What’s on the Menu in Restaurant Valuations? A Recipe for Managing SBA Lending Risk

Restaurants are at the heart of America’s small business economy. We all have fond memories of celebrating life events at our favorite restaurants, leading to a lifetime of consumer loyalty. However, a bad experience at a specific dining location, can make us swear never to return. This is the dilemma of the restaurant industry. A great experience can drive recurring business, but an active and diligent management team must continually maintain a consistent level of service so one bad experience does not turn a consumer away for life. As Warren Buffett once said, “It takes 20 years to build a reputation and five minutes to ruin it…”

The National Restaurant Association estimates there are approximately 749,000 restaurants in the United States, with a majority qualifying as small businesses. Given their size and structure, restaurant acquisitions are commonly financed through SBA 7(a) loans. As a result, our team of valuation experts sees a significant number of transactions in this sector.

The value drivers and key considerations outlined here are intended to help SBA lenders make better-informed decisions when reviewing any restaurant-related transaction.

Three main cost drivers determine a restaurant’s profitability and ability to service debt:

Over the past five years, labor costs have increased by approximately 35%. This is primarily due to rising state minimum wages, staff turnover, and increased demand for qualified workers. Labor typically accounts for 25 to 35% of gross sales. Upscale restaurants tend to fall toward the higher end of that range as their workforce tends to be more specialized with less cross-functionality among roles.

The stress of labor costs can be mitigated through various strategies such as implementing improved scheduling technology, investing in staff training, and adopting automation where feasible. Restaurants may also reduce labor expenditures by strategically adjusting operating hours to avoid negative margins during hours of low performance.

For any prospective buyer, consideration must be given to the owner’s level of involvement and appropriate adjustments to compensation amounts. The salary listed may not accurately represent the market value for the services rendered. In some cases, owner-operators will work full-time in the business while taking a below-market wage, which requires adjustment in the valuation process, increasing labor costs, and reducing the purported profitability. Others may take substantial compensation as wages while also compensating additional staff to perform management functions, which would yield a positive profitability adjustment during the valuation process. All else being equal, restaurants with competent management independent of the owner tend to provide higher valuations, due to lower key person risk. Although there may be opportunities to improve labor efficiency post-sale, these improvements are generally not assumed in the valuation or offer price. Projected cost savings are not guaranteed and should not be baked into the purchase economics.

This expense comprises approximately 30-40% of gross sales and has risen approximately 35% over the past five years. Individuals have experienced this in their daily lives at the grocery store and should not be surprised when restaurants experience the same stressors and must raise menu prices accordingly. However, the consumer’s discretionary spending budget limits the extent to which restaurants can increase menu prices. The extent to which this can impact a restaurant’s operations may be mitigated by location and convenience factors such as proximity to major roads, major businesses, or walkability factors. Further, costs can be reduced by streamlining menu options and highlighting only the most popular dishes. There may also be an opportunity to add pre-cooked foods to save on kitchen labor and food costs.

From a valuation perspective, if we are relying upon the historical performance of the restaurant to perform the valuation, it is critical to select only the years that are representative of future expected food costs and their associated margins. For example, if a restaurant only successfully began to raise its prices in 2024 to mitigate rising food costs, it would likely be inappropriate to consider 2023 performance.

Every restaurant is located somewhere. The key questions are where and how much square footage it should occupy. There’s a balance between having enough seating for peak hours and avoiding excessive square footage. Many restaurants have closed due to rising rents, which can quickly absorb their thin profit margins. Appropriate valuation considerations include potential rent escalators, which could be material to the business operations.

Generally, when a restaurant is leased, rental rates should target between 6-10% of gross sales. These lease arrangements are typically structured as triple net, modified gross, or gross (full service). However, it is not uncommon for restaurant and retail leases to also include a percentage rent clause. Under a percentage rent clause, the tenant must pay additional rent equal to a percentage of gross sales over a specific dollar limit specified by the lease. While these lease clauses are most common in franchise and quick service restaurants, they may occur in retail or hospitality leases. It is essential to adequately analyze the restaurant’s historical sales and growth projections in relation to your potential liability should the percentage rent clause be triggered.

In many cases, the seller may control both the operating business and the real estate occupied by the business. Under this condition, any lease contract or historical rental payment would not be considered arm’s length and should not be used in the valuation. In related-party real estate transactions, rent must be normalized to reflect market rates. Suppose the seller chooses to retain the property while leasing it to the buyer of the restaurant operation. In that case, a rent adjustment reflecting these terms will be essential to the valuation to project cash flow available for debt service, reinvestment, and dividends. Similarly, suppose the property is sold along with the business. In that case, rental payments to a related party cannot be presumed to represent a market rate, and normalization is required to value business operations independent of real estate properly.

A surface-level analysis of cost ratios can highlight whether a restaurant is outperforming or underperforming its peers. However, to produce a reliable valuation, we must dig deeper.

A reliable valuation does not begin with standard rules of thumb such as “restaurants sell for 2-3x SDE (EBITDA + ‘Owner’s Compensation’)” or “30-40% of annual sales”. These rule-of-thumb statements oversimplify the valuation process and do not consider critical factors. No two restaurants are alike; therefore, each requires specific considerations when determining its value. Relying solely on sales multiples provides no insight into cash flow, while a generic SDE rule of thumb misses critical business risks. These realities expose the limitations of using rule-of-thumb valuation methods.

Demographics and local market dynamics matter. A growing population is usually a positive indicator, while a declining population or income per capita may be viewed as an additional risk factor. Restaurants, like all Main Street businesses, are closely tied to the economic profile of the surrounding area.

Before relying on a shortcut like a rule of thumb, consider these questions:

Restaurant valuations often overlook capital expenditures because they appear below net income. But to determine free cash flow—the amount available to service debt—you must consider any future capital expenditures. It is necessary to consider the remaining useful life of the kitchen equipment, refrigeration, and HVAC systems. An on-site equipment appraisal is often the best way to assess the remaining useful life of fixed assets.

In the case of franchise restaurants, it is crucial to understand if there are any mandated reinvestments. Many franchisors mandate periodic reinvestment in branding, signage, or equipment. These requirements are usually written into the franchise agreement. Valuations must factor in these capital obligations, as they directly impact available cash flow and future profitability. Franchisees should also understand any transfer restrictions that may impact the available buyers’ pool when looking to sell.

Do not double-count operating assets. A restaurant that owns a liquor license and deploys it should not have the value of the license added to its operations. It is an intangible asset that drives the cash flow used to value the business. Only under a liquidation scenario would the license’s value be considered as there would be no expected cash flows from the restaurant.

It should certainly be expected that the results of the factors above, and many more, will be reflected in the historical performance of the restaurant being valued. However, value is predicated on future results. Future results are what allow the borrower to service the debt. A valuation needs to consider how any of the above factors may alter the future performance of the restaurant versus its historical figures.

As always, business valuations marry the numbers to a story. It is simple to assume that historical performance is a proxy for future performance. Still, without understanding the above factors, it is challenging to state that the assumption is anything but speculative.