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BONUS CONTENT - How to Influence the Value of Your Restaurant
Barry K. Shuster

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If I ask you to estimate the value of your house, you might research listings and selling prices of comparable properties in your neighborhood or town. Depending on the current state of the housing market, you might be elated or dismayed over the value of your home compared, let's say, with what you had projected its value would be today three years ago; however, in the latter case I doubt you would say, "I poured my heart and soul into that property, and, the market be damned, I expect to be compensated for it," or "I'm getting divorced, and I need to get enough money to pay my alimony."

It is also unlikely that you would assume that you would recoup the cost of a swimming pool if you knew that buyers in your market do not value pools or even consider them a liability. And while you might pay heed to "rules of thumb," such as what local economists say about average home appreciation (or depreciation) in your market, you would only use such information as guidelines to be weighted along with many other factors.

As with most assets, the value of a home is ultimately driven by the market, which sometimes favors sellers and sometimes favors buyers. So why do some restaurateurs seem to place so much weight on factors beyond what the market is willing to pay when determining the value of their businesses?

"Selling a restaurant is a more emotional transaction than selling a home," says Neal DePersia, a Cary, North Carolina, business broker with National Restaurant Associates, who has brokered more than 50 restaurant sales. "Restaurateurs want to recoup their sweat equity," he says. On the other side of the deal, however, prospective buyers are driven by the romance of owning a restaurant, and might not be truly objective in their purchase.

"As brokers we have an ethical responsibility to give sound advice to sellers on pricing, and our message is not always what they want to hear, DePersia says. "The price is established by the market." That begs the question: How do you define market value for an independent restaurant? Unfortunately, there is no pat answer or formula.

Douglas Fisher, a certified management consultant, writes in his article "Restaurant Valuation: A Financial Approach (Cornell Quarterly, February 1991)," "the value of a restaurant should be based on its fair-market value," which, when it comes to restaurants is affected by a number of variables:

Fair market value is defined as the highest price available in an open and unrestricted market, between informed prudent parties acting at arm's length and under no compulsion to act, and is expressed in monetary terms. This definition works best when the value is based on several restaurants being available for sale so that the buyer has several purchase options. Additionally, it is presumed that the restaurant owner is not being forced to sell for any reason. Since the seller is neither compelled to sell nor the buyer to buy, a transaction will take place only if the value of the restaurant is considered fair by both parties.

Based on this ideal scenario, for both parties to realize fair market value in a given restaurant sales transaction, both seller and buyer need to have options and a minimum of compulsions to act. This scenario may be the exception rather than the rule in transactions involving independent restaurants, and thus fair market value is less predictable using this definition, regardless of the valuation techniques applied.

While it may be difficult for the owner of an independent restaurant to assign a hard-and-fast value to his or her concept (the valuation of franchise units tend to be more predictable due to their uniformity and franchisor support), the question, "What is my independent restaurant worth?" is not an impossible conundrum. There are factors that drive actual and perceived value of independent restaurants, and allow owners to maximize the valuation of their businesses.

Before we delve into these factors, you should consider that the time to address these issues is not when you are under significant time constraints. You do not have complete control over the timing of many of life's events, including the need to evaluate your business. You probably want to assess the value of your business annually. The slings and arrows of outrageous fortune might force you to sell your business due to unexpected misfortune or in response to unanticipated opportunity. You might face a divorce or the departure of one of the partners in the business, requiring you to value a marital or partnership interest. Or you might just find that the market is particularly ripe for cashing out of one or more of your units. You are in a better position if you have taken the time to carefully build the value of your business before these situations arise.

Number Games

"Business valuation is more art than science," DePersia says. Based on experience, however, he and other restaurant experts have arrived at various valuation formulas, ranging from "rule of thumb" to fairly sophisticated methodologies. For example, DePersia has found, in the geographic market he serves, that a typical successful restaurant will list for roughly one half of reported annual sales, and usually sell for 25 percent to 40 percent of reported annual sales. Thus, a restaurant with $2 million in annual sales might list for $1 million and sell for $500,000 to $800,000. But in the end it depends upon a number of factors such as location, financial performance, age and condition of equipment, as well as occupancy costs -- whether a lease or real estate purchase.

Fisher, author of the aforementioned article, divides the "maintainable annual cash flow" by the "weighted average capitalization rate" (the rate of return on the purchase price and cost of capital needed to finance the business) of the restaurant to arrive at fair market value. How he derives these figures is outside the scope of this article; however, by his own illustration, he determines the fair market value of a restaurant with a maintainable cash flow of $71,235 and a capitalization rate of 34.25 percent as: $71,235/0.3425 = $207,985.

According to restaurant valuation expert Craig Salvay, principal of QuikValSM based in Prairie Village, Kansas, whether the valuation is performed for the benefit of an institutional lender or a prospective buyer, "the number people really look at is sustainable free cash flow," that is, your "net operating income adjusted for market real estate rent (where the operator owns the real estate), and reduced by both the cost of recurring capital expenditure (leasehold improvements, fixtures, furniture and equipment) and the cost of maintaining inventory, receivables and other current, noncash assets.

Revenue is telling, but it does not tell the whole story. 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," Salvay says. "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.

According to Salvay, 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 incidentals," Salvay says. "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).

As the old saw goes, however, garbage in, garbage out. 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.," DePersia says. 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," DePersia says. 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 for one of the businesses listed by DePersia 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. DePersia also recommends running a business without burying personal expenses in the financial statements for a year, prior to selling, to help provide a more accurate and favorable picture of the cash flow.

Sustainable Revenue

Institutional lenders, investors and buyers are not only interested in the current value of the business, but its long-term prospects, as well. A good percentage of prospective buyers of independent restaurants are focused on whether the business will provide a reasonable living and service the debt of the purchase for the next 20 years.

A P&L statement and balance sheet are merely snapshots of your business's financial status at a certain point in time. Sophisticated buyers and investors are concerned with the future of the business for the long haul. And that's why you need to consider the sustainability of your revenues in the valuation equation, according to Salvay. "There are several key factors with which you need to be familiar [in creating sustainable revenue]," Salvay says. These include the physical condition of fixed assets, competition and location, all of which contribute to the perception of the value of the restaurant at present as well as its staying power. Maintaining your physical assets in good condition influences your ability to serve guests efficiently, as well as maintains the morale of the staff. When DePersia contemplates brokering the sale of a business for a new client, his first order of business is to look at the size of the restaurant, its concept, menu, health scores, and condition of equipment.

On this note, you should be aware that improvements don't necessarily equate to market value. Consider an independent coffeehouse that spends more than $150,000 on improvements to its leased space. The results are beautiful and dramatic. Unfortunately, given the annual revenues of the business -- for example, $250,000 per year, it is unlikely that it will ever recoup these expenses when it comes time to sell.

You need to look hard at the improvements in your space, whether it's leased or you own the real estate, to determine if it is necessary to your business. You also need to consider whether a future buyer will value the improvements sufficiently to help you at least recoup your losses at the time of sale.

The consistency and effectiveness of the business's marketing and customer service, among other things, will determine how well it has been able to fend off existing and new competition. Of the factors cited by Salvay, location is the most crucial aspect of sustainability, but is the one most difficult to change once you've picked a spot (more on that below).

The Dirt on the Dirt

If you have the good fortune (in most cases) to own rather than lease your land and space, the valuation of your restaurant is going to be significantly influenced by the value of your real property. For the purpose of this article, we are removing real property value (other than the value of the leasehold, as we will discuss) from the equation, and sticking to the value of the business and its FF&E (furniture, fixtures and equipment).

Commercial real estate valuation is distinct from business valuation in some pretty fundamental ways. There is a larger market for 2,000 square feet of store front than, let's say, a Thai restaurant concept. Sales and lease information on the real property in which the restaurant is operating is much easier to find than business sales and income data on comparable local restaurants in that market.

In any event, if you own your business's real property, you may want to know the value of your business as segregated from the real estate, as many operators sell their restaurant businesses, but retain ownership of the space and become landlords.

For those of you who, like most independent restaurateurs, lease your space, the value of your leasehold can be an important factor in the selling value of your business. "Most buyers and sellers underestimate the value of the lease," DePersia says. He says you create leasehold value in your business when you negotiate the lease with the landlord. In a perfect world, the lease should be assignable to future owners; otherwise, the buyer will not receive the benefit of attractive terms and conditions you negotiated at the time you purchased the business.

According to business valuation consultant Richard Williams, long initial terms (more than 10 years) with long renewal options are important. He also advises against going into partnership with your landlord, in the form of rent as a percentage of sales of your business. In the real world, Salvay says, landlords -- especially those who own prime locations -- are not as willing these days to grant assignable leases without extracting a stiff premium from the lessee, and the terms rarely release the restaurant seller from responsibility for the lease if the new tenant defaults.

That said, you need to be willing to negotiate for the best lease possible for the short and long run. Even if you are unable to negotiate an unconditional assignment and release from your leasehold interest, you and your attorney might be able to negotiate lease terms dictating that assignment and release "shall not be unreasonably withheld." In this case, the landlord would agree to be reasonable in his approval of any new tenant. This will provide the landlord some control over the risks associated with an assignment. It would give you the opportunity to assign a good lease to a qualified tenant.

In a growth market, the long-term value of your well-negotiated lease can be significant. For example, DePersia cited a restaurant near the campus of a university for which the lease was negotiated when student enrollment was about 10,000. When the owners sold the business, student enrollment had swelled to 25,000, more than doubling the restaurant's market. For the new owners, the ability to assign the lease on its original terms was an attractive selling point.

Location

An important service offered by brokers, but one sellers should consider undertaking whether they hire a broker or market the business themselves, is a demographic, competition and traffic study. DePersia hires a firm to create custom demographic reports for sellers. The value of this information -- current and projected -- is significant to smart buyers. David Molee, who purchased an Irish pub concept in North Carolina, studied the zoning and development plan for the area, and realized "growth would soon kick in," he said, attracting more competition, to be sure, but offering more potential customers. In this case, the projected demographics was icing on the cake, so to speak. Molee wanted to take over a successful restaurant business that would "generate money from the start," he said, and have long-term growth potential.

Choice of location is the single most important decision a restaurateur will make in terms of the business's sustainability of revenue, Salvay says. He underscores eight key factors when looking at location:

1. Access. "In only a few rare cases, is going to a restaurant an impulse trip," Salvay says. "Most dining out is a destination trip." Exceptions to this rule are restaurants at shopping centers, along highways, and in densely populated urban areas with much pedestrian traffic. In these cases, people are more likely to eat on impulse. For everyone else, ease of access is critical.

2. Parking. Again, most dining excursions are destination trips. Available and convenient parking is critical. If guests know that parking near your restaurant is hit or miss, they will forgo your business for a competitor, even if they prefer your food and service.

3 and 4. Visibility and Signage. These two factors are grouped because they both relate to your advertising. Restaurants that are tucked away from view or have limited signage due to overly restrictive sign laws or otherwise, are at a serious marketing disadvantage.

5. Zoning. You need to know the kinds of structures and businesses likely to spring up around you. Will it be office space and retail or light industrial? The type of development in your area can affect the number of potential guests on any given day, or the willingness of guests to drive to your location.

6. Residential and Commercial Demographics. These are corollary to the issue of zoning. Make no mistake, the chains carefully study the current and projected demographics of a region. You can immediately tell more about the character of a town by its chain restaurants and big-box retailers than almost any other visible evidence. Are there enough office spaces in the area to attract the affluent working professionals who are likely to visit your hip, upscale bar and grill? Are there enough families with kids to make a themed pizza operation successful?

7. Competition. While you might think you want to be spaced far away from your nearest competitor, a factor which Salvay describes as the "agglomerative effect" favors the congregation of competing concepts, which is why you'll see competitor chain restaurants within a stone's throw of each other in busy shopping areas. The agglomeration of competing restaurants can draw people to the area, and actually allows the competing businesses to have more traffic than if they were more widely separated. (As with all generalizations about business, there are exceptions to this rule. A recent Cornell University study identified choosing a location saturated with competitors as a key factor in restaurant failure. This is one of the reasons that a sound demographic and traffic study is critical, in determining if the market can support your location).

8. Labor. Restaurants have to have access to labor and labor has to have access to you. Most restaurant jobs are near or at minimum wage, and very likely a percentage of your workers will need public transportation to get to you. Otherwise, you may have to pay a premium to fill certain positions.

You Can't Control Wages, Just Productivity

And while we're on the subject of labor and its effect on the value of your restaurant, Salvay says, you also have to take measures to ensure that you maximize your rate of labor productivity, which is measured as a ratio of sales to wage hours worked. You have very little control over your cost of wages, which will be be determined by the minimum wage and the local market for labor. You can, however, influence the output of your labor with the quality of tools you provide your workers, the efficiency of your layout -- especially, the kitchen -- and the atmosphere created by management through training and looking for ways to boost employee morale. High labor productivity will be reflected on the financial statements as well as in a low rate of labor turnover. There is great value for a new owner to take over a business in which the staff knows how things run and are happy working in the organization.

No Pat Formula

If there were a pat formula for determining the value of your independent restaurant, we would gladly provide it. In fact, the value of independent operations is driven by myriad factors and ultimately determined by whatever buyers are willing to pay or lenders are willing to lend, at any given time. Observed market multiples of sales or income, such as noted by DePersia, certainly give you a starting place in pricing your business.

Again, however, buyers are interested in how much money they can pull out of the business after they service their debt over the long haul. This hinges on the sustainability of revenue and the true income and free cash flow of the restaurant. Anything you can do now to improve these numbers will make your business a more attractive target for a buyer and a more acceptable risk for a lender.

As far as taking emotion completely out of the valuation equation, that might be a little much to ask. After all, this is the restaurant business.

That said, try to keep your head as clear as possible, and consider the following principles of restaurant valuation, whether you intend to sell or finance your business this year or in 20 years:

Free cash flow is among the biggest indicators of the value of your business. You don't get paid for income you can't prove. Keep clean books.

Show buyers and lenders that your business has staying power. Maintain a restaurant that can produce sustainable revenue.

Your leasehold can have value to the next owner. Negotiate a strong lease from the start, and attempt to obtain long initial and renewal terms and assignment and release provisions that are favorable to you.

Pick your location carefully, and with an eye toward the future. It is one of the most critical factors affecting business value, and one that cannot be changed easily.

Unless they really improve the appeal of your restaurant, those antique chandeliers from Venice had better be something you really love. The next buyer might not consider them worth paying for. Try to make physical improvements that increase the asset value and sustainability of revenue of your business, such as replacing or repairing tired kitchen equipment and fixtures that are essential to your restaurant.


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