Distrust and Verify
If you’re buying a restaurant business, somewhere between plunge-taking and handshaking you may hear a desperate emotional cry for validation known as “the asking price.” It is sometimes followed by an absurd claim called “cash flow.” Zaniness like this may be tossed around in business-for-sale listings in the hope that buyers will believe a family of five is selling a million-dollar snow cone shack because it doesn’t fit with their biofuel holdings, but don’t laugh.
Just as many a seller is motivated by a bottom-line cash amount–often in the form of the down payment–that they want to walk away with, so many a buyer will wave away layers of financial detail when the purchase of their dream is in sight. Don’t let that be you.
In a 2014 survey of members of the International Business Brokers Association, IBBA Chair Cress Diglio commented, “Price expectation continues to be the number-one issue where buyers and sellers disagree. But the second biggest hurdle is poor financial records.”
“Being intimately aware of the financial health of your company might not be glamorous, but it is as important as monitoring your fermentations or selecting hops.”–Collin McDonnell, HenHouse Brewing Company, Petaluma, CA, quoted in Serious Eats
Impossible though they may seem, the asking price and stated cash flows frame your doorway into the seller’s situation and the quality of the business you’re buying. Take a deep breath and step through the portal.
You both know the asking price is negotiable. But how did the seller arrive at it?
Valuation: A Number x An Opinion
Small business sales are priced according to a multiple of earnings, explains Barbara Findlay Schenck in Small Business for Dummies. “Translated, that means that a prospective buyer learns how much a business makes for its owner each year and offers a purchase price of between one and five times that amount, depending on how strong and competitive the business appears and how easily it’ll transfer to and thrive under a new owner.” For all restaurant transactions tracked in 2014 by BizBuySell.com, the average multiple was two times cash flow.
But, you say, the place you have your eye on did $1,500,000 in sales last year, broke even with a full staff, and is on track to generate a 4 percent profit this year. Why isn’t net profit the basis for earnings?
One word: Enron.
Smart, motivated sellers provide at least two years of tax returns, expense reports, and income statements because those documents not only reassure prospects that the business has been well run, but also clearly point to room for improvement. That’s a prime motivator for smart buyers, since restaurants succeed and fail not on breakthrough concepts but on small management improvements and missteps.
If like many you’re stepping into the job of running the business, you’ll need at minimum to cover your salary. Those upward-trending sales and profits and positive growth forecasts may have you drooling, but all you’re buying right now is cash flow.
Paying the Piper
One way to view cash flow is in terms of owner benefit: the owner’s salary, perks and net income as found on tax returns, plus depreciation and interest expense–or, as Entrepreneur.com defines that, “what the owner was paid and paid out that you will inherit assuming the same business performance.”
Owner benefit, however, is easy to misstate. “Most pro-forma statements overstate sales, average check size, and seat turnover; they underestimate capital needs and working capital (cash reserve) amounts; and they overlook some expenses,” advises Kendall College’s Christine Letchinger. Go by those, in other words, and you may quickly find yourself in a cash-poor death-spiral like 30 percent of all small businesses do each year in America, unable to pay your bills or your staff and under the immediate threat of closure.
What you need to know specifically is the owner’s discretionary cash flow, defined by business broker William Bruce as “all the the total cash that the business generates in a year that is available to the owner after deductions for only the necessary operating expenses”–i.e., the amount after legit deductions. To support this, there must, again, be tax returns.
Even when a seller can prove accurate cash flow figures for the current and previous year, don’t go by their projections; do your own. In his investing bestseller Zero to One, startup guru Peter Thiel observes: “Most of the value of low-growth businesses is in the near term. An Old Economy business (like a newspaper) might hold its value if it can maintain its current cash flows for five or six years. However, any firm with close substitutes will see its profits competed away. Nightclubs or restaurants are extreme examples: successful ones might collect healthy amounts today, but their cash flows will probably dwindle over the next few years when customers move on to newer and trendier alternatives.”
If the importance of getting professional help for your business purchase has not yet sunk in, consider this about singer Chris Brown: He has a few bucks, and (in investing, anyway) one might imagine, credible advisors. Did he purchase a fabulous indie restaurant? No. Like a lot of celebrity restaurant investors, he owns Burger Kings. Fourteen of them.
“Restaurants are a marriage of two things: art and commerce. It’s the hardest things to put together. It’s the sexiest and crappiest investment on the planet.”–Tim Love
Who among us could not stand to improve our financial reporting? Use an accountant, if not a buyer’s broker and a real-estate attorney with in-the-trenches restaurant experience as well.
This brings us to the last and perhaps most dramatic argument for verifying cash flows in your restaurant business purchase endeavor. As you’ve learned, many restaurant sellers underreport income to prospective buyers, so it’s your job to dig deeper to ascertain real sales and earnings–just as the IRS does when it sends its cash-business auditors hunting for fraud. (“Fortune-cookie analysis of sales for calculation for income” is evidently a leading indicator of tax underpayment.) But let’s say a seller “comes clean” with you and offers their restaurant as an “off-the-books” business, one without verifiable records.
If you must, go ahead and benchmark. There are industry mean prices you can check. But experts advise holding out. In that circumstance, according to leading Atlanta restaurant brokers Robin and Eric Gagnon, “you are not buying a restaurant with cash flow; you’re buying a fairy tale.”