For anyone buying or selling a restaurant, the most valuable data point you need is an accurate valuation. Unfortunately, bad data abounds, and online research doesn’t always yield the best result. This article, written by an expert in restaurant valuation, provides a comprehensive understanding of the methods and best practices for determining a restaurant’s value.
Understanding the Basics of Restaurant Valuation
Understanding valuation begins with a knowledge of the basics and an understanding of the terms used by the investment and lending community. Those with a financial understanding are familiar with the term, EBITDA, an acronym for earnings before interest, taxes, depreciation, and amortization. For multi-unit transactions most restaurant valuations are based on a multiple of EBITDA.
This acronym is important to understand since it reflects the go-forward position of the business for the buyer. Taking each element on its own, here is why these normal “costs” associated on a profit and loss statement are stripped from the expense category and added to the earnings of a restaurant.
Interest: The new buyer could come into the transaction without debt which means no interest. On the other hand, they could borrow a sizable portion of the purchase price at high interest rates, putting pressure on the earnings to service the debt. However, what will occur in the future is not material to the past and the seller’s interest will not carry over to the buyer. Thus, interest is ignored when calculating the cash flow for the business.
Taxes: Like interest, income taxes are dependent on the future and the individual earnings and tax bracket of the buyer. Thus, income taxes are removed from the expenses. Sales tax, a requirement in all states on restaurant sales is also, ignored in a sense, since it is typically netted down from revenue since sales tax is a “pass through” expense that is collected by the restaurant owner and the paid to the state.
Depreciation and Amortization: These two, closely aligned elements are the most confusing to many of those buying a restaurant. These are non-cash expenses. They have the effect of reducing the income, but they are not actual cash outlay by the seller.
The United States tax code allows a business owner to write off or depreciate an asset over the useful life of the item. For example, a 6-burner stove that cost $4000 may have a useful life of 10 years, thus, even though no cash expense is paid, the seller can “write off” or depreciate the asset over the ten year life, reducing his income.
Amortization is remarkably similar to depreciation but is used for intangible rather than tangible assets. This category includes things like franchise agreements (intellectual property), or goodwill (only present when a business was previously sold), or any asset that doesn’t take a physical form. For both depreciation and amortization, the seller’s accountant can use the tax code to accelerate the write off, sometimes resulting in a very favorable tax strategy but significantly decreasing the earnings on the books. That is why depreciation and amortization are also removed when recasting a business for restaurant valuation purposes.
Another acronym that restaurant buyers and investors should be familiar with for restaurant valuation purposes is SDE or Seller’s Discretionary Earnings. This is also referred to as SCDF (Seller’s Discretionary Cash Flow) or Owner Benefit. The starting point for SDE is EBITDA as explained above. However, for the purposes of SDE and the valuation, items are “added back” to the earnings of the restaurant. These items may include:
- One time or non-recurring expenses: a major repair that would likely not repeat next year, like a cooler replacement, would be added to income for the restaurant valuation, restating the earnings.
- Owner Earnings: Any compensation paid to an owner who works in the store is added back. This is unique to the SDE model and occurs on all single store opportunities because this is the way that Small Business Association (SBA) backed loans are evaluated. Banks assume, under the SBA lending standards that the new owner will be an owner operator and thus will get the benefit of this payroll.
- Manager Salary: If an owner is not working in the business but a manager is in place and drawing a salary, their compensation is added back. Why? The SBA model assumes that the new owner will take over the roles, the responsibilities, and the hours of the prior management, so the benefit of that salary will go the buyer and improve the restaurant valuation.
- Owner Personal Expenses: Any expenses that are paid by the business for the benefit of the owner are also added back. While these can be wide ranging, they might typically include items like automobile expense (for a vehicle not required in the operation of the business), cellphone expense or excess travel and travel and entertainment expense paid by the business that are discretionary for the new owner.
Now that you are familiar with common definitions associated with restaurant valuation, let’s explore key factors influencing restaurant valuation.
Key Factors Influencing Restaurant Valuation
While some online resources point to location as a reason a key factor in a restaurant valuation, I personally discard this idea. At the end of the day, while location is important, its impact is demonstrated in the numbers and location alone, for a poor performing restaurant, doesn’t move the needle in its valuation although for asset-based restaurant valuations, it can be a factor.
In addition, a buyer may consider market trends or local competition (or lack thereof). Primarily however, the financial performance of the restaurant including revenue, profits, and control over prime costs (food, labor, and occupancy), is the single most crucial factor in the restaurant valuation.
Methods of Restaurant Valuation
There are three main ways to determine the value of a restaurant that can be substantiated in the market. Only one qualifies the business for SBA lending.
Asset-Based Valuation: In an asset-based valuation, the restaurant broker is examining the market factors including the amount of equipment, condition of equipment, location, lease, and opportunity for the future to assign the restaurant valuation. Typically, this method applies to restaurants that are not cash flow positive. It could also include restaurants that are too new to have filed taxes or prepared profit and loss statements for multiple years (a requirement for lending). In limited circumstances, it can include restaurants where the owners do not declare all the earnings from the business, though in today’s digital transaction economy, that is increasingly rare. Asset-based valuations can qualify for unsecured lending but not SBA lending. We Sell Restaurants has lenders to assist with unsecured lending options at this link.
The asset-based valuation is based on the new owner assuming the lease and equipment of the business and either improving them through a turnaround situation or converting them to a new concept use. These are particularly valuable for franchise brands looking to expand into new markets that are seeking “second-generation” space, or previously operated restaurants they can convert to their own use.
Income-Based Valuation: This is the most trusted method relied upon by lenders to value the business. An income-based restaurant valuation takes the SDE or Seller’s Discretionary Earnings and multiples it to arrive at the value. The “multiple” can vary depending on whether the business is a franchise or independent, how many units are involved, the time of year, value of the leases, quality of the books and records and other variables. A restaurant broker expert has access to comparable sales, multiples applied during the lending process and current market conditions to arrive at an accurate multiple for determining the restaurant valuation. We Sell Restaurants has lenders specialized in the restaurant space available to assist on cash flow positive business at this link.
Sales-Based Valuation: An “old school” method of restaurant valuation that buyers and sellers should also be aware of is the sales-based valuation method. This is a method by which an inexperience business broker may attempt to gauge the value of a business based on sales. Unfortunately, this is not a valid method for arriving at a valuation since the prime costs (food, labor, occupancy) between two similar volume locations can result in vastly different earnings and thus significantly impacting the restaurant valuation.
Tips for Accurate Restaurant Valuation
If you are a restaurant seller in the market for a truly accurate restaurant valuation, the most important tip for you is to have up-to-date, detailed, and accurate financial records. A dated profit and loss statement from eleven months ago will not accurately reflect the business today. Buyers expect to see the current financial picture. Lenders will require the most up to date numbers and it is just not possible to arrive at the correct answer to “What is my restaurant worth?” without the latest financial information. Ideally, you will have a trailing twelve months of financials, but even quarterly financial statements are better than something from last year.
A second tip for those selling their restaurant with the real estate is to consider paying for a professional appraisal, or an update to one you may already have. Real estate prices have been increasing for both commercial and residential real estate and the restaurant valuation is dependent on the cash flow of the business supporting the debt service on the real estate.
There are intangible assets to be considered in the restaurant valuation as well. If there is an existing franchise, make sure you are aware of the cost and terms for assigning the franchise agreement. If you are not a franchise but operate multiple restaurants, consider up front if these will be bundled together as a package or sold independently. If they are sold independently, you will need to consider how you will license the name, recipes, and any trademarks for ongoing use. It could also affect a buyer’s position on acquisition if there will be other parties using the same name without any type of control over quality or product.
A final, and the most critical, tip for those selling a restaurant is to keep all the expenses and income on the books. You may get a short-term gain from paying employees in cash or failing to record all revenue, but the long-term cost can be high. You bear the regulatory risk for not reporting your tax filings correctly and, devalue the business since earnings on the books are the only ones that count in restaurant valuation.
Common Pitfalls in Restaurant Valuation
Restaurant sellers, buyers and investors should be aware of the common pitfalls in restaurant valuation. The most frequent pitfall we encounter are brokers that are either uneducated or unfamiliar with the hospitality business who overvalue the restaurant. This occurs when a seller has an emotional attachment and drives the interaction. It is important for sellers to be careful about a general broker who just accepts whatever listing price is suggested since personal feelings can inflate a valuation. At the end of the day, valuation is a math problem and—I’ve warned about this frequently—there is a wrong and right answer.
Another pitfall for sellers is underestimate the liabilities attached to the business. Restaurant sellers should factor in any funds owed. In addition, they should be aware that some liabilities may be transferred or even removed at closing. Very experienced restaurant brokers understand how to work with lenders and the SBA on items held over from lending during the pandemic whether it is from PPP (Paycheck Protection Program), or low interest loans issued at that time.
This article provides restaurant sellers, buyers, and investors with thorough understanding of the complexities involved in restaurant valuation, underscoring the importance of accurate financial records, understanding of key valuation metrics, and awareness of common pitfalls. This knowledge is vital for both buyers and sellers in the restaurant industry to ensure fair and realistic valuations. For an accurate valuation of your restaurant business, consult the experts at We Sell Restaurants.
Robin Gagnon, Certified Restaurant Broker®, MBA, CBI, CFE, is the co-founder of We Sell Restaurants, a brand that has carved an unparalleled niche in the industry as the nation's leading and only business broker franchise focused on restaurants. Under Robin’s leadership, We Sell Restaurants has grown to 45 states where it dominates the restaurant for sale marketplace, including franchise resales, delivering on the founder’s vision to Sell More Restaurants Than Anyone Else. We Sell Restaurants was named one of the most influential suppliers and vendors in the country by Nation’s Restaurant News and has earned a position on INC 5000’s list of fastest growing privately held companies. Franchisees of We Sell Restaurants surveyed by Franchise Business Review placed it 25th in the nation in franchisee satisfaction.
Robin is the Chair of the Women’s Franchise Committee of IFA and is a member of the IFA Board of Directors. She is also an MBA and Certified Franchise Executive (CFE) and has her CBI (Certified Business Intermediary) designation from the International Business Brokers Association. She co-authored Appetite for Acquisition, a small business book award winner in 2012 and contributes frequently to industry press appearing in Forbes, QSR, Modern Restaurant Management, Franchise Update, and others. She has appeared on The TODAY Show as a restaurant expert and Entrepreneur Magazine has named her to their list of the “Top Influential Women in Franchising.”