To help California restaurant owners transact sell their restaurant businesses, Mission Peak Brokers is providing a How to Sell Your California Restaurant series of blog posts. We hope to provide restaurant sellers with information and insight on all the key elements involved in selling restaurants. Whether you are ready now or plan on selling in the future, arming yourself with essential information on the process of restaurant business sales will empower you throughout the business sale.
While there are several methods for valuing businesses, we will only cover the most common method here for a cash flowing restaurant valuations which is the Seller’s Discretionary Earnings (SDE) formula. This method is also known by several other names such as Owner’s Benefit and Income Valuation. This method is used by the Small Business Administration (SBA) and is the standard used in most business sales.
SDE involves analyzing the restaurant’s past three year’s tax returns and most recent Profit & Loss (P&L) statement to normalize the financial portrait of the business regardless of a particular owner. What does this mean exactly? Add-backs are those deductions taken by the owner to reduce their tax exposure but which are now added back to show the actual cashflow an owner can expect to receive. It involves identifying and adding back any expense that benefits the owner which is then added to the net profit.
Add-backs include the owner’s salary and related payroll tax, one-off expenses, personal expenses run through the business, non-operating deductions, non-financial deductions. Interest, amortization and depreciation are always added back. SDE also normalizes the financial results without regard to business entity; so that corporations, partnerships, LLCs and sole proprietor financial performance can be compared. The total result is essentially the total cashflow to the owner.
Restaurant Valuation Multiples
Once the SDE is determined, the next step is to identify a multiple of the cashflow. Most restaurants will have a multiple of 2-3x cashflow. The multiple is based on numerous factors as well as region. Factors affecting multiples include consistency of earnings, earnings trends, location, favorable lease terms, longevity of the business, goodwill, franchise, number of units, unique selling proposition, competition, etc.
The general restaurant valuation rule of thumb is 2.3 x cashflow.
A common issue are restaurant owners who fail to report income. The business owner will often insist that these phantom funds should be used in the pricing formula. Yet this is disingenuous insofar as the owner has already enjoyed the benefit of getting tax free income and should not be also be rewarded by adding in the funds into the valuation without any documentation to support their claim.
Additionally, due to their tax avoidance, they prevent SBA financing since lenders will not add-back unreported income. The seller has misrepresented their earnings, so what is not to say they are not misrepresenting the unreported amount and other factors of their business?
Key Financial Indicators for Restaurant Valuations
For a restaurant valuation, there are 5 key financial indicators to examine which also help compare opportunities for sale. The key indicators are essential for a proper analysis of the SDE, understanding how financially efficient the restaurant is performing and areas for improvement. The 5 key financial indicators for restaurants are:
- Gross Sales
- Cost of Goods Sold (COGS)
- Labor Expenses
- Rental Expenses
- Profit Margin
For experienced restauranteurs, gross sales is the most important metric since these buyers typically know their operating costs by heart and will then easily determine what their profit will be. Gross sales is
Costs of Goods Sold (COGs) is a restaurant’s inventory primarily made up of non-durable goods such as food, beverages and paper supplies. Some restaurant owners include labor costs in this category as well. COGs indicate the level of quality, operational efficiencies and, where too high, the opportunity for a more skillful owner to contain costs to increase profit. Overall, COGs should be approximately 25-35% of gross sales.
Labor expenses, including the owner’s salary, is usually 20 – 25% of gross sales. Next to COGs, this is one of the highest expenses. Restaurants are notorious for paying some employees under the table, so it’s important to find out if that is occurring. If so, the undocumented labor expenses must be deducted to further adjust the SDE.
Rental expenses include rent, taxes, insurance, and CAM (Common Area Maintenance). Rental costs should ideally be about 8-10 % of gross sales. In California, this amount tends to be a bit higher 10-12% of gross sales. Additionally, the lease length, number of renewal options, and any deferred maintenance by the landlord should be considered.
Net profit margins for a well operated restaurants is over 11%. Oftentimes, the higher the liquor sales, the higher the profit margins. It’s also helpful to examine monthly sales to determine how seasonality factors influence gross sales and profit in order to make improvements as well as anticipate cashflow.
If you would like a complimentary restaurant valuation contact us today.
If you are interested in selling your restaurant, Mission Peak Brokers can help. We are highly experienced and knowledgeable about restaurant business sales, including bars, cafes, nightclubs, etc. We have closed numerous eatery business sales in the Bay Area. We have represented sellers and buyers. In addition to business sales, we also provide commercial real estate sales and business/commercial financing. Contact us today for additional information.