We all ask ourselves every time we buy something of material value "is this the best price I can get?" or "am I paying too much for this?" We do it for car purchases, home purchases, hotels, car rentals, etc.
So why would it be any different for business purchases? Except the difference is there are huge markets in those other products to determine a value such as hotel prices, car rental prices and home purchases.
But businesses searches or price history simply don’t exist. So how does one determine whether one is over- paying for a business?
The first step is to determine whether you’re buying income or an asset to help save you money and later make you money. What I mean is there are businesses that have a history on earning income, those I refer to as income businesses. Then there are businesses that are failing, but there is residual value that remains in the assets of the business. Exactly what that value is will depend on the individual’s needs.
For example, let’s say you want to open a pizza business and you have your own concept and recipes. So you don’t want to buy an income business; rather you want to reduce the amount of money you spend to open one. To build a pizza facility can cost anywhere from $75,000 for the low-end take-out place to $400,000+ for the full service place. So you look for asset purchases to reduce your cost of building a restaurant from an empty shell. Assume for purposes of this little analysis, all locations are created equal. Now you find a restaurant, but let say it doesn’t have the kitchen design you need and you’ll have to spend $30,000 remodeling it. Then across the street there is another restaurant available that exactly fits your needs. Economically this means you’re willing to spend up to $30,000 more for this space than the one across the street. Do you see it?
Now, let’s add another factor. You determined the cost of building your restaurant from scratch is $150,000. But you only have $75,000. So building a new one is not an option.
So let’s look at that restaurant we found with the kitchen that works for you. Perhaps it needs a bit of cleaning and facelift, but you think you’ll only have to spend $5,000 to fix it up. So how much is this space worth to you? It certainly isn’t $150,000. And it certainly isn’t zero. My rule of thumb is about 30% of the cost to build it. So perhaps $45,000.
Often we can buyers asking what the income is for a restaurant that’s selling for $40,000. I hope by reading this you’ll understand that the broker isn’t selling a profitable restaurant; rather they’re selling you an opportunity to reduce your start-up costs and to get in the business at a lower price. Sometimes this work, but sometimes it doesn’t.
But think about, would you rather spend $150,000+ to find out your pizza business failed? Or would you rather spend $50,000 to find out your pizza concept failed? And the truth is, you’ll always be able to get something back for the restaurant, causing you to reduce your risk even further.
Income sales are actually easier to value than asset sales. In fact once my agents brought me a restaurant in a nice part of Los Angeles with a price tag of $350,000. I wanted to reject the listing because it had no income and in fact was losing money. I listen to them, and thank God I did. We have two solid offers in a month for $325,000! In this case, the buyer obviously wanted a restaurant in that area and was avoiding the cost to build a new one, but more important, it was an area where there was no vacant space.
That being said, a buyer must either have mastered reading financial statements or have a CPA who can read them with a buyer’s eye. The buyer needs to dig into the financials. Often a buyer will receive a tax return and see that it shows a loss. But that’s not the whole story at all. There are personal owner expenses that must be identified and added-back to the income to determine the owner cash flow.
This is an area where few broker have the skills to dig in deep to find the owner’s true cash flow. Teaching one the art of finding these items is outside the scope of this article.
But once the cash flow is identified, then one needs to determine the multiple to apply to the cash flow to determine the price/value.
Multiples vary on basically four factors: (1) Strength of revenue (2) strength of earnings (3) lease and location and finally, (4) condition of the facility and equipment.
I like to give a rating to each point. The rating I like is 1 to 6, with 6 being great! Then creating an average which I then apply to a scale to determine the multiple I should use to value the business.
Strength of Revenue
Is the revenue (sales) growing, steady of shrinking? If revenues (sales) are growing, then give it a 5 score. If sales are growing strong, give it a 6 score. If they are shrinking dramatically in the past few years, give it a one.
Strength of Earnings
This is a measure of how well the owner is managing costs. But to clearly understand this section, one needs to understand what the industry standards for costs percentages are for that business. Nevertheless, if the owner is managing the costs at industry standard year after year, perhaps the business gets a 4. But if the costs are improving year after year, then perhaps the business gets a 6.
Lease and Location
There are a number of variable to consider when looking at a lease and location. First, how much time is left on the lease? Are there options? Are the options transferrable – often options are personal to the current tenant and not transferrable. Is there a personal guarantee required? Are there restrictions in the lease – if you want a club, then you certainly don’t want hours of operation restricted to closing at 10pm. Is the lease transferrable? Many landlords will take advantage of inexperienced tenants by placing hidden restriction on the lease’s transfer, so watch that! The more favorable each of these items, the close to a 6 score one would give this business.
Second, and often the most important issue is the rent, and an issue often over looked by buyers. I often see folks get into a lease where the rent is so high that there is absolutely no way for the business owner to make money. I have a rule of thumb I like to use, if you take the rent (including CAM/NNN) and divide by 6%-8%, the answer represents the sales you’ll have to achieve in order to make a fair profit. In other words, if the rent is $5,000 a month including CAM/NNN then one should expect to be able to sell $83,000($5,000/6%) a month. Let’s say this is a 2,000 Sq. Ft. facility doing sandwiches…that’s a lot of sandwiches folks! If you don’t think it is achievable, then you’d give the space a low score and this could be a reason to completely walk away from the deal.
Finally, location plays an important role in success, but I think it is less than most make it to be. A great marketing program backed by great food and service will always out strip a great location in my opinion. But nevertheless, if the rent is right and the location is super, give it a 6 score. If the rent is high and the location is great, give it a 3 score and if the rent is high and the location is awful, give it a 1.
Condition of Facility and Equipment
This measure is pretty straight-forward. Is the facility in great shape or worn-out? Is the equipment well maintained, or falling a part. If you walk into a restaurant that’s clean, it usually indicates things are taken care of. Score is high if the facility looks great as well as the equipment.
So you’ve got a score for each category, now what? Add them up and divide by four. This results in a number.
Score Mutilple of Cash Flow
So if your business earned a 3.5 average score, then the multiple is about a 2.0 or so. Do you see it? If your business scored a 5, then the multiple would be closer to 2.7 or 2.8.
So a business with a cash flow of $100,000 and a score of 5 should have a price of about $270,000.
Of course, I’ve been doing numbers since college and this is second nature to me.
We at SellingRestaurants feel obligated to educate the public, our customers and our clients with information that can help them make more intelligent buying and selling decisions.
Mel Jones is one of the premier restaurant brokers in the nation having published hundreds of articles on buying and selling a restaurant and bar business, selling thousands of restaurants in CA., WA and AZ and building one of the most copied business models in the brokerage industry. Mel started SellingRestaurants in 2004 with the one simple concept, give the buyers the information they need to make intelligent buying decisions without being pestered by a broker or hiding information, prepare the business for market by researching key details that make or break deals and educate the buyer on the buying process to create an intelligent buyer. Prior to SellingRestaurants, Mel was a Chief Financial Officer for Universal Music Group, the largest music company in the world. There he participated in more than $11.5 billion of merger and acquisition transactions. He also work for top companies such as Nestle Foods, USA. He hold a Bachelors in Business Administration Finance as well as attened Law School at Gonzaga University. Give Mel a call at 480.274.7000 or e-mail him at [email protected] if you have any questions.