Business and Operations
Part 3: Should you buy a failing pizzeria?
By Lloyd R. Manning
Part 3: Should you buy a failing pizzeria?
By Lloyd R. Manning
In this final instalment, discussion will centre on the top price you should pay to acquire a failing or closed pizzeria.
In Part 1 of this series, we briefly discussed the reasons why pizzerias fail and in Part 2, asked the question, “Can its faults be corrected?”
In this final instalment, discussion will centre on the top price you should pay to acquire a failing or closed pizzeria. It assumes you have methodically conduced due diligence, identified its shortcomings, know why it is failing or has failed, that its faults are correctable, and that you can get it into a profitable position.
The remaining question is: “What is the most you should pay?” or perhaps more correctly, “What is this restaurant worth?”
The common terms of price and value are not synonymous. Price is what you are willing to pay, which could be motivated by differing influences. Value is what an average buyer would pay, and what an average seller will accept, both being fully aware of all circumstances and neither being unduly stimulated. For a specific reason you may willingly pay more and the seller take less than what something is worth. That’s price!
When negotiating the purchase, always balance opportunity with skepticism. This requires a combination of sophisticated analysis and strategic planning. Only by recognizing the unique aspects of the target pizzeria can a buyer identify an opportunity and avoid a costly mistake.
A difficulty is that the traditional valuation methods fall short when considering failing or failed businesses. The standard approaches of market comparisons or the discounting of cash flows do not cut it. In my opinion, the concept of applying the selling price of one business as a value indicator of another is wishy-washy to start with. For gauging cash flow projections, any financial statements obtained are probably unreliable and forecasts are guesswork.
The only procedure with merit is the value of the tangible assets, tempered by common sense. By this procedure there are three value categories to be reconciled: the value of the furniture, fixtures and equipment (FF&E), the leasehold interest, (this assumes you are not buying the real estate), and the leasehold (a.k.a. tenant’s) improvements to the real estate.
As there is little, if any, income increment to be accounted for the only consideration is liquidation value, the lowest denominator. Any goodwill that might exist is intertwined with the leasehold interest and need not be considered separately. Although we will value the contributors individually in real life, any purchase offer would be for the complete turnkey package.
When valuing the FF&E as a part of a going concern, in place, in use, and in good repair, assuming an average life of 15 years, any item that is five years old or newer is worth two thirds of new cost, five to 10 years old one half, and older than 10 years one third. Your cost and forced liquidation value should not be more than one half to two thirds of this.
Anything that is obsolete, worn out, in need of repair, or you cannot use, has no value what-so-ever. If you have the balance sheet of the pizzeria, the un-depreciated book value of the FF&E should set the maximum price.
Check each piece of equipment item by item to determine condition and suitability. Make sure everything works properly. Look for dough mixers that don’t mix, pizza ovens with warped decks, deep fryers with the belly burned out, and so forth. Only pay for what you can use, and don’t pay too much.
Although a strategic lease could be the most valuable asset of a pizzeria, if the terms are untenable, it’s a liability.
Although Canadian statistics are quite skinny, the American Restaurant Association, says that an equitable restaurant rent is between six and eight per cent of gross sales. They do not differentiate for reason of specialization, such as a pizzeria, or note that in recent years, as a per cent, rental rates have been declining.
A consideration when determining what to offer for a failing or failed pizzeria is leasehold advantage or disadvantage, the remaining term and renewability of the lease. The advantage is the difference between the annual rent at the market rate (what you would pay were the property vacant) and what the rental contract stipulates.
To demonstrate, let us assume that market rent is $24,000 per annum, contract rent $18,000 per annum, and the remaining term is three years. You gain $6,000 per year for three years, which must be discounted into net present value. Using, say an eight per cent discount factor, the value of the leasehold advantage would be $16,700. Do not add it on. Only know it’s there when negotiating.
If it is a disadvantage, say the market rent was $18,000 per annum and the contract $24,000 per annum, this would be a disadvantage of $16,700 and deducted from the price you would pay for this pizzeria. The interest rate is what rate you expect on your investment, which could be different than eight per cent.
The present value you can work out by using a financial calculator. If you forget the discounting your answer will not be exact, but close. Remember, any advantage is only to the end of the current lease term. You must assume that at that time the rent will increase to market rate.
If the current rent is too high, the landlord will try to convince you to renew at this rate and if successful, the disadvantage continues. The best practice is to always negotiate for a new lease with an acceptable rental rate, term, and conditions.
There are two considerations when considering leasehold improvements, which are improvements made to the building at the expense of the restaurateur. Most leases contain a clause whereby at the end of the lease term they become the property of the lessor. That is, they will have no value to you at that time.
If you are negotiating a new lease their value is nil. If you are assuming the existing lease the procedure is to determine the purchase cost of these improvements at the time of installation, and then depreciate them straight line based on the initial term of the original lease without holdovers or renewals.
The un-depreciated remainder sets the maximum value. If the initial cost was say $100,000, the lease was for 10 years, and eight have gone by the residual value is 20 per cent or $20,000. Deduct from this figure anything you must discard, redo, or update.
The summation of the in-place values of the FF&E, the leasehold interest, and the leasehold improvements set the upper limit of any price you might pay for this pizzeria.
If the restaurant is operating, depending upon the degree of distress it is having, you probably should not pay more than two thirds and often less than one half of this amount. If the restaurant is closed it should never be more than one half.
If no one buys, the owner or receiver will have to remove the FF&E and perhaps sell the restaurant by auction, there will be no leasehold interest to be considered, and they must walk away from any leasehold improvements. This will create a substantial loss.
With a closed restaurant, as it remains closed, the value of the assets declines further. The bargaining power is yours, so use it wisely. Negotiate on the basis of the seller’s level of desperation, not your anxiousness.
|✔ Establish that the pizzeria’s failings are correctable, that you can turn it around, and make it profitable.|
✔ If employing a professional appraiser, ensure this person has experience in appraising failing or failed businesses. Few have.
✔ Due diligence means being watchful and skeptical, leaving nothing to chance or speculation.
✔ Search for hidden flaws: location, legal, financial, and physical.
✔ Review the lease with the landlord and your lawyer.
✔ Check licensing, liquor if applicable, health department, fire department, and municipal bylaws to ensure the pizzeria complies with all.
✔ Search for unpaid accounts, liens on equipment, pledges, conditional sales agreements, equipment leases.
✔ Check for unpaid supplier accounts, unpaid wages, unremitted employee tax and other deductions, etc. Have the seller sign a bulk sales declaration.
✔ If franchised ensure the franchise is assignable. If there is franchisor’s transfer fee, deduct it from your offered price.
✔ Conduct a profitability/break even analysis.
✔ Buy on the basis of what exists now, not what you can make of it.
✔ Never hurry. Failed and failing businesses are tough to sell, often impossible.