Key Factors to Consider Before Purchasing a Restaurant
Through bull markets and bear markets, people’s need to eat remains relatively unchanged. Habits may change based on if consumers are feeling richer or poorer in a specific market, but they will still require nourishment. For this reason, along with low barriers to entry, purchasing a restaurant may seem like a wonderful business venture. For those with a passion for food it presents an opportunity to combine work and pleasure. For less culinary included individuals, a restaurant presents an opportunity to diversify their holdings. Regardless of what type of buyer you may be, it is critical to understand if you are buying a business that contains the essential elements to sustain profitability and grow, or if you’re purchasing a business that is heading for trouble.
Before jumping into a deal to purchase a restaurant, be sure to ask the following questions.
1. Is the lease transferable?
Location, location, location. Restaurants live and die based on the number of people coming through the door. Location can play a critical role in the success of your business. When it comes to restaurants, many landlords are hesitant to sign a lease with a new owner. This is doubly true if you don’t have a strong history in the restaurant business. When you purchase an existing restaurant, one of your goals should be to retain existing customers. If a lease is not transferable, retaining existing customers may prove difficult if you are forced to find a new location.
Prior to getting too far into the diligence weeds, be sure to review the lease and speak with the landlord, if possible. Understand if the lease is transferable. If so, will you have to negotiate new rates or continue with the existing rates until renewal? If the lease is not transferable, you will need to work with the landlord to draft a new lease agreement.
2. In what condition is the equipment?
Restaurant equipment can be expensive to maintain and to purchase new. Be sure you have a clear understanding of the working condition of all equipment. Having to purchase a new exhaust hood for $1,000 on day one isn’t something any new owner wants to do.
If you aren’t 100% confident in your abilities to inspect the equipment, find a professional who is. Yes, you will incur fees for their services. However, it is better to know what you are getting into as opposed to going in blind. A professional inspector can help clue you in to equipment that may be on the brink of going bust.
Be sure to also hire an inspector to look at the building and who understands your local health codes. While equipment is important, you should also seek to understand if the building suffers from any structural issues that may be costly to repair. Additionally, if the current restaurant isn’t up to code for the health inspector, you could face fines and repair fees.
3. What does the customer think?
Reputation in the community can make or break a restaurant. Thankfully, today it is easier than ever to get a handle on what consumers think. Go to review sites, such as Yelp, to read what people have to say about the food, staff, and experience. If the restaurant has a stellar record, that is good news. Restaurants with numerous bad reviews may require some serious evaluation. Many consumers do not know that a restaurant has changed hands. If they have had a bad experience, they may be reluctant to try again, assuming that the same management is in place and the same problems exist.
If you decide that you want to proceed, despite negative reviews, be prepared for an uphill battle. It will be up to you to devise a plan to fix the existing issues and convince consumers to give you a second chance. It may not be easy, but, as with many things in life, determination can overcome may obstacles.
4. Will the existing owner sign a non-compete?
Here is a situation you don’t want. You buy a restaurant known for exquisite dumplings. With your excellent marketing and management skills and the entire staff remaining, you are confident that you can grow the business. To your surprise, you find the prior owner is opening a new shop nearby a few weeks after the sale is complete. This is a problem. Loyal clients may leave your establishment to eat at the new restaurant.
This is where a non-compete agreement comes into play. How this is structured depends on you and the seller. You may specify a geographic area in which they cannot open up a restaurant. This may include a time condition as well. Whatever is agreed upon, be sure to get terms that you are comfortable with. The restaurant business is competitive enough without having to go head-to-head with the prior owner of your establishment.
5. Cash Flow
I couldn’t end this list without including some financial considerations. It is true that in every deal you do, the financials will play a key component. You will want to review the financial statements and tax returns. Of particular importance will be the restaurant’s real cash flow. Since restaurants typically sell for a multiple of cash flow, this figure deserves some extra attention during due diligence.
What the owner claims cash flow to be and what is verifiable may be two, very different figures. Real cash flow will give you a solid metric by which to understand a restaurant’s profitability. It is worth clarifying the difference between nominal cash flow and real cash flow.
Nominal cash flow refers to the actual dollar amount of money that a restaurant brings in (i.e. from meals) and pays out (i.e. to suppliers). This figure is not adjusted for inflation. Nominal cash flow could be useful for projecting certain figures, such as rent when the average rental increase is known in advance.
Real cash flow is inflation adjusted to reflect the change in the value of money over time. This helps to equalize cash flow figures from year to year. This will be important when analyzing a company that has a long history to see how current cash flow compares to historical cash flow. Be sure to ask the seller for documentation that represents a complete financial history. You may find that cash flow has actually decreased in terms of spending power in recent years, even if the figure appears larger than prior years.
Restaurants have a notoriously high failure rate. The questions outlined above should be seen as a jumping off point, and not a complete due diligence checklist. If this is your first venture into purchasing a restaurant, enlisting a professional who knows what questions to ask may be a wise decision.
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