Typically, the buyer has somewhere between 10 and 20 calendar days from the time the asset purchase contract is accepted to complete his due diligence. The due diligence includes the items indicated below:
Inspections
Physical Inspections – The buyer should hire a general contractor or building inspector who is capable of evaluating all the mechanical systems—plumbing, refrigeration, electrical and heating, ventilating and air conditioning—to make sure they are working correctly, and have a reasonable life remaining. Additionally, all the equipment and fixtures should be inspected to make sure they are in good working condition. The recommended procedure is that, upon the initial inspection of the equipment and fixtures, the buyer and seller walk through the business and check off all the equipment to make sure it is there. This list is prepared by the seller immediately after listing the business for sale, and the equipment list is signed by both buyer and seller at the time the
purchase contract is executed. The equipment list is also signed again by both buyer and seller after the final walk thru is completed by the parties, immediately before the close of escrow.
Health Department Inspection – In most counties in California, before a business license is issued to a new owner, a change-of-ownership health department inspection must be signed off by the county health inspector. This means that before the sale is completed, the health department does an inspection for a change of ownership, and this has higher standards than a routine health department inspection that was done periodically while he was operating the business. On a change-of-ownership health department inspection, the inspector will call out all items that are now required as a result of code-upgrade changes and are typically required for a change of ownership—such as three compartment sinks, mop sinks, hand sinks, special floor drains; all surfaces including walls, floors and ceilings must be smooth and washable, etc. It is usually the buyer’s responsibility to pay for the inspection report, which is a couple hundred dollars, and it is the seller’s responsibility to clear all these items before the close of escrow. If the seller does not want to clear these items, usually the price is adjusted downward accordingly for an “as-is” sale, making the buyer responsible for these changes. If the buyer plans to undertake a major remodeling of the business after the close of escrow, then the health department inspection is not that meaningful. The buyer’s remodeling plans will have to be approved by the health department.
Fire Department Inspection – If you have a type 1 hood (a hood system for a full kitchen with open flame cooking), you need to have a fire suppression system built into the hood system. If a fire occurs over the cooking area, the fire suppression system will activate, and hopefully extinguish the fire.
– All of the fire extinguishers need to be checked and filled regularly.
– You must have proper egress and ingress areas for customers and employees.
– The duct system which connects between the hood and roof needs to be cleaned out quarterly by a professional hood-cleaning company.
Your electrical system must be up to code, and have the proper electrical work completed throughout, including updated circuit breaker systems. American Disabilities Act (ADA) – This is the Federal law set up to assure that you have the proper facilities for disabled customers. Such areas as entry ways, front doors, restrooms, parking spaces, table heights, and seating areas must be properly adjusted to accommodate disabled customers. If you are buying an existing restaurant which does not accommodate disabled customers, you need to check with the local building and planning department to see what the requirements are to comply with ADA. In some cases, you may be grandfathered in, which means that as long as you don’t make any major changes to the restaurant, the existing conditions will be acceptable. However, it is best to update your business to accommodate disabled customers, as society is becoming more conscious about incorporating the disabled, and you want to minimize any exposure to possible litigation for non-compliance.
Other Areas to Inspect – If you have a NNN lease, it means you are usually responsible for taking care of the entire building, rather than just the foundation and side walls. It is likely that you are then possibly responsible for maintenance of the roof, parking lot, and other parts of the building.
Therefore, make sure you have the roof inspected by a roofing company, the parking lot inspected by a paving company, etc., so you know the condition of these areas, and won’t have any surprises after you close escrow. If work is needed, make sure the work is done before the close of escrow, or that you receive the proper credits from the seller towards the purchase price to cover this corrective work.
Restaurant Realty works closely with its clients throughout the due diligence process to assure that all of the above items are reviewed.
Review of Books and Records
a. Federal Tax Returns and Sales Tax Returns – The actual sale of a business is determined by a review of the Federal tax returns for prior years’ sales history, and a review of the sales tax returns for the current year’s sales history.
b. Unreported Sales – Frequently, in the restaurant, bar, or nightclub business, single-unit owner operators do not report all of their sales—which is a violation of the law. Typically the sellers do not receive credit for any sales not reported for tax purposes, as they have already been compensated by receiving increased profits (the result of not paying taxes on unreported sales). However, to truly determine the actual sales of the business, a good restaurant broker will recast the actual sales by tying in the cash register, or point-ofsales system sales tapes, with the guest checks and the invoices, to determine the true sales.
c. Income-and-Expense Statements and Balance Sheets – Specifically, a buyer needs to review the income-and-expense statements and balance sheets for the prior three years, and for the current year’s year-to-date income-and-expense statement and balance sheet.
d. Bank Statements – Additionally, the buyer will want to review bank statements for the prior twelve months, evaluating the cash sales and charge sales to help further support the actual reported sales.
e. Invoices – The buyer will also want to review invoices for various items including: 1) a detail of the premises rent. This is especially true if there are NNN expenses which will detail the monthly common-area maintenance costs such as taxes, insurance and maintenance costs, or 2) any tax bills the buyer may be responsible for, such as property taxes or unsecured personal property taxes.
f. Buyer’s Discretionary Cash Flow Statement – The broker will also prepare a buyer’s discretionary cash flow statement, which is the actual income-and-expense statement recast. This means adjusting the income and expense categories to truly reflect the actual cash benefits the owner is receiving.
Review of Special Licenses
If the business being purchased has a license allowing the owner to serve alcoholic beverages, you want to examine those licenses to see if there are any special conditions attached, such as restrictions on certain days and hours when you can’t serve alcoholic beverages. If you are buying a nightclub with an entertainment license, you need to review the conditions to see what days and hours you are allowed to provide entertainment, and what type of entertainment you can provide, such as dancing, live music, DJ, and karaoke. Specifically some licenses will allow live music, but only certain types, such as live music, but with no amplified instruments.
Review of the Premises Lease
Make sure if you are assuming an existing premises lease that all of the terms and conditions, and length of the lease are adequate. Make sure the lease is transferable, subject to the approval of the landlord, and that the existing rent and future rent schedules will work for your operation.
Other Agreements to Review
• Franchise Agreement – If you are purchasing a franchise business, make sure to review the terms of the franchise agreement in detail. Make certain that the length of the franchise agreement is long enough to satisfy your business requirements.
• Equipment Lease – If you are assuming an equipment lease, make sure you understand the terms of the equipment lease, and determine if the equipment will belong to you at the end of the lease, or if it reverts back to the equipment lessor. Most equipment leases at the end-of-the-lease period belong to the owner of the business for a nominal payment (like $1) at the end of the lease.
• Phone Book Yellow Page Contract – In some cases, you will be assuming the “Yellow Page” phone book annual contract, so review this contract.
• Equipment Rental Agreements – Some equipment is rented on a month-to-month basis. If you do not want to continue this agreement, you can usually give a 30-day notice to terminate this agreement.
• Seller’s Disclosure Statement – This agreement discloses all of the seller’s possible business problems, and is completed by the seller, and submitted to the buyer before he enters into the purchase contract. Review it carefully to make sure there are no pending lawsuits, no major future developments in the area which may hurt your business, or any other factors which will negatively impact your business.
• Attorneys Review of Documents – The buyer must have his attorney review the various legal documents used in the business. If the operator is not familiar with some legal points, there could be legal restrictions that are unacceptable to him, but need to be renegotiated before the operator purchases the business. It is prudent to have the lease reviewed by the operator’s attorney to assure that the current and future terms and conditions are acceptable, Section VII has additional information regarding the lease. The operator’s attorney should also review any other legal documents, if applicable, including the franchise agreement, the equipment lease, and all use permits—food permit, alcohol license, conditional-use permit and entertainment permit, etc. All of the above-mentioned documents have terms and conditions which legally bind the operator. Noncompliance with the terms and conditions could result in the operator losing his right to continue running the business, or force him to run the business in a compromising way, which could have a negative impact on the his sales and profits.
• Accountant Review of Financial Statements – It is important to have the operator’s accountant review all the business financial books and records. This assures that the seller had properly recorded all of the businesses income and expenses activities, and that the financial statements accurately reflect the true financial picture of the business.
• Review of all Web related contracts / accounts – It is important to review all web related contracts and accounts. Make sure you understand the domains and/or websites that will be transferred to you, social media sites (ie. facebook pages/twitter accounts), details on any discount coupons outstanding (ie. Groupons), details for managing directory site accounts (ie. Yelp, TripAdvisor, CitySearch, etc.), email addresses used for managing these sites, email marketing list, online reservation/delivery contracts, etc.. This information is especially relevant when you are assuming the restaurant name/menu.
Restaurant Realty works closely with their clients throughout the due diligence process to assure all of the above items are thoroughly reviewed.