Buying or selling a restaurant can be a difficult venture in any economic climate, but is significantly more risky in today's economic climate. Before you begin the process of buying or selling a restaurant, you should have a good understanding of the process and the possible pitfalls, since this is likely to be a significant transaction in your business career. Remember, buying and selling a business is a business unto itself.

Within the various retail formats in the food industry, restaurants seem to involve the most subjectivity. Buyers often seem to be attracted by the romance or perceived glamour of the restaurant business which can impair both objective evaluation and negotiating leverage. Conversely, sellers can be reluctant to acknowledge bona fide negative factors that reduce the value of a restaurant and may cling to a higher, hard to justify sales price. To improve your chances for success, consider the following summary description of common pitfalls in the buy-sell process.

There may be many reasons for buying an existing restaurant, as opposed to starting a new venture. The most obvious benefits are the existing restaurant’s track record and its location. Other advantages may include an existing liquor license or other franchise/license, such as a sidewalk café. Depending on the location, these licenses may be significant assets, greatly enhancing the value of the transaction. For example, while a new liquor license application is pending before the State Liquor Authority (“SLA”), the “transferee” of an existing liquor license may operate under a temporary permit. A “new” location offers no such advantage. As such, new ventures must go through the entire approval process before doing business.

The State Legislature is attempting to make it increasingly difficult to open new licensed premises in certain locations. A 1993 amendment to the Alcohol Beverage Control Law requires an additional hearing to prove that the issuance of new licenses within 500 ft. of three or more already licensed premises will advance the "public interest." Recently, community opponents used this provision in State Supreme Court to block the SLA from issuing a license to a new restaurant in Soho.

Likewise, a sidewalk cafe franchise is a valuable existing asset. A new franchise requires an arduous, expensive and time consuming land use application, with the results by no means "guaranteed." However, existing franchises run with the land, and are not personal to an individual operator.

When you purchase a restaurant, what you are primarily buying (other than name, phone number, lease, leasehold improvements, equipment, etc.) are: (i) a stream of income (which alone should justify the sale price); and (ii) the ability to ultimately sell the restaurant and realize a capital gain. Anything that could adversely affect or reduce the “net" amount or term of the stream of income, or the value of the business for resale, must be carefully considered before you tender your first offer. Unfortunately, in many instances, purchasers only become aware of such negative factors when it is too late.

Accordingly, buyers must spend more time up-front, conducting their "due diligence": legal, financial and field research on the business to determine precisely what that business is worth to the purchaser.

Many of the essential issues in the deal may not be definitively addressed and resolved in negotiation or in the legal instruments memorializing the transaction, but can only be clarified or resolved by considerable early due diligence. For these and other reasons, it is important that your professional advisors be very conversant in the food/restaurant business, as well as knowledgeable of the legal and accounting considerations.

(i) THE BIG LIE: While the sales volume of the subject restaurant may appear to substantiate the purchase price, the actual profits, taking into account all of the apparent and not so apparent costs and expenses may not justify the sales price. It is imperative to conduct a lengthy "trial run" period, confirming sales volume, actual expenses, and "take home" profits.

(ii) THE "WHITE KNIGHT" STRATEGY: The seller or their business may be troubled - they may be in default on their supply/credit agreements, their commercial lease, or may be under investigation by tax or other regulatory authorities (State Liquor Authority, Board of Health, etc., see discussion below). The seller, having superior knowledge of the customer base, the neighborhood and the potential for increased competition, may be seeking to sell before these factors become apparent to prospective purchasers. If so, a patient purchaser may be able to negotiate a lower price or better terms.

(iii) THE CHINA SYNDROME: The seller may know the location has the potential for significant disruption or interference of business operations. For example: (a) the location does not comply with the Americans With Disabilities Act, or other Building or Fire Department regulation, necessitating substantial alterations; (b) under- ground storage tanks are located on the property, allowing the N.Y.S. Department of Environmental Conservation to conduct an investigation, and, if necessary, require remedial measures which could significantly disrupt the business.

Your due diligence, should, at a minimum include a full title and judgment/lien search. Potential buyers might be amazed at what basic inconsistencies or problems such a search could reveal, such as a restaurant not zoned for such use (the restaurant use must be reflected on the certificate of occupancy). The title search should include all outstanding municipal violations against the premises. In New York City, you would want to know all Building Department, Fire Department, Environmental Protection, Sanitation or Health Department violations. A judgment/lien search may reveal such basics as defaults in creditor or supplier agreements, or problems with the State Tax Commission. A buyer should also check with the SLA to determine if there is a history of complaints or disciplinary action at this restaurant.

It is unlikely that a seller who has built a thriving, highly profitable restaurant with no current or imminent problems would sell for less than a very generous price, unless there are some negative issues which are not yet apparent. Remember that every business has both its "nut" (total operating expenses) and a "hole" ("surprise" expenses) - buyers must identify the extent of both, because hidden costs can turn a viable business into a troubled one. Therefore, the goal of a buyer's due diligence is, in part, to determine the seller's true motives for selling.

We recommend the following strategies: (i) negotiate for the right to offset against promissory note payments for seller's breaches or misrepresentations; (ii) conduct a lengthy trial run with a purchase contingency (based upon certain thresholds for sales, expenses, etc.); (iii) obtain the right to reduce the principal amount of the notes for catastrophic business interruptions outside of the buyer's control (e.g. termination of lease because of landlord's default on its mortgage, eminent domain, etc.).

Sellers must also be "diligent" in researching potential buyers. This is particularly true when they are not receiving the total purchase price at closing or remain liable post-closing on the commercial lease or other agreements. In a troubled economic climate, the risk is even greater that the buyer may not be able to make good on the promissory note payments. Sellers must carefully screen potential buyers to determine whether they have the dedication, skill, experience and financial wherewithal to survive and hopefully prosper in the business being acquired.

Obvious ways to reduce risk include selling for all cash, keeping the promissory note payment period as short as possible, and having the deal secured with "hard" assets. Be careful when deciding between the "better" buyer and the higher sales price by taking into account the likelihood of the buyer's full compliance and the potential cost of enforcing that compliance.

(i) THEY ARE UNDER-FINANCED: We all know that under-financing is a major cause of business failure. In the event that your buyer is borrowing all or part of the capital that they will deliver by closing (i.e., contract deposit, non-financed balance, closing adjustments), they will now be further encumbered with the financial bur- den of repaying that indebtedness (typically short-term), in addition to all of the expenses associated with operating the business. Accordingly, it will be much more difficult for such a buyer to make good on your promissory note payments. Remember, the landlord, suppliers, employees and even the buyer's salary will get paid before you.

(ii) THEY ARE INEXPERIENCED: A major concern of sellers is that the buyer does not have substantial experience in running and operating a restaurant, or will not actively manage the business. If the buyer is not very experienced in restaurant operations, or does not intend to be a "hands-on" manager (thereby increasing employment expenses and chances of theft), the buyer's ability to service your promissory note obligation and remain current on the rent and other expenses may be significantly impaired.

Cover your "back." In order to minimize the common problem of receiving the last six months payments on the promissory notes, give the buyer an incentive to fully satisfy their obligation by making reductions in the purchase price or other incentives contingent upon the purchaser's full compliance with all terms and obligations of the note and related sale agreement.

Remember - when you are selling a business and either lending the buyer capital to purchase the business or are compelled to remain liable on the commercial lease or other agreements, some of the most essential considerations are: Who is the buyer?; What is their background?; Do they have sufficient start-up capital (not including borrowed funds)?; and will they actually manage and operate the restaurant?

Christopher J. Gulotta, Esq. is in private practice with offices in Manhattan and Westchester. His firm, The Gulotta Law Group, PLLC represents clients in business law, franchises, litigation and real property law (both commercial & residential). Mr. Gulotta is a faculty member of the Continuing Legal Education Departments at Fordham Law School, Pace Law School and at the Association of the Bar of the City of New York, where he lectures on the subject of buying and selling retail businesses. Mr. Gulotta is also a featured columnist for The New York Law Journal, The National Law Journal, Convenience Store News and the Veteran Leadership Program, Entrepreneurial Division.

Jeffrey A. Chester, Esq. is in private practice in Manhattan and can be reached at (212) 725-1700. He has over 12 years of experience in commercial transactions, real property law (including commercial leasing and zoning work), and licensing matters before administrative agencies (including the State Liquor Authority). He has represented numerous restaurants and cabarets. Mr. Chester was a founding member of the Association of the Bar of the City of New York's Committee on Land Use and Zoning.

This article is intended to provide practical advice and information for the food service entertainment industry in New York City. It is distributed with the understanding that neither the New York State Restaurant Association nor the authors are rendering legal opinions nor offering legal advice to the readers Of the article. If legal advice or opinion is required, the services of an attorney should be engaged.

Copyright © 2001 The Gulotta Law Group, PLLC