What is this restaurant business worth?

Question

I'm looking at buying an established restaurant franchise that has been around for 6 years.  There is a well-compensated manager in place who handles day to day operations.  Owner is absentee and has weekly conference calls with manager and visits site every month or two.  I am local but would keep the manager, I dont want to buy myself a job.  Sales are steady near $850k/yr.  NOI after paying manager is steady near $65,000/yr.  Average location in an average retail strip center, interior build out is above-average.  There is a business broker involved, they are indicating bank would loan 70% of price, seller will finance 15% so 15% cash down required.  Any input?

Jim Shepard · Answer

@Larry Flanagan I would be very cautious on buying a restaurant and operating it absentee.  I own 8 Subways and the ways employees come up with to steal is unbelievable!   I have 8 cameras in each store (1200 to 1800 sq. feet) and its not enough.  7 of the cameras are pointed towards employees and only 1 towards the public.  I have only had one armed robbery in 23 + years but 100's of employee thieves.

Don't get me wrong, a restaurant can be a great business but I don't recommend it to absentee owners.  The business has been very profitable for me but its a 7 day a week job.  You have to understand all of the procedures and be able to operate the business yourself - you never know when that manager is going to leave!

If you are still going to pursue the business, I would get ahold of the franchisor and get a circular from them.  The circular will contain information on the business, the upper management team of the franchise, list of current franchisees, list of franchisees that have gotten out of the business, lawsuits, etc.  Start making phone calls to current and old franchisees to discuss their feelings towards the franchisor / business.  These people would have a better idea on the valuation of the business.

One last idea.  Go work for a franchisee for a month for free.  Work nights and weekends while doing your day job.  See if you like the work and can stand on your feet for 12 hours.  You might find out that you are real happy that you didn't buy the business and a whole lot easier to walk away from it before you buy it.  I don't want to discourage you but I also don't want to see you lose your shirt in a hurry!

Joel Owens · Answer

I have a friend that owns Subways. He watches people use their IRA's to build out a new store at hundreds of thousands and then buys them out after a year of being open for next to nothing. Puts his systems in place afterwords and increases the value. I do not know how many he owns now as it's been years since I have talked with him but at the time he had 20 or so.

Subway the quality of food just isn't there anymore and the Fogle thing hurt their image. I prefer Firehouses subs and also Jersey Mike's is very good for quality. You pay a few bucks more per sub but it is a lot better.

I would add on to what Jim is saying as he has some good key points. I was in the food business for over a decade and know it well in all facets including an owner.

It is possible to be absentee owner.

Typically an owner tries to sell a business at a 3 times multiple of net profit. So 65k times 3 = 195,000 purchase price.

As a buyer I want a 2 multiple or lower so 130k. Used to bank loans years ago were hard to get in the down turn for businesses so most owners would take 30 to 50% down and hold the note on the rest. Holding the note might be 3 to 5 years and sometimes they didn't want to hold the note anymore so sold off to a business note investor at a discount. Example sold for 130k and note of 65k. Couple years in of a 5 year note 45k is left. You just want the money now so sell to a note buyer for 25k and get everything now versus in 3 years time.

A few additional things not mentioned to watch out for.

1. FFC's ( fixed food contracts ) - these are critical. Franchise concepts one of the benefits is that food costs are set not to go up more than XX versus if you order small amounts from a food distributor you have no control over their supplier or what they charge. This helps keep food costs inline for profit. If you were a little guy with a pizza place paying 1.90 a pound for cheese and the market goes way up in costs to 2.75 a pound you would get crushed on your profit margins. Dominos pizza for example would have a contract saying the cheese could be no more than 2.10 a pound in that situation etc. So they can predict what a best and worst case scenario is versus the little guy who can't do anything. The little guy I have seen where also they use a quality product such as a certain pepperoni for a pizza that their customers love. The food distributor carried it for awhile as they were getting a special but now someone else came in to offer them a cheaper deal. Now you are getting charged for the same price but a crappier product that your customers do not like. You cannot order pallets of it to get the distributor to carry it. Now you are left having to go to another distributor and keeping track of multiple accounts and deliveries which interrupts your business.

2. Watch out for corporations and their royalty fees. Many franchisees have sued because they require you to keep doing specials multiple times a month to drive market share and sales. The corporation makes money off of the gross sales for a royalty fee sometimes 3 to 5%. So by having to run specials all the time you get almost nothing but they get a fat check. Also you want to have a say in what quality food is used and they have to have franchisee approval on switching something. There was a larger pizza chain corporation in the past that switched food suppliers, changed the quality of the product, and was still charging the same price for ingredients as they made more money. The franchisees filed suit and won against the parent corporation. They now control the quality, cost, and how the supplier is for the brand.

3. Re-imaging requirements. The property might look okay now but the parent corporation is fixing to require a large re-image be completed in a few years at a very substantial cost to you the owner. That can lose production with sales and wipe out years in profits in some cases.

4. You need to look very closely at the lease agreement. I want the seller paying any franchisee rollover fee. This is a fee charged by the parent corporation to  change to the new owners. I also would look at the lease to see if you are required to disclose annual sales. If so the landlord can asses how well you are doing and upon renewal really up your rental rates. Additionally the business might be profitable now but that is based on a rent rate of XX. Upon review you discover that rents are fixing to rise with a large increase coming or 3% a year versus the 2% a year standard. In that case your food and labor costs might keep rising but the sales might not rise at  a pace to offset the rent increase thus taking profit down to 40k from 65k and margins get squeezed tighter and tighter. I would want to renegotiate the lease if market rate is 20 a sq ft but my vintage lease is 24 a sq ft for example. Also even if market rent rate was below market I would want to negotiate to have the former owner on the hook versus me and also negotiate away or reduce any rental hike increases coming. You could also put in a provision where rent increases are linked to the improvement of the business. If you aren't making more money then neither is the landlord etc. Of course if I was the owner of the strip center I would be doing exactly the opposite of what I am saying.................. : )

5. Look at all the  equipment and make sure it is not fixing to go out. A commercial meat slicer might be 1,000. A new pizza oven can go up to 30,000 or more. Big difference in replacement expense. You can buy used to replace but they break down at your busiest times of course and are not as efficient.

6. Make sure you are buying the assets of the business only and none of the liabilities of the current owners corporation.

7. Make sure the sales are audited annually and you have a POS system that tracks everything from orders to inventory. It's easier to see where costs are and it helps prevent errors from servers scribbling orders each in their own handwriting which is hard to read. That leads to food order errors and takes more time  and lost money.

8. Make sure your location for the restaurant is optimal. A great book that is about site selection is here.  ABC's of Site Selection by Frank Raeon   http://www.amazon.com/The-Cs-SITE-SELECTION-Winners/dp/1453541411

If you determine your site is optimal then you need to look at things within the retail strip center for improvement.

The signage. Is it old and outdated? Have some businesses left and they are still on the road sign in a more visible position? Negotiate to have your sign placard moved higher up in a better position along with being allowed to place temporary signs next to the road.

Is there currently a better vacant space in the center than where you are at?? Maybe the end unit has come available or a better part of the center next to the anchor for more foot traffic at the same rent price. Also the end unit if it has a drive thru you could gain additional sales. Maybe your unit needs expansion into another unit and you can negotiate TI's for the landlord to pay so you can expand. Your current space could also be more than you need or have  a bad layout making the move more optimal to another unit in the center.

9. Make sure you are not buying yourself a job. I only look at businesses these days where profit is 200k or higher with a manager in place. I do very well with my commercial real estate business and my rule is no investment can take up all of my time or be a job. It has to stand and produce on it's own. It's true that most small food businesses require an owner operator but if you have size you can scale and put in multiple management layers. You still have to oversee it but on a minimal and less intensive basis allowing you to spread out your time effectively over many investments . For food my profit margins have to be 25 percent and higher for me to consider a business. The reason is I am taxed higher than owning real estate and I can generate 15% cash on cash annually owning a strip center and have businesses pay me the rent. If all I can get is 15% owning a business then I might as well own the strip center instead with better tax planning and be on the beach instead of dealing with employees and managers .. .... : )

Hope it helps. No legal advice given.

Joel Owens · Answer

Hi Mike,

Location is one factor but management and employees is also key. A big mistake I often see is large corporations make food in their test kitchens and get everything perfect. Then in the actual stores the execution of making the product is poor which leads to low sales. I personally believe a great cook is the most important thing a restaurant has. If the food is great every time people tend to forgive long waits and sometimes poor customer service. If you get food fast but it sucks then everything else doesn't matter.

Take car audio for example. I can take a 100 subwoofer speaker  with a marginal amplifier and make it sound pretty decent with my skill that I have. Someone else could buy a 400 subwoofer top of the line and a 500 amp and build a crappy box and set the amplifier wrong and it could sound the same or worse as the inferior product. That is the skill part where I could make the top of the line equipment sound amazing by proper installation and knowledge.

Another example is people believe a pizza you just throw all the toppings on it and that's it. Nothing could be further from the truth. How you shape a dough ball and optimal proofing and stretching gives it texture. Typically people spread the palms in the middle of the dough causing it to be too thin and oil pooling in the middle. Instead you work the outside of the dough ball with the rim of your hands and then slap out 2 to 3 times with a spin and that gives a nice levelness to the dough throughout. The sauce of the pizza when you do the ladle on the dough should be level. This way you do not get sauce rings in the dough where one bite is dry with no sauce and one bite has too much. The toppings even if top quality need to be spaced out properly so that in each bite and slice you get the perfect harmony of taste. People that create excellent food are masters at what they do and there is a science behind it.

Mike Nelson · Answer

Great response @Joel Owens.  I know next to nothing and have little interest, but I found your post fascinating.  I know in particular, some Subway restaurants have been very successful (because of location?) while others have been real failures.

Larry Flanagan · Answer

Thanks for the input.

What is this restaurant business worth?

Most Popular Reply