Chapter 3 - Should You Buy or Build?

Advantages of building | Disadvantages of building | The advantages of buying | Disadvantages of buying | Three major considerations to think about before buying | Tax considerations in buying | leasing or trading | Determination of purchase price | Valuation of assets | Tax savings check list

The fundamental consideration facing all prospective restaurant owners is whether to build or buy a food service operation. Most of the time analysis of the location and the characteristics of the sites or physical facilities available are the determining factors in this deci­sion. At other times, because a variety of opportunities may exist in a single community, the future restaurant owner is faced with a num­ber of alternatives. In this case only a detailed examination of certain basic factors involved will enable the newcomer to make a profitable and satisfying decision.

Assuming that the opportunities of either building or buying a res­taurant operation exist in a single community and that in terms of location value both are equally good, what are the fundamental factors involved? The simplest and perhaps the most effective method of deter­mining these factors and their relative value to you is by listing the comparative advantages and disadvantages of buying or building a restaurant operation.

Advantages of Building:

1. Type, size and average check. Your training and experience with a definite type and size operation many times makes it mandatory to begin with an operation whose characteristics and operating prob­lems are completely familiar to you. For example, a table service restaurant is completely different from a cafeteria. More to the point, however, a table service operation containing a cocktail lounge, incor­porating a catering service or a frozen food or bakery take-out sales department is also different from a table service operation that does not have these features.

Your experience and training may make it possible for you to offer curb service in addition to regular table service operation. The layout, physical characteristics and operating problems are again different from a simple table service operation.

Differences in the seating capacity of an operation bring attendant changes in the labor force and mechanical equipment required to handle the volume of business. An operator who is experienced with a table service operation with a seating capacity of 80 may well find it difficult to operate an identical unit with a seating capacity of 205.

Finally, even within the type of operation other problems arise. For example, an operator who is familiar with a table service operation that has an average check of $1.25 for dinner may find himself unable to conduct successfully a table service operation whose average check is $2.50. The menu, specifications for food, food portions, methods of processing and service, amount of personnel training needed, linens, atmosphere may all be completely dissimilar.

A distinct advantage of building therefore is the opportunity to begin an operation by building it to fit your specific requirements in terms of your training and your experience.

2. Architectural design. Today's new restaurants are being con­structed to furnish their own theme and sales promotion. Cantilevered
ceilings, types of lighting, signs, parking places, landscaping, and the exterior design of the building are but a few of the items that are carefully planned to furnish a steady and profitable sales promotion for the operation.

When you build an operation, you have the greatest opportunity to make the operation reflect your own personality, your desire to please the patrons and have the operation contain within itself its own built-in sales appeal.

3. Materials, furnishings and equipment. A newly constructed restaurant operation can and should be designed to take advantage of
all the new types of materials that have flooded the markets today: the new construction materials, removable sound conditioned ceilings, natural and synthetic fabrics, flooring materials, lighting, and many other items can now be selected not only for dramatic or eye appealing effects, but for long run economy, freedom from excessive repairs and ease of maintenance.

Add to this advantage the opportunity to select new equipment such as radar ranges, flex-seal pressure cookers, and a host of other im­proved pieces of equipment in the frying, refrigerating, processing and serving lines and you have a strong reason to build from the ground up.

Disadvantages of Building:

1. Cost. The greatest single disadvantage of building a restaurant operation today is the initial cost. Generally considerably more money is likely to be needed to build than either to buy or lease. In a tight money market, high labor and materials cost, a modest estimate of investment needed to build a successful operation is $1,000 per seat. The results of a recent study made by the Can Manufacturers Institute showed that investment per seat differs materially in all operations. The investment ranged from $1,800 in a diner to $400 in a small table service operation. The $400 figure, however, represented an invest­ment in an old established operation.

2. Working capital. In addition to the amount of cash required to build and/or equip a new restaurant, working capital requirements are likely to be much greater for an operation that has recently been constructed. The established restaurant that is purchased or leased has a definite volume of business that can be accurately determined. The new operation, on the other hand, will have a surge of business at the opening followed by a slow decline lasting anywhere from three to eighteen months until sales volume stabilizes.

During the time that income is established, cost of labor, utilities and other semi-variable and fixed expenses may have to be met from a rapidly diminishing working capital. The cost of food and supplies can generally be met from sales of food; however, advertising, insur­ance, deposits for public utilities, legal and advisory expense, house banks, auditors or bookkeeping expenses, may be considered as a steady drain on working capital. If items such as insurance, taxes, and licenses, have been prepaid, the minimum amount of working capital needed to operate the restaurant successfully, take advantage of dis­count purchasing, provide an emergency fund for extraordinary ex­penses and to free the owner from tension of associated financial problems is six times the estimated monthly payroll.

Advantages of Buying an Established Restaurant

1.  The volume of business is established.

2. Advantage is taken of the former owner's skill in selecting a location, determining the menu, purchasing equipment, laying out equipment, assembling and training labor.

3.  Eliminates competition.

4.  Is usually easier to finance than to build.

5.  May be a bargain.

The two most important advantages of buying an established opera­tion in preference to building one are that the volume of business is established and that the former owner has organized man, machinery, methods and procedures into a productive entity. Without one or both of these advantages it is seldom profitable to consider purchasing the operation.

The importance of these two advantages therefore, suggests a care­ful and detailed analysis of present and future sales, and the valuation of the organizational skill that created the enterprise. Accountants, lawyers, engineers, purveyors, townspeople, bankers, realtors, and public officials may have to be enlisted to aid you in a profitable decision.

Accountants should examine the original cost, sales and expense records to help you in the evaluation of the equipment and inventory, to determine present volume and trend of sales, to budget and control operating expenses.

Bankers, realtors, and public officials can aid you in determining present and potential danger areas such as a deteriorating neighbor­hood, new restrictive zoning laws, shift of business areas to other sections of the community, plans for new highways or a redirection of traffic, lease cost and availability if the owner of the restaurant does not own the land.

A good lawyer will investigate liens on the business assets, clear title to fixed and current assets, will draw up a purchase agreement protecting you and the business.

Engineers can examine the building for structural defects, describe the adequacy of heating, air-conditioning and ventilating systems, plumbing and electrical lines, check on all heavy equipment and estimate costs of remodeling, if necessary.

The purveyors and townspeople can give you a good idea of why the owner wants to sell, if his operation has a good reputation for pay­ing its bills, and satisfying its customers; in other words, if the owner ran his business—managed it effectively—or if the business ran him.

The advantage of eliminating competition is self-explanatory. If the restaurant that is to be purchased is identical as regards type of serv­ices offered, menu selections, average check and appeal to a certain class of customers, it may be better to purchase the existing operation than to build another nearby and share the market.

Generally, an established restaurant can be financed much easier than an operation that is to be newly constructed and equipped. Of course, even with a new operation it is possible to defer approximately thirty to forty percent of the value of heavy kitchen and certain other dining room equipment by installment payments. Also, several other financial arrangements with the owner of the land may be made that are advantageous to both. The land owner, for example, may agree to build a restaurant operation on his land according to your specifica­tions and lease the operation to you. Lease cost will then vary accord­ing to the amount of investment by the landowner, contractual agreements regarding exterior repairs, landscaping, furnishing of utili­ties, participation in building improvements and other items. If, on the other hand, your experience, reputation, and training does not justify this investment by the land owner, he will obviously prefer to sell the land to you and thus create an additional financial problem that must be met by you.

Most of the operations that are purchased from the former owner are bought with a much smaller cash outlay than is generally supposed. For example, a restaurant that is offered for $35,000 can be bought with a $5,000 to $10,000 cash deposit and the remainder financed through a purchase money mortgage. An established operation may be financed by relatives and friends, silent partners, the public, through stock purchases, banks and other financial institutions. Meth­ods of financing and loan sources will be described in succeeding chapters.

The last advantage connected with the purchase of an established restaurant is that it may be a bargain. The owner may wish to sell for business reasons: a partner's death or a husband's death; for personal reasons: poor health, wife's death; decision to retire or move to another community; or he may wish to sell because his business is unprofitable or is mis-managed. There are many reasons for selling a going operation. A careful investigation into the reasons may reveal that the operation is favorably priced and can be made profitable through your good management.

Disadvantages of Purchasing an Established Operation

1.  Bad reputation.

2.  Over-equipped or over-investment.

3.  Too much fixed overhead.

4. No technological advances in construction, use of materials, equipment, fixtures, and design.

5.  Relatively difficult to promote.

6.  Good will can't be transferred.

The three major factors that should be considered before buying an established operation are the operation's reputation, the amount of over-investment and fixed overhead. A bad reputation is always diffi­cult and occasionally impossible to overcome. The reputation may have been caused by poor quality food, unsanitary conditions, poor service, untrained and/or unorganized personnel, condemnation by health authorities, former lawsuits, mis-management, and a host of other reasons. When you purchase an established operation, you also purchase an established reputation. If the reputation is bad, you are saddled with a greater-than-average risk. Not only have most of the potential customers formed the habit of not patronizing the establish­ment, but also the entire tone of the business in terms of type of customers and size of the average check has steadily deteriorated. A talk with the townspeople, purveyors, bankers, chamber of commerce, and other public officials will usually reveal the extent of damage caused by poor reputation. An operation that has this type of reputa­tion has no good will and is never a bargain.

A poor selection of, and too large investment in, kitchen and dining room equipment and fixtures, is a serious disadvantage that must be considered before buying an established operation. Where this disad­vantage exists, it is usually coupled with a poor layout. In combination these two disadvantages can ruin your operation before you open the door. Unless extensive remodeling is done, the layout changed, equip­ment that is not needed dismantled, and equipment selected that will be needed in terms of processing your menu properly, service will be slow, food quality will be poor, employee morale will be low, and your customers dissatisfied.

The other major disadvantage, too much fixed overhead, is so seri­ous that this factor alone can and should dissuade you from purchasing an established operation. Items such as rent, licenses, insurance costs, taxes, mortgages and other outstanding obligations that you are asked to assume may be all out of proportion to the potential sales.

There are only two ways to make a profit: increase sales or reduce costs of operation. When sales cannot be increased and costs are excessive and fixed, your chances of continuing the operation success­fully are very slim indeed.

The remaining disadvantages are not as serious as those previously mentioned, but they should be considered. Generally obsolete equip­ment, poor construction and use of materials in fixtures and design are and should be reflected in a lower purchase price.

The relative difficulty of promoting an established operation in contrast with a sparkling new operation can be overcome to some degree by advertising, changes in store fronts, methods of service, interior decorations, and other operational procedures.

Many times the reason an operation is successful is not because of good food at moderate prices or its location, but more important, it is successful because the total atmosphere is a reflection of the owner's personality. The operation radiates with high employee morale, hos­pitality, warmth, and the owner's very evident desire to serve and please his guests. This good will cannot be transferred easily. Obvi­ously it is of great value to the new owner because a high volume of sales is assured during the first few months of operation. Customers are in the habit of patronizing the operation. However, if the former owner's personality and friendliness is not matched, sales will drop and a number of operational headaches will arise. The value of good will therefore should always be analyzed in terms of whether the good will is created because of an ideal location, the need for the services the operation offers, or if it is tied to a single man's personality.

Determination of Purchase Price

In addition, if the prospective owner decides to operate an estab­lished unit, many problems arise that might not appear if he built from the ground up. Since the most important problems can be grouped in the classification of tax and valuation considerations, the final section of this chapter concerns itself with problems in this cate­gory.

There are only three basic procedures which a restaurant operatoi can use to take over an established food service operation: he can purchase, lease or trade. If the restaurant is incorporated and he de­cides to purchase, the prospective owner has the further problem of deciding whether to buy the assets for cash or purchase the stock of the corporation. Each decision may have a vital bearing taxwise and will directly affect the profit picture for years to come.

The basic concept motivating the prospective operator's thinking is to take over the operation at a reasonable cost and in such a manner that the consumption, use, deterioration, and obsolescence of the assets are reflected as soon as possible in the reduction of taxable income. The underlying theory is to obtain the quickest return on the investment in an operation by realistically including as expense the utilization of assets, thereby reducing taxable profits.

The problem of determining the total price and the subsequent valuating of assets is a good illustration of this procedure. The total price that may be offered for an established operation varies with the volume of business, the percentage of estimated profits and the num­ber of years required to recover the investment in the operation. A rapid rule of thumb formula for determining total investment in the operation is the multiplication of estimated profits before income tax by a price factor of 2Vi to 5, depending on the volume of business.

The price factor will increase in proportion to the increase in sales volume because of the close relationship between total investment in an operation and volume of business. An investment of $10,000 for example should result in obtaining a sales volume of at least $40,000, whereas an investment of $100,000 in an operation may mean that sales volume is expected to reach a minimum of $250,000.

To illustrate this concept of price determination, if a prospective owner on the basis of his experience estimates that he should obtain as profit before income taxes, 10% of sales, the investment percentage factor is this 10%.

	Example 1	Example 2
Estimated Sales	$100,000	$400,000
Investment Factor	10%	10%
Sales × Investment Factor	10,000	40,000
Price Factor	3	4
Approximate value of restaurant to the prospective owner	$  30,000	$160,000

If, on the other hand, the prospective owner estimates that he will obtain as net profit before income taxes only 5% of sales, his total investment factor is five percent.

	Example 3	Example 4
Estimated Sales	$100,000	$400,000
Investment Factor	5%	5%
Sales × Investment Factor	5,000	20,000
Price Factor	3	4
Approximate value of restaurant to the prospective owner	$  15,000	$  80,000

From the above examples an important principle can be deduced. The estimated valuation of a restaurant will vary according to the amount of profits expected by the buyer and by the owner. The differ­ence therefore between the price asked and price bid may be thought of as operational efficiency index. If the owner of the restaurant is operating with the data shown in example 1, the asking price of $30,000 is realistic. On the other hand, in the same situation, if a prospective operator bids $15,000, shown in example 3, the owner will not sell. The difference between the two valuations has come about because the owner can operate twice as efficiently as the buyer. Con­sequently, on this basis alone he will not sell because he refuses to be penalized for the buyer's inefficiency.

After a careful analysis of the balance sheets and the profit and loss statements, a realistic total valuation can be placed on the business. All figures should be independently checked by a CPA trained in the necessary investigation. The investigation should cover all the items found on the financial papers. A complete analysis involves the valua­tion of current and fixed assets including a description of the condi­tion, present value and title of tangible assets, and the estimated value of intangible assets such as good will; the type and amount of current and fixed liabilities that may be assumed by the new owner; an ap­praisal of present net worth, a detailed study of profits claimed, based on the owner's income tax returns and a report of the type, amount and reasonableness of the expenses shown in the profit and loss state­ments and in the income tax returns.

The result of following the two procedures outlined above is that three valuations are placed on the same property: the present owner's valuation—this usually includes good will, the rule of thumb formula based on operational efficiency, and the financial analysis based on a study of profits claimed and expenses incurred and on the appraised values of all assets minus any claims on the business not made by the owner. If the three appraisals of valuation are made realistically, the present owner's valuation is usually the highest, the rule of thumb appraisal is the median and the financial appraisal excluding good will is the lowest of the valuations made. In almost all instances the final purchase price will be determined somewhere below the present owner's valuation and above the rule of thumb appraisal.

Tax Considerations

Taxwise the concept of valuation of assets is based on placing a high value on all short lived assets and a low value on all long lived assets. Assets such as food inventories, liquor inventories, paper supplies, and cleaning supplies, should be valued at a high figure. Assets such as buildings, ranges, ovens, dishwashing machines, and other heavy equipment should be valued low. A little thought on assets such as land and good will, which will last as long if not much longer than the business, will clearly demonstrate that they should be valued low.

The reason for placing high or low values on assets in this manner is to reduce taxable income as much as possible the first years of opera­tion. The investment in short lived assets is returned in the form of expense such as depreciation, repairs, and maintenance replacement, or cost of goods sold, reducing profits and in the case of depreciation, increasing working capital available.

The section on tax savings describes certain procedures thoroughly. At this time it is sufficient to point out the following rules.

1.  If other circumstances justify the decision, lease the land in­ stead of purchasing. The lease cost is deductible each year. The cost of purchasing the land is not a deductible operating expense.

2.  If land and building are purchased, allocate greater value to the building and less to the land. Investment in the building can be re­
turned in the form of depreciation. Land, on the other hand, cannot
be depreciated.

3.  If purchase money is needed, finance through bonds rather than stock. In addition to broadening the ownership equity, financing
through sale of stock involves double taxation later when dividends are paid. Interest on bonds is a deductible expense.

4. Consider leasing equipment having a life of 10 years or more. Lease cost is immediately deductible. The cost of purchasing the equipment can only be recovered through depreciation over a 10-year period or the estimated life of the equipment. Where equipment may be financed through a lease, a graduate percentage lease based on sales volume fluctuations is much better than a fixed rental cost. As sales volume increases, payments for equipment increase, reducing taxable income. As sales volume decreases, payments decrease, con­serving working capital.

5.  If the owner is willing to offer a purchase money mortgage to aid in financing the purchase of the restaurant, consider reducing the amount of the principal and increasing the interest rate. Interest is a deductible expense, repayment of principal is not.

6.  Separate promotional, administrative and certain legal costs from total organization cost or building construction cost. Organiza­tion expense is not a deductible expense in the year the cost was incurred. It cannot be deducted until the business is discontinued.

Similarly, building construction cost is an addition to the value of the building, and as such is deductible only through long term deprecia­tion. Expenses of promotion, advertising, real estate taxes, and admin­istration on the other hand are usually deductible as expenses in the fiscal year in which they were incurred.

7. If estimated profits are well over $25,000 annually, consider dividing your organization into two or more organizations: one organ­ization owning the fixed assets and renting these assets to the operating organization. For example, have two partnerships or two corporations instead of one.

8.  If you are a present owner of an established restaurant whose value is considerably depreciated, consider a trade of properties instead of a sale and subsequent purchase of property. When a sale is made, the difference between the book value of the property and the sales price represents a capital gain and the profit is taxed accordingly. The capital gains tax can be very substantial. The trading of properties, on the other hand, is a tax free exchange where no gain on the transaction has been made.

To illustrate, take the case of a restaurant valued at $50,000 that can be resold for $100,000. If the property is sold, there will be a gain of $50,000. But if it were exchanged for another restaurant valued at $90,000 and $10,000 in cash, the taxable gain will be limited to the amount received in cash or in this instance, $10,000.

If on the other hand this same restaurant were traded for another valued at $90,000 and no cash or securities were received, the exchange would usually qualify as tax free. The $10,000 difference between the resale value of $100,000 and the traded value of $90,000 would not be treated as a loss. There may be a gain in trading properties, but losses are never recognized on any tax free exchanges.

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