Restaurant List Price vs Selling Price: Why Can This Be A Moving Target?
As I’ve discussed in previous blogs, restaurants are priced one of two ways. For profitable restaurants, the price is established by a multiple of the cash flow. For restaurants unable to achieve profitability, the price is based on assets in place. (For more on this, see blog III Valette).
Sometimes sellers will come to a broker with a price in mind. This might be based on the seller’s debt that will be paid by the proceeds of the sale. Or it might merely be a number that the seller, for whatever reason, won’t go below.
If this price is not in the ballpark of the valuation, the broker should have a frank discussion with the seller so they understand that the broker may not be able to secure a buyer with a price that is too high over the valuation. At this time, the broker should also discuss with the seller some things that may come up during the sales process that could put downward pressure on the eventual sales price.
The first potential situation would occur at the onset of the sales process, and it would be an offer from the buyer. Again, if the price is determined in accordance with the market, buyers generally submit an offer close to or at the list price. Here’s a side note – sometimes offers will come in above the list price and, although this is rare and only under specific conditions, sometimes there can be a bidding war. I’ll talk more about this scenario in a Small Plate episode in the next week or so.
The offer price is a negotiation, and sellers working with experienced brokers know this may not be the end of the negotiation process. Some sellers will tell the listing broker they are firm on the list price, but things may come up that may challenge that rate and sellers may need to be flexible on the price (even after the purchase price has been negotiated) or they risk losing the buyer. And why is that the case? All kinds of unanticipated challenges arise at the change of ownership. For the most part, those challenges live with the sale. In other words, they’ll be the same for any buyer purchasing the business. So, it may be in the seller’s best interest to be open to negotiate the price as challenges arrive. Or…not.
The other two events that can bring the sale price into question happen during the buyer’s due diligence period.
These are as follows:
- The terms of the lease that the landlord will extend to the buyer.
- The change of ownership requirements mandated by the local agencies and, in particular, the county health department.
At the change of ownership, the landlord may assign the current lease terms to the buyer thus making no changes to the lease terms. Or the landlord may take the opportunity to bring the rent to market rate, and this can be a substantial increase.
For instance, I have a seller who has been operating successfully for more than 30 years in a location that has progressively become very sought out. They have enjoyed below market rent, but the landlord will bring the rent to market rate at the change of ownership. This will cause a discrepancy with the margins found in the seller’s historical financials and those in the buyer’s projections. Due to this situation, the buyer may request a reduction in the purchase price.
The other threat to the eventual sales price of the restaurant, and this varies from region to region/ county to county, is the health department change of ownership process. This is the time the health department and, in some municipalities, other agencies of the county too, will come onsite for code enforcement. In the general course of operations, the health department won’t require operators to fix or upgrade the premises based on codes that have changed since the owner was issued their health permit. These things can be as simple as installing a cleanable surface to extend 8’-0” about the mop sink, or as complicated and expensive as replacing an outdated hood.
So, let’s talk more about the health department change of ownership. When a restaurant changes hands, a code enforcement inspection is conducted. This is VERY different from the inspections that happen during the normal course of restaurant operation. Most often it is conducted by a different subset of the health department. And it can be brutal!
For instance, when Karen purchased Flour Chylde, she was required to put the existing grease trap in ground. And this required a lot of money, time and co-ordination between the landlord, the seller, concrete contractors, the building department, a licensed architect/engineer to create the plans, and a plumbing contractor. And Karen had to re-budget her purchase as the seller was absolutely firm on the sales price. With that said, however, there was still a lot of negotiating to be had, as the work was conducted during the escrow process so the bakery would be fully operational and permitted by the change of ownership. This means, the seller is paying rent while there are disruptions to operations.
And what about the employees? Especially in today’s climate, securing and retaining employees is challenging. So, are employees paid during disruptions? Thinn for a moment about what this might look like. Concrete might be cut in the middle of the kitchen. Of course, all of this kind of work could have been conducted after the change of ownership. But that isn’t in the best interest of the buyer because after the close of escrow, the buyer is completely and financially responsible for any and every additional cost or potential mishap. After all, the buyer has now purchased the business and has fully negotiated and executed a lease with the landlord.
And it’s not just the health department, some municipalities require every agency to sign off on the site at change before they’ll issue a business permit to the buyer. These agencies may include the fire department, building department and planning department, and the water/sewer agencies. I’m working on a deal now where the fire department came onsite and is requiring expensive upgrades to the exit doors and exit signage. Since the buyers negotiated a very low purchase price with the seller, the seller is not in the financial position to offer a concession. As a result, the buyers are asking the landlord to contribute some TI (tenant improvement) money to help offset the costs.
Some of you may be thinking, one party should be held responsible for the change of ownership costs at the outset of the deal, and many business brokers do establish that in advance. But when they do, they generally put it in the camp of the seller. And why do they do that? The short answer is it makes their job easier.
But if they do that, they’re putting their seller at an unfair disadvantage, as the costs may gobble up the entire proceeds of the sale. And what if the work far exceeds the seller’s calculation of the costs? Does the seller then come back to the buyer and ask for more money? Sometimes the broker and seller ballpark the cost and merely add that to the purchase price, so the buyer ultimately paying for the costs.
- Health Department requirements will be different depending on the concept. Many buyers purchase restaurants to implement an entirely new concept that might require different cooking equipment, thus the health permit requirements mandated by the seller may not translate to the new operator.
- Landlords will offer different terms to buyers/new tenant based on several things including their experience in the industry and their financial strength. For instance, if the buyer is an acclaimed chef who’ll attract a lot of business to the area where the landlord owns more property, the landlord may want to make the conditions more attractive to the buyer. Perhaps the seller will offer a contribution to tenant improvements or rent abatement. Conversely, if the buyer is a bit of a risk, the landlord may want rents up front or an increased security deposit.
As you can see, there are a wide variety of factors that impact restaurant pricing. Every situation is different. I have found that there is no way to know what the transfer costs are until the escrow process is underway. Although it can make the broker’s job more difficult, you want a broker that is going to take the time to work in your best interest and take each restaurant transfer on a case-by-case basis. It’s important to stay flexible and consider the needs of both the buyer and seller.
Ryn Longmaid is a restaurant broker and consultant at Santa Rosa Business & Commercial in the San Francisco NorthBay and the host and founder of the Facebook Live Series, Deep Dish: discussions on the business of restaurants for restaurateurs, restaurant buyers and sellers and the restaurant curious.
As well as being a licensed real estate broker, Ryn is a CBB with the California Association of Business Brokers (CABB), a CBI with the IBBA and she holds an MBA in Sustainable Business Management. In addition to being a proficient business broker, Ryn has over 20 years’ experience in the restaurant, hospitality, and food industries. She has served as the executive chef for Amy’s Kitchen, personal chef to actor Don Johnson, she founded and operated a successful and longstanding restaurant. She has also held teaching posts in restaurant management at the Art Institute-San Francisco and The Culinary Institute of America-Greystone.