The value of a business when buying a restaurant can be calculated using the income valuation method. Make sure your restaurant broker understands and relies upon this approach to valuation if you’re buying a restaurant.
In the old days of pricing restaurants for sale, it wasn’t uncommon to see an inexperienced restaurant broker attempt to value a business based on sales. Those days are long gone, and your expert restaurant broker should be relying on the industry standard, Income Valuation to set pricing.
This method calculates the total owner benefit derived from the business or Seller’s Discretionary Earnings (SDE). This approach is the most trustworthy in generating consistent results across varied businesses (from a diner to a pizza restaurant for sale).
Agents practicing restaurant brokerage for a living should be well informed and knowledgeable about this approach for several reasons. First, financing sources rely on this method to set values for bank financing. Verified earnings under the income valuation method and twenty percent down qualify for lending from SBA backed lenders. For an individual buying a restaurant, using consistency of this method, allows them to manage their risk and gauge the correct offer price. It also allow you to compare competing opportunities across a common scale.
The Income Valuation Approach uses a restaurant’s profit and loss statement or P&L plus the tax return to look for all the owner benefit delivered by the business. In turn, the higher the owner benefit (sometimes call Seller’s Discretionary Earnings or SDE), the more the seller will get for his bar or restaurant for sale.
The math principle is straight forward and easily learned by those buying a restaurant. Take net income and add back benefits to the owner (salary, insurance, auto or other) PLUS non-cash expenses like depreciation and amortization PLUS cost of debt service (interest) to get to Seller’s Discretionary Earnings (SDE) or owner benefit.
It is not uncommon for inexperienced brokers or those buying a restaurant to rely on a store’s “potential.” There’s nothing technically wrong with this if they are not valuing potential into the pricing. That would be wrong. A seller can only be compensated for his direct benefit. If you are buying a restaurant and see opportunity to run a better operation, reduce food costs, save money on labor or otherwise improve the business to earn more, the benefit belongs to you. It can’t be factored into the offering price for buying a restaurant.
The point of calculating benefit is to get a true, not distorted, picture of current operations and current owner benefit to calculate pricing. Any future potential included in the benefit distorts pricing and overprices the opportunity to the person buying a restaurant.
Once owner benefit is reached, the broker will use this as a multiplier to calculate the value of the restaurant. Typically, restaurants for sale trade between 2.5 and 3 times owner benefit. This large variance is based on any number of things that can positively or negatively affect the range. If you are buying a restaurant with excellent books and records, it will trade at the higher end of the range. A hot franchise concept may also trade higher. Over saturated concepts may also trade at the lower end.
Seasonality can also affect the multiplier with sports bars trading down in summer months and higher in the fall. You should ask any broker why and how they arrived at the pricing model to be certain they are relying on the best market data and trended information for buying a restaurant.
If a broker cannot share his strategy, comparable pricing and other factors affecting the price, find a better broker. Pricing, when buying a restaurant, is not a guessing game but a definable model. The best brokers with financial experience, degrees or holding the Certified Business Intermediary designation from the International Business Broker Association know and understand this methodology.
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