It seems odd that a business owner would work his or her whole life on their business and then determine the business’s value based on what they “think “the business is worth, or an industry rule of thumb. If the sale of your business is going to fund your retirement you should know what your business is worth.
Mr. Jones, A Quick Service Restaurant owner, has determined (based on industry rules of thumb, and conversations with friends) that restaurants like his are sold for multiples of between one and three times seller’s discretionary earnings (“SDE”), plus fixtures, equipment and inventory. SDE is defined as earnings before interest, taxes, depreciation and amortization, plus owner’s compensation. Mr. Jones knows his average SDE for the past five years has been $300,000. He “knows,” therefore, his business is worth $900,000 plus the value of the fixtures, equipment and inventory of $100,000 (owner estimate), or $1 million. Mr. Jones is 50 years old and has based his retirement plan on the restaurant value of $1 million. Mr. Jones and his wife like to spend money and the restaurant represents over half of their net worth.
A valuation would have determined the following:
- The restaurant is 20 years old, looks its age and certain equipment needs to be replaced within the next two years.
- The restaurant does not have a state of the art Point of Sale system (“POS”).
- The rent being paid for the premises is below market rent. Rent expense is expected to increase significantly when the current term expires. This will reduce SDE in the future.
- The building that the restaurant operates from has new owners. There is no guarantee that the new owners will want to lease the premises to a restaurant when the current lease term expires in three years.
- The minimum wage is expected to increase significantly in the next year. This will reduce SDE in the future.
- Parking available for restaurant patrons is maxed out.
- Population growth is expected to be two per cent for the next five years and income is expected to grow at two per cent in the same time period.
- The SDE information is based on the income tax returns prepared by a non-designated accountant.
Contrast the above scenario with another Quick Service Restaurant, with the same SDE and the following circumstances:
- The financial statements of the company are reviewed by a professionally designated accountant.
- Management has recently had a valuation report prepared. SDE is taken from this valuation report.
- The restaurant is located near an NHL arena.
- Population growth in the next five years is expected to be 15 per cent, and income growth is expected to be eight per cent over the same time period.
- The restaurant is four years old and has six years left on its lease, with two five-year renewal options.
- The restaurant’s POS system is new.
- It is easy to see that if we assume the restaurant in scenario 2 has the characteristics of a restaurant selling at multiples of three times SDE plus the value of the fixtures, equipment and inventory, and we estimate that value to be $1 million, then the value of the restaurant in scenario 1 is significantly less than $1 million. It is likely Mr. Jones restaurant would be worth less than $400,000.
Clearly there is a gap between Mr. Jones’ estimate of the value of his business and the actual value.
- The first thing Mr. Jones has to do is get the restaurant valued by a valuation professional.
- He needs to talk to the landlord and determine whether they will renew the lease. If the landlord is not willing to renew the lease, then it is unlikely Mr. Jones will be able to find a buyer.
- If the lease will not be renewed, Mr. Jones may decide to keep operating the business as is, invest his SDE in investments outside the restaurant and turn the lights off when the lease expires in three years. (1)
- If the lease will be renewed, Mr. Jones will have to decide if he wants to invest the time and money necessary to maximize the value of the restaurant. Last spring, Ottawa’s Calabria Restaurant in Centretown announced it was closing after 42 years of family operation, after it was given notice by its landlord that its lease would not be renewed. In September 2013, the Mayflower Restaurant on Elgin Street, in Ottawa, also announced it would close, after 35 years, due to lease issues. Mr Jones should be prepared.
If you need further information, reach out to your McCay Duff advisor.