You built a successful restaurant operation and are now thinking about selling. What do you need to think about to make your business ready for sale? And importantly, maximize the proceeds you will receive.
Any sophisticated buyer will go through a due diligence process. What this means will be somewhat different depending on what legal form through which you are conducting your business and whether you are selling the assets of your entity or equity in the legal entity itself. There are both legal and financial aspects to due diligence as well as operational but we will pass on the operational aspects for this post. It is critical that you engage an experienced attorney to draft your documents and work with your CPA to take you through the process.
Let’s first assume your purchaser is buying assets and assuming certain operating liabilities. It’s likely an easier due diligence process under these circumstances. The buyer will want to feel confident that you actually own the assets that are being sold. Make sure you have purchase contracts, bills of sale, and receipts to prove you have clear title to the assets. It’s more complicated if real estate is part of the sale, because the real estate might be held in a different entity and, well, purchasing commercial real estate is just more complicated.
If you are leasing your location(s), the buyer will be interested in your leases in terms of transferability, percentage rents, rent escalation clauses, remaining lease terms, potential guarantees, etc. Closely related to the ownership issue is whether the assets might be subject to liabilities. For example, if kitchen equipment was purchased under a capital lease, the buyer will want to make sure payments are current. Generally, assets being sold and liabilities being assumed are scheduled out the in APA (asset purchase agreement).
If you are selling your equity interest as opposed to your entity’s assets, most of the same considerations laid out above apply but we layer on the notion of “contingent” liabilities. These are liabilities of the entity, known or unknown, for which you are not sure how much, if anything, will need to be paid at a future date . Such contingent liabilities could be lawsuits filed already or lawsuits which have not been filed that you might not be aware of.
Perhaps a manager made unwanted advances to a server or a customer had a food-related illness. Obviously, if a complaint has been filed but not yet settled, it might be reasonable to estimate a number. The more difficult proposition is where no complaint has yet been filed. Then, you have to rely on your experience where a customer or employee has raised an issue, but it has not yet turned “nasty”. The most difficult situation is where you have no knowledge of an issue yet. For this reason, most buyers generally do not prefer to buy equity.
Another issue to consider when selling your equity interest is to consider whether there might be assets in the entity that are not part of the deal and how those assets are to be moved out of the entity prior to closing. One situation where an equity purchase might be beneficial is if there is a favorable contract in place that might not be transferable under favorable terms in an asset sale.
Financial and Tax Aspects of Due Diligence
Savvy buyers generally value businesses based on some multiple of cash flow (EBITDA or earnings before interest, taxes, depreciation and amortization). Therefore, it is critical that you have your financial house in order. Buyers will want to look at financials, including compiled, reviewed or audited financial statements, and tax returns for numerous prior years. Often, adjustments could be made to “normalize” earnings where owners might be taking compensation outside of a normal range (either too high or too low). Perhaps rents to related entities owning real estate are outside of a normal range. Chances are negotiations will ensue if the real estate is to be maintained by the seller. Either party might look to a business valuation firm to provide a “quality of earnings” report. Buyers will also look at the processes performed to keep the books and the various controls in place, especially when the employees are part of the deal.
Buyers will usually want to look at income tax returns to see how the returns match up to the financial statements. Even in asset sales, buyers will want to make sure that the income reported for financial statement purposes (typically want a higher number) lines up with income reported for tax purposes (a lower number is usually preferred).
In addition to income tax returns, there are many other tax returns that buyers should examine prior to closing, particularly in equity purchases. Such returns include sales and use taxes, property taxes and unclaimed property tax returns. Unclaimed property is often a problem for restaurants that sell gift cards, although not all jurisdictions seek to recover unclaimed gift cards. Also, many restaurants typically have numerous small paychecks to servers that might go uncashed and those amounts can add up. Finally, payroll tax returns are critical because we see many examples where restaurants use payroll withholdings for other purposes or unscrupulous employees might embezzle such amounts.
- Keep up to date with all legal, income and other tax filings
- Maintain strong financial controls and keep your financial house in order
- Be prepared to engage in the due diligence process
Do you still have any questions? Feel free to contact a Henry+Horne professional to help you answer them. For more information on how Henry+Horne can help with getting your restaurant business ready for sale, check out our Restaurant business acquisition page.
Bradley S. Dimond