Avoid These Common Restaurant Business Red Flags
Buying a restaurant is both exciting and nerve-racking. Due to the number codes and regulations that a restaurant owner needs to comply with, there are numerous risks involved when buying a restaurant for the unwary buyer. Restaurants sellers vary in degree of experience, knowledge, education and integrity. Consequently, there are no guarantees that restaurant sellers are fully compliant with all the laws that govern their business.
We have seen restaurant sellers fail to report substantial revenue, pay a majority of their personnel under the table, fail to purchase workers’ compensation (considered criminal fraud that can lead to imprisonment), etc. Therefore, it is important to thoroughly investigate a restaurant business opportunity without rose-colored glasses to assure that the seller was sufficiently compliant before completing your restaurant business purchase.
To avoid unnecessary risks in the purchase of restaurant, it’s important to properly plan, investigate and prepare your acquisition so that you are not left holding the bag on a bad deal. Be aware and informed as you conduct your investigation and due diligence.
The following are the top 5 dealbreakers when buying a restaurant. Not all red flags are dealbreakers but usually when a restaurant business sale falls apart, one of these red flags is usually the culprit. We hope this information will help you be wary of these issues should they emerge in your investigation and due diligence.
Top 5 Dealbreakers When Buying A Restaurant
1). Red Flag: Existing Liabilities
When you buy a restaurant, the seller must disclose any current liabilities. Restaurants can find themselves in trouble for health code violations, hiring undocumented workers, paying under the table, sexual harassment, etc. All of these issues could be issues for the unwary buyer.
Buyers should take the time to protect themselves from the seller’s liabilities by only purchasing the restaurant’s assets. By purchasing just the assets (i.e. lease, equipment, name, inventory, etc.) rather than buying the entire business (i.e. the corporation), buyers avoid inheriting the seller’s liabilities also known as successor liability.
The safest way to avoid inheriting the seller’s liability, known as “successor liability”, is to:
- Buy the restaurant by an asset sale rather than stock sale.
- Form a new business entity such as an LLC, corporation or partnership to receive the restaurant’s assets.
- Process your restaurant through a business escrow to assure clearances of liens and taxes.
- Demand that the restaurant seller provide written, signed disclosures regarding the seller’s legal compliance with all laws and codes that pertain to the business.
- Assure that the purchase agreement includes the seller’s “Representations & Warranties” where the seller clearly states that they are in compliance with relevant, governing laws.
- Hire an experienced restaurant broker to optimize a successful, liability-free transaction.
- Following these steps act as shields to protect your purchase.
Of course if any of these issues arise, the safest course is to consult with either a business or real property attorney to assure that you can avoid or minimize legal risks.
2). Red Flag: Lease or Landlord Issues
Depending on the economy and number of tenants, the timing of your sale could be either within a landlord or tenant’s market. Moreover, the market bias could switch in a heartbeat. When negotiating a lease, the market bias will influence how beneficial lease terms will be.
Most restaurant sales involve a lease transfer known as a “lease assignment”. This means that you will inherit the terms that the seller negotiated. Most commercial leases contain a provision requiring the landlord’s approval of the assignment to the new buyer-tenant. To approve the assignment, landlords will ask for sufficient proof of creditworthiness, relevant experience and references. If there is only a short time period of time left on the lease, then you will be able to negotiate a new lease.
For the most part, keep your occupancy costs to no more than 6% of gross sales. Paying more than 6% means that you will be working to pay the landlord and will have a hard time breaking even.
Unfortunately, unreasonable landlords can cause conflicts and delays in the buyer’s acquisition and derail the purchase. The remedy is to become familiar with the lease by carefully reading it and hiring a real estate attorney if you need further information on the meaning of the lease provisions.
Some commercial leases which contain a provision where a landlord may under certain circumstances (such as if there are only a few years remaining on the lease) “take back” the leased space if a tenant attempts to assign their lease. Obviously, this can be a huge barrier to a successful sale. On the other hand, a saavy buyer can not only avoid this problem but use the opportunity to negotiate a new lease with more beneficial terms depending on market conditions. Buyers should contact the landlord early in the sales process to minimize uncertainty or surprises before the transaction nears closing.
3). RED FLAG: Liquor License Transfer Issues
Restaurant buyers must also be approved for the restaurant liquor license for the restaurant sale to successfully conclude. Liquor license transfers, through California’s Alcohol Beverage Control (ABC) department are tedious and require conscientious effort to complete. You will need to obtain the relevant documents and signatures from the seller, complete the liquor board’s application process, obtain fingerprints, pay the necessary fees and be very patient as the transfer process can take weeks.
Transfers of liquor licenses take a long time to process because the state needs to assure that the buyer-transferee is not connected to organized crime. This is one of the reasons that the buyer must be fingerprinted. Buyers will felony backgrounds will not be able to secure the liquor license transfer. To get around this, buyers will have a family or partner without a felonious background apply for the license. The average waiting period for a liquor license transfer is about 2 months.
4). RED FLAG: Nonpayment of Sales Tax
An unfortunate common delay in the escrow process is the state taxing authorities indicating that back taxes are due and payable before issuing their approval for the business sale. Restaurants are notorious for having a lot of unreported income. Many restaurants try to minimize sales tax owned to the state by underreporting revenue. When the seller tries to sell the business, the sale may trigger an audit of the restaurant’s sales. Through the state’s investigatory powers, they will demand financial documents, and interview the seller to determine whether back taxes are due to underreported sales.
To assure that you don’t face this issue after the owner is long gone, be sure to:
1). Hire an accountant to help you conduct your financial due diligence particularly if you are not a “numbers person”. Most restauranteurs are creative types and may not be as attentive to the financial aspects of the business they are running and/or buying. Regardless, if you find yourself overwhelmed by trying to determine whether the seller is compliant with paying their sales tax to the state, hire an account to crunch the numbers and verify that the sales tax was paid.
2). Make sure your sale is processed through a business escrow. The escrow officer will seek a clearance from the state on any back taxes owed so that there are no clouds on the title transfer leaving you stuck paying the seller’s back taxes.
5). RED FLAG: Equipment Leases & Deferred Maintenance
Restaurant equipment can be expensive to replace. During due diligence, you ill want to investigate the restaurant’s equipment to 1). assure it is actually owned by the seller; and, 2). in good operating condition.
The seller should disclose any equipment leases and liens. Nevertheless, when a restaurant leases equipment, the lessor typically files a UCC lien on the business. A business escrow officer will run a UCC lien search to assure that there are no liens. Bulk Sales law also requires that there is notice published in a newspaper for a specific period to give creditors notice about the sale to pursue their lien before the sale concludes.
Some equipment leases are written with a “due on sale” clause indicating that the lien must be paid off in a restaurant sale. If they don’t get the payment from the seller (as they should unless otherwise contracted), if there’s no bulk sale notice then the equipment lessor can pursue payment from the buyer.
If you need to capitalize the kitchen equipment soon after you buy the restaurant, then the cost of replacing the equipment or maintenance expenses should be factored into adjusting the purchase price. It is, therefore, critical for you to have the equipment inspected by a professional during due diligence before you release the contingency on equipment and property.
It is critical to schedule the health inspection as well after you complete the financial analysis to make sure the equipment is in compliance and any new, stricter regulations are brought to your attention and hopefully grandfathered in or that you are made aware of additional costs that might be incurred with future upgrades.
These 5 top red flags when buying a restaurant are important for you to keep in mind as you investigate your restaurant opportunity. Taking your time up front and being conscientious as you examine the business is pivotal in helping you decide on whether to proceed with the acquisition or to pass. Most restaurants have a risk of liability, so it is imperative that you, and your professional team, do your very best to assure that you do not inherit the seller’s misdeeds.
If you would like assistance in evaluating and pursuing a restaurant acquisition, contact us so that we can schedule your consultation and assist you in pursuing your dream of restaurant ownership.