Understanding Restaurant Valuation as a Buyer

Buying a restaurant can be the pursuit of a lifelong dream. At the same time, it can represent a significant investment for a restaurant buyer that will require study and analysis to make sure you are both paying a fair price and position the opportunity for long-term success. That is why understanding restaurant valuation is so important for making informed decisions. This article will break down the key factors that affect restaurant valuation as well as provide actionable tips for restaurant buyers.

Key Components of Restaurant Valuation

There are several key components of restaurant valuation, and each is discussed in detail below. Ranging from tangible to intangible assets, each of these components can impact the overall pricing and ultimate value of the restaurant business.

1. Business Assets You can see and touch: This includes all tangible assets like kitchen equipment, furniture, and fixtures. The business pricing or valuation does not include fresh inventory, only physical assets. The condition and quality of these assets impact can impact their value however restaurant equipment overall has a very long useful life.
2. Financial Performance: Profit-and-loss statements provide a clear picture of the restaurant’s profitability. Looking at the financial results over multiple years, establishes trending for both revenue and profitability, giving the buyer confidence for a long-term investment.
3. Lease Terms: Favorable lease agreements, including option years, and rental rates, along with the transferability and assignment of the lease, add value to the business. Lease terms of at least ten years are a requirement for SBA lending.
4. Location and Market Potential: While financial results are the key drivers of value, prime locations with high foot traffic can work in favor of the valuation. Extreme examples of this might be an airport or stadium location.
5. Intangible Assets: Franchise restaurants, on average, trade higher than independent concepts with the same results. This is due to brand recognition, national loyalty programs, and reputation that can influence the value of the business.

Restaurant buyers should evaluate each of these components individually and collectively when deciding on the right opportunity for them.

Common Valuation Methods for Restaurants

Restaurant buyers may be confused by the valuation methods cited in the purchase of a restaurant but overall, there are three methods they may encounter and SDE or Seller’s Discretionary Earnings is the most frequently used for purchases of fewer the five or more stores. It is most commonly applied in an SBA (Small Business Association) lending scenario. Let’s review each method.  

Seller’s Discretionary Earnings (SDE): This method calculates the total financial benefit available to a single full-time owner-operator. It includes net income, owner’s salary, and discretionary expenses.

Formula: SDE = Net Profit + Owner’s Salary + Add-Backs (discretionary expenses).

Revenue Multiples: This method values the restaurant based on a multiple of its gross revenue, typically ranging from 0.25x to 1x of annual revenue. This is a very basic and unreliable means to estimate the value of a business since restaurants with the same volume could deliver vasty different earnings results based on their management of food, labor, or occupancy costs.

EBITDA Multiples: For larger restaurant groups, EBITDA is often used. EBITDA is the abbreviation for earnings before interest, taxes, depreciation, and amortization. The typical multiple range may depend on the concept, profitability, or other factors.

When evaluating restaurant opportunities, make sure you understand the method used to calculate the value and are clear about any addbacks and owner salary applied to the business.

Assessing Financial Performance

As you assess financial performance, there are three areas that any restaurant buyer should review in depth. These include revenue trends, profit margins and add-backs.

Revenue Trends: Are sales growing, declining or consistent? Any answer may be the right one if you have a plan for revenue growth.

Common growth indicators include:

• Expanding Revenue Streams: For example, can the business add catering, delivery, or online sales?
• Customer Demographics: Does the restaurant appeal to a growing or underserved market?
• Marketing: Is the owner effectively marketing the business to the area or are their opportunities for grass roots marketing?
  
  

Red Flags: On the other hand, there could be red flags that show up at this stage of business review. For example:

• Saturated Markets: Is this a concept that’s been duplicated in multiple forms making it difficult to stand out? Don’t be afraid of a high concentration of restaurants, just the “me-too” aspect of too many that are the same.
• Declining Revenue: Understand the reasons behind any decrease in sales and have a clear plan to address them. Revenue can solve a multitude of other problems.
  
  

Profit Margins: What is the “bottom line” on the restaurant? What is the gross margin (sales minus cost of goods sold?). Both are barometers of the overall health of the business and how it is covering operating expenses and generating profit. Well run restaurants should hit 10% to 20% in net income levels. If they business you’re considering is not hitting that number, perform a gap analysis to understand what you must implement to either control costs or increase revenue.

Add-Backs: Add-backs should simply be thought of as expenses that go away when the owner goes away. Thus, they can be “added back” as they will represent earnings for the new operator. Examples might include auto expense, cellphone expense, insurance, owner compensation or literally any expense paid on behalf of the owner. You should be sure that all discretionary expenses added back into the valuation can be easily confirmed.

Evaluating Assets and Liabilities

Restaurant buyers should also spend time evaluating any assets or liabilities associated with the business.

Assets to Evaluate: Evaluate the assets of the restaurant prior to purchasing with particular attention to:

• Equipment: All equipment should be inspected by a third-party who has experience with commercial equipment. This includes all kitchen equipment like ovens, fryers, flattops and more.
• Refrigeration:       A separate vendor should do a review of all commercial refrigeration to confirm it is holding temperature, seals are in good order, and there are no major repairs on the horizon.
• HVAC – The air conditioning requirements of a restaurant place a lot of stress on equipment to both handle the front of the house and a hot kitchen. Make sure that an air conditioning specialist inspects this and confirm whether there has been a maintenance agreement in place as many landlords require this. If so, request the maintenance records.
• Hood System:       Make sure the Ansul fire suppression system is in good working order. This is necessary to keep the restaurant well ventilated and free of smoke from cooking as well as provide protection in the event of a kitchen fire.
• Lease Agreement: Review the terms, duration, and transferability of the lease.
• Intellectual Property: This includes franchise agreement, use of any owned trademarks, recipes, and branding elements.
  
  

Liabilities to Consider: Confirm before buying any liabilities that could transfer or be created for you as a result of the purchase. These may include:

• Debt Obligations: Any purchase agreement should detail that any outstanding loans or debts are the obligation of the seller and must be cleared up by closing. The closing attorney will run a lien search to be sure the business is free and clear of all encumbrances before transfer.
• Online Reputation:       Check the reviews and reputation of the business online and in social media. While some level of “negative noise” might be present, persistent reviews with the same issues may indicate a larger issue.
• Pending Repairs: Structural or equipment repairs identified in the inspections cited above must be remedied before closing or they will become the buyer’s liability and may require additional investments post-purchase.
  
  

Overall, spend adequate time and effort to understand the condition of all assets and protect against acquiring liabilities prior to closing.

Understanding the Lease Agreement

A restaurant’s lease can contribute to the valuation in both positive and negative ways so spend some time understanding the full consequences of the lease. If the lease term is under ten years, it means any lending can only be amortized over the life of the lease. If you have eight years on the lease, this may not be an issue. If you have only three years remaining, it is a deal killer.

What is the lease rate compared to current market rates? If you have an under-market lease which is assignable with assumptions of those terms, that’s a win for the restaurant buyer. If you have a short lease subject to renegotiation, that is a different scenario altogether. Reviewing the lease agreement is crucial for understanding the long-term feasibility of the business.

In general, here are some lease factors to evaluate:

• Term Length: Longer leases with renewal options provide stability and increase value.
• Rent Amount: Ensure the rent is competitive and sustainable based on revenue.
• Transferability: Confirm that the lease can be transferred without significant restrictions.
• Landlord Relationships: Good relationships ease the transition and pave the way for future negotiations.
  
  

The Importance of Brand and Reputation

A strong brand and positive reputation enhance a restaurant’s value. Franchise brands with national relationships, brand marketing and strong market position have an edge. At the same time, a local concept, well established for a number of years is also a winning combination in certain market. Overall, buyers may pay a premium for businesses with loyal customers and strong market positioning.

Brand and Reputation Considerations:

• Customer Reviews: High ratings on platforms like Yelp, Google, and TripAdvisor demonstrate customer satisfaction.
• Social Media Presence: A well-maintained online presence adds value by enhancing marketing reach.
• Unique Selling Proposition (USP): Restaurants with a clear USP stand out to buyers. A unique selling proposition may be related to the menu, product offerings, overall cuisine or other ways in which the restaurant has been marketing.

To understand the validity and contribute to the restaurant valuation, review customer feedback and online presence as part of your process to understand the strength of the restaurant’s brand.

Leveraging Seller Financing

Seller financing can make a restaurant purchase more accessible for new restaurant buyers by reducing the need for an upfront investment. Buyers appreciate seller financing since it conveys confidence from the seller in the future performance of the business.

There are a number of advantages of seller financing including:

• Lower Initial Investment: This can reduce the down payment amount in some instances.
• Favorable Interest rates: Sellers can offer terms that are better than those found with traditional lending paths.
• Lower Fees: SBA lending has a number of fees that while, “baked into” the payment, still equate to a large number over time. With seller financing, there are no SBA “points” or guaranty fees assessed.
• Faster Closing Process: Transactions may close more quickly without traditional lenders.
• Seller Confidence: A buyer know the seller has confidence in the business to pay the debt in the future.

Overall, seller financing can provide a great option for buyers in the market to purchasing a restaurant.

After the Sale - Post-Purchase Success

A good deal isn’t just about the price; it’s also about making sure the business remains successful after the sale. In our book, Appetite for Acquisition, we devote an entire chapter to this topic and offer the following tips:

• Retain Key Staff: Maintain a reliable team to ensure continuity.
• Introduce Incremental Changes: Focus on small improvements to maintain customer loyalty. In fact, we tell you to “do nothing” for the first 100 days except study the business
• Leverage the Seller’s Knowledge: Use training or consultation during the transition.
• Enhance Marketing Efforts: Revitalize the marketing strategy to attract new customers.
• Clean and Refresh: While no large scale changes should be made to the menu or operations, cleaning and painting are always a good idea.

Overall, buyers should work to identify opportunities for growth and improvement but first truly understand the operations of the business.

Determining what constitutes a “good deal” when buying a restaurant involves more than just comparing the asking price to industry benchmarks. A comprehensive understanding of restaurant valuation, including financial performance, assets, location, brand strength, and growth potential, is essential for making informed decisions. By leveraging valuation methods, conducting thorough due diligence, and working with professionals, you can confidently assess whether a restaurant aligns with your goals and is worth the investment. Beyond the numbers, a good deal is also about finding a business that aligns with your vision and has the potential to thrive under your ownership.