Ask a restaurant owner what the business is worth and the answer will often reflect what went into creating it.

There may have been millions spent on the kitchen, fit-out and equipment. Years may have gone into building the brand. The restaurant may occupy an exceptional location and have thousands of loyal customers.

All of those things matter.

But a prospective purchaser will usually begin with a different question:

What sustainable earnings will this business generate for me after I buy it?

That distinction lies at the heart of restaurant valuation.

Cost and value are not the same thing.

Suppose an owner spent R5 million developing a restaurant.

That R5 million is historically important to the owner, but it does not automatically make the business worth R5 million.

Equally, a restaurant created for considerably less could become worth substantially more if it develops strong, sustainable and transferable earnings.

Purchasers generally do not reimburse sellers for historical effort or expenditure.

They purchase the future economic benefits of the business.

This is why valuation usually begins with earnings.

Start with sustainable earnings

The figure appearing at the bottom of the income statement may not necessarily represent the earnings a purchaser should value.

Privately owned businesses frequently require normalisation.

Consider a simplified example.

A restaurant’s accounts show annual earnings of R1.4 million.

The owner works full-time in the business but takes only a modest formal salary. If a purchaser would have to employ an experienced operator at R500,000 a year to perform the owner’s functions, the economic earnings available to the purchaser may be closer to R900,000.

Now reverse the example.

Perhaps the accounts show R900,000 in earnings but include R200,000 of genuinely non-recurring expenditure that will not be incurred by a purchaser.

Maintainable earnings might then be higher than the reported accounting figure.

Neither adjustment should be automatic.

The objective is to determine, as objectively as possible:

What level of earnings can this particular restaurant reasonably be expected to produce under new ownership?

Then comes the multiple.

Once sustainable earnings have been established, purchasers and sellers commonly consider an earnings multiple as one method of assessing enterprise value.

For illustration only, suppose the parties ultimately agree that maintainable annual earnings are R1 million and a purchaser is prepared to pay three times those earnings.

That implies a business value of approximately R3 million.

Change either variable and the value changes.

If maintainable earnings are actually R700,000 at the same illustrative multiple, the value becomes R2.1 million.

If the business deserves a lower or higher multiple because of its particular risks and qualities, the answer changes again.

The important question therefore isn’t merely:

“What multiple do restaurants sell for?”

It is also:

“What earnings are we multiplying, and how confident is a purchaser that those earnings will continue?”

What determines the quality of those earnings?

Two restaurants producing exactly the same current profit need not have the same value.

One may have an experienced management team, long trading history, excellent financial records and limited dependence on its owner.

The other may depend almost entirely on its founder.

One may have a favourable lease with several years remaining.

The other may face an imminent lease expiry and substantial rental increase.

One may have consistent revenue throughout the year.

The other may depend heavily on a short tourist season.

One may require little immediate capital expenditure.

The other may have kitchen equipment approaching the end of its useful life.

A rational purchaser will take these differences into account.

The lease deserves particular attention

For many restaurants, the lease can materially influence value.

A purchaser should understand the remaining term, renewal rights, rental and escalation provisions, operating costs and any restrictions affecting assignment or change of control.

Location may be one of the restaurant’s greatest strengths, but if continued occupation of that location is uncertain, some of that value may be at risk.

This is one reason restaurant transactions sit at an unusual intersection between the purchase of an operating business and the property from which that business trades.

What about the equipment and fit-out?

Owners understandably attach value to expensive kitchens, furniture, extraction systems, bars and fit-outs.

These assets certainly matter.

A purchaser who acquires a fully operational restaurant avoids the cost and time involved in creating one from scratch.

But care is required not to count the same value twice.

If the restaurant is being valued as a going concern based on its earnings, the operational assets necessary to produce those earnings will ordinarily form part of the overall business proposition.

Surplus assets, financed equipment, stock, vehicles or other items may require separate treatment depending on the particular transaction.

Value is ultimately tested in the market.

No valuation formula can determine with certainty what a restaurant will sell for.

The eventual price results from an interaction between the quality of the business, seller expectations, purchaser appetite, financing, risk and negotiation.

A strategic purchaser may see value that another buyer does not.

A purchaser already operating several restaurants may identify synergies.

An owner-operator may value the opportunity differently from a financial investor.

That is why valuation should be regarded as a disciplined assessment rather than a promise of a particular sale price.

Think like the purchaser.

For an owner contemplating an eventual exit, perhaps the most useful exercise is to look at the restaurant from the other side of the table.

If you were considering investing several million rand of your own money in the business, what would you want to know?

Would you be comfortable with the accounts?

Would you understand how the reported earnings were derived?

Could the restaurant operate without the seller?

Would you be comfortable with the lease?

Are the licences, employment arrangements, contracts and records in order?

Would you have confidence that customers will continue coming after ownership changes?

Ultimately, a restaurant is not valuable merely because it is busy, fashionable or expensive to recreate.

To a purchaser, its value lies substantially in the sustainable economic benefit that can be transferred from one owner to another.

And that is why perhaps the most important valuation question is not:

“What have I put into this restaurant?”

It is:

“What, exactly, will the purchaser receive when I leave?”

Laughton Appollis is a Cape Town commercial attorney and director of L. Appollis Attorneys Inc. The firm specializes in the confidential sale and acquisition of established restaurant businesses.

Restaurant owners who would like to discuss how a prospective purchaser might assess their business are welcome to contact Laughton confidentially.

L. Appollis Attorneys Inc.

083 274 7769

lappollis@lappollisattorneys.com