Risk vs. reward — putting a price tag on your business

Most restaurant owners at some point face either a decision to sell their business or to buy another operation and expand. Both decisions are difficult. It takes a courageous owner to recognize when the time is right to sell. On the other hand, it takes courage – and capital – to grow an operation into a multi-unit chain. But whether you are selling or buying, the first step in the process is understanding the risks versus the rewards involved in the transaction so you can evaluate your options.

Sellers need to understand the perspective of buyers; buyers need to understand the perspective of the sellers. While both parties bring different goals to the table, sellers and buyers can agree that anyone interested in buying a business expects to:

  1. Earn a respectable profit,
  2. Be able to continue to enhance the value and marketability of the business,
  3. Possibly develop additional locations and then,
  4. Cash out to a leisurely retirement in the Bahamas (at an early age, of course).

Business opportunities today are plentiful. If you want a buyer, your business will have to speak of value without you speaking of its value. That value is associated with the "risk vs. reward" principle. Anyone looking at alternative business opportunities realizes that all investments have risk; the goal is to earn a return greater than the associated risk. The difficulty is accurately determining the ROI (return on investment).

Evaluating "Risk vs. Reward"

Estimating the value of your business can be a very detailed process, and you should seek advice from a professional with experience valuing businesses in your industry. Two quick ways to estimate the value of your business are to calculate the Cash on Cash Return and the Return on Total Investment for the three previous years.

Potential buyers will typically look for a Cash on Cash Return of no less than 35% and a Return on Total Investment of no less than 20%. If a seller is asking a premium price for the business, the buyer must be able to justify the risk in paying top dollar. Ibbotson and Associates (Chicago) collected data and a relationship of returns for various financial instruments over a period of 50 years. Their results provide a good picture of the average annual return and volatility of return over a long period of time. An examination of the returns also provides an idea of average returns over various economic cycles.

If a person could earn an average of 18.2% investing in small stock mutual funds, why would earning anything less in a restaurant investment make sense? As the seller, you must be able to provide an ROI that is similar to the ROI the buyer could earn taking a similar risk in the market.

Unfortunately, there is more to it than just comparing the ROI. To factor in the business risk you should consider what is referred to as "risk premium" by James H. Schilt in his book Schilt's Risk Premiums for Discounting Projected Income Streams. The chart developed by Schilt suggests that you add a risk premium to the ROI of the business based on the business model.

Schlit suggests that a risk premium in the 16% – 20% range is reasonable. The small stock return of 18.2% combined with the risk premium of 18% is a rational means of supporting the 'respectable investment return' dilemma. With the fickle nature of the public and their tendency to migrate to the newest theme, accepting anything less than a combined risk of 35% would be irresponsible decision making by the buyer. Keep in mind that this formula excludes discretionary draws and expenses over and above that necessary for unit level operations and debt service.

Avoid the Traps

A good rule of thumb is to operate your business as though you were going to sell it tomorrow. Making decisions without considering the impact on your economic value costs more than the current cash outlay. One of the errors many small businesses make is failing to report all earnings. Buyers will probably ask for copies of your prior three years tax returns to support the information you provide. As a business owner, you should report everything. To do less will cost more in the end than the immediate tax savings. There are many legitimate ways to reduce your income other than not reporting income.

Another potential trap is assuming the buyer will have the same personnel philosophy as you. For example, you may pay your manager 25% more because he/she takes care of things and you don't want to train another manager. You should realize that the value of your business could be diminished if this compensation does not impact the top or bottom line. The buyer of your business will have to continue with the same compensation arrangement that you had in place or risk losing a valuable part of your management team. This increases the risk to the buyer and may affect the value of your business.

Closing the Deal

If you want to sell your business, make sure you have done your homework. So, what are the Four R's in selling your business?

  • Recognize the risk the buyer is taking,
  • ROI – the bottom line,
  • Readily provide facts and figures to validate the success of your business,
  • Rethink your business practices and avoid the pitfalls of unintentionally devaluing your business. PMQ

Michael A. Roberts, CPA, has been associated with Horne CPA Group since 1987, where his practice is concentrated on providing consulting and accounting services to restaurant franchisees nationwide. For the past 18 years, he has worked with more than 600 restaurants in 42 states. He frequently speaks at conventions and is a consultant to various organizations within the franchise community.

Horne CPA Group was established in 1962. Headquartered in Jackson, Mississippi with 9 offices across the South, Horne CPA Group enjoys a practice of national scope. The firm is currently ranked among the nation's Top 100 accounting firms and among the Top 10 firms in the Southeast.

Contact Mike Roberts at 615-377-9946 or mike.roberts@hcpag.com for information on tax or management advisory services.