few operators survived simply from accepting government-backed SBA funding and praying the restaurant business would return to the good old days. The so-called “pivots” your business made to stay afloat could be an important narrative in determining the valuation of your business. Make no mistake, the narrative can be as important as the numbers to a prospective buyer.
Given the enormous challenges posed by the pandemic, it might not seem fair to base the value of the concept on how it has fared during Covid, but it is telling in terms of how strong the business might be going forward.
In assessing the restaurant value, Brooks Bassler, founder and CEO of BB’s Tex-Orleans, a Cajun restaurant in Houston, Texas, banks on “how well the business performed during the pandemic compared to its peer groups.” Covey believes that restaurant valuations are going to be different post-Covid. There are concepts that were struggling prior to the pandemic and might have survived with government-backed SBA funding, but are otherwise unsustainable. There are concepts that prior to the pandemic had desirable locations that lost their luster due to lower occupancy of surrounding businesses. Conversely, he notes, some restaurants were able to make significant changes to adapt to the new market conditions, including leaner operations and robust off-premises sales, and are coming out of the pandemic stronger than ever.
In that case, the performance of the concept during the past two years could be an important selling point. According to Huger, “You have to look at historical gross sales and net profit for several years prior to 2020. This can offer a value based on capitalized earning prior to 2020.”
Huger believes if management can show it has been able to maintain relatively strong top-line sales, keep loyal guests engaged, and retain seasoned employees during the pandemic, the market value should be at or above capitalized earnings prior to 2020. “If the business has not been able to maintain a strong staff and engage its loyal customer base, earnings prior to 2020 should not be considered.”
Joe Meagher, a long-time restaurant broker with Mid-American Advisers says the current marketplace is the best restaurant sellers’ market in several years, with prospective buyers coming out of the pandemic with a significant amount of money to invest. He notes, “If you made it through the past two years of Covid that says good things about your operation.”
A BANKER’S PERSPECTIVE
Institutional lenders certainly are among the most detached and objective assessors of business valuation, and “no restaurant gets a loan based simply on its revenue.” This perspective can be a useful tool in developing an objective view of your restaurant’s value.
Banks lend money based on sustainable free cash flow – the amount available to repay debt – and may lend up to and beyond 2 1/2 times that sustainable free cash flow, but usually not more than 60 percent to 70 percent of the value of the bank’s appraised value of the leasehold improvements, fixtures, furniture and equipment.
You determine the free cash flow of the business, first by determining the net operating income of the business; that is, subtracting operating expenses that are required for generating sales from the total sales related to your primary business. For example, as a restaurant your sales related to your primary business would be food and beverage, “not toys, souvenirs, T-shirts and other incidental sales.”
The expenses that are required for generating sales include your cost of labor — both direct costs (wages and salaries) and indirect costs (benefits, insurance, FUTA and FICA) and consumables (including food and paper products).
Complicating the detailed financial analysis required to determine the true free cash flow of a restaurant is that many independent restaurateurs do not report all of their income. Many restaurateurs try to expense a number of owner perks, such as automobile payments, cell phones for themselves and the family, etc.
Moreover, these items are not always clearly identified on profit- and-loss (P&L) statements, but buried within line items such as “extraordinary expenses,” which requires digging to determine the true value of the restaurant, in terms of income and cash flow. Unreported income can represent a high percent of the worth of the restaurant. However, “if the seller can’t prove the income, he shouldn’t expect to get paid for it. You can’t have it both ways.”
In determining the true sales volume of the business, smart buyers will want to look at the business’s invoices or its bank deposits. For example, an out-of-town prospective buyer offered to work at the restaurant for free for a week to determine if the sales added up when compared with what was being reported by the owner. Some restaurant brokers also recommend running a business without burying per- sonal expenses in the financial statements for a year prior to selling, to help provide a more accurate and favorable picture of the cash flow.
The good news, according to a number of brokers we interviewed, is that the restaurant purchasing market currently is strong in many regional areas; but the key as mentioned in the main article is “recasting the financials” to show potential new owners their estimated future earnings. No matter what kind of business you are selling today, the buyer is most interested in the potential return in the future.
FACTORING THE LEASE INTO VALUATION.
“If the business is worthless but the lease has value – such as 10 years remaining at a favorable rent – and it’s transferrable, then the lease may have value more than the business,” says restaurant consultant Rudy Miick, the principle and founder of The Miick Companies in Boulder, Colorado. “In this case, the value is zero or at best a dime on a dollar for equipment, but the lease is the price, and the bonus is all the build out.” The key, says Miick, is to always negotiate a transferrable lease and to get multiple options on lease terms so that there is something to sell and/or transfer at the completion of three or four years.