RESTAURANT DUE DILIGENCE

Contact Neufeld Legal PC for corporate transactional and legal matters at 403-400-4092 / 905-616-8864 or Chris@NeufeldLegal.com

Due diligence is a critical process for any business acquisition, and it's especially important when buying a restaurant. The goal is to verify the information provided by the seller, assess the business's true value, uncover any potential liabilities, and ensure a smooth transition. Rushing this process can lead to significant financial and legal problems that can very quickly arise after the acquisition and can prove exceedingly costly to deal with after-the-fact. As such, the value of comprehensive due diligence, with knowledgeable and experienced professonals cannot be understated when pursuing a restaurant business acquisition.

A. Financial Due Diligence

The financial strength of a restaurant business is of paramount importance, in addition to discerning any financial weaknesses. The goal is to confirm profitability, understand trends, and identify any hidden costs or liabilities.

• Review of Financial Statements: Request and meticulously examine the last three to five years of financial records, including:

  • Income Statements (Profit & Loss): Analyze revenue, cost of goods sold (food and beverage), and operating expenses (labor, rent, utilities, marketing). Look for consistent trends, and be wary of any sudden changes or red flags.

  • Balance Sheets: Review assets (cash, equipment, inventory) and liabilities (debt, outstanding loans, accounts payable).

  • Cash Flow Statements: Understand how cash is generated and used within the business.

• Tax Returns: Compare the financial statements to the last few years of business tax returns to ensure consistency and accuracy. Be cautious of any claims the seller makes about "off-the-books" income, as this is often difficult to verify and could expose you to tax liabilities.

• Revenue and Expense Analysis:

  • Sales Verification: Validate sales numbers using POS (Point of Sale) reports, credit card statements, and sales tax filings.

  • Prime Cost Analysis: Analyze the restaurant's prime cost (cost of goods sold + labor costs) and compare it to industry benchmarks. A high prime cost could indicate inefficiency.

  • Expense Breakdown: Scrutinize all operating expenses, paying close attention to labor costs, rent, utilities, and marketing spend.

• Debt and Liabilities: Identify all outstanding debts, loans, and contingent liabilities (e.g., pending lawsuits, unpaid taxes, or vendor bills). Be sure to get a list of all creditors and review any loan or financing agreements.

B. Legal Due Diligence

Understanding the legal standing of the business, contracts, and compliance, together with known and potential liabilities, is critical to limiting one's further exposure to potential significant costs.

• Licenses and Permits: Verify that all necessary licenses and permits are current and transferable. This is especially crucial for:

  • Liquor License: This can be a long and complicated process, so confirm the transferability and status of the license early on.

  • Health and Food Service Permits: Check the history of health department inspections and any past violations.

  • Business License, Fire Permit, and Signage Permits.

• Contracts and Agreements: Review all existing contracts and agreements to understand your obligations and potential risks. This includes:

  • Lease Agreement: This is one of the most important documents. Scrutinize the terms, including lease duration, renewal options, rent increases, and any clauses regarding maintenance or required improvements. Make sure the landlord is willing to transfer the lease to you.

  • Supplier and Vendor Contracts: Understand the terms, pricing, and any exclusivity clauses.

  • Franchise Agreements: If it's a franchise, review the franchise agreement carefully to understand your obligations and the franchisor's requirements.

• Legal Standing:

  • Business Structure: Review the legal entity and its articles of incorporation or other governing documents.

  • Intellectual Property: Confirm ownership of all intellectual property, including trademarks, trade names, and recipes.

  • Litigation and Disputes: Check for any past, pending, or threatened lawsuits, claims, or legal disputes.

C. Operational Due Diligence

Operational due diligence focuses on understanding the day-to-day workings of the restaurant to assess its efficiency and potential.

• Equipment and Assets:

  • Physical Inspection: Conduct a thorough inspection of all kitchen equipment, furniture, fixtures, and other assets. Check for their condition and age. Consider having an experienced technician inspect major items like the HVAC, refrigeration units, and grease trap.

  • Ownership: Verify that all equipment is owned by the seller and not leased.

  • Inventory: Perform an inventory count of all food, beverage, and supplies to confirm the value.

• Staff and Human Resources:

  • Employee Information: Review employee contracts, wage information, and benefits. Check for any outstanding payroll liabilities or unpaid overtime.

  • Staffing Levels: Assess the current staffing levels and their impact on labor costs.

  • Key Personnel: Find out if the key employees (e.g., head chef, manager) are willing to stay on after the acquisition.

• Suppliers and Supply Chain:

  • Review supplier relationships and contracts. Ensure a reliable supply chain is in place and that the cost of goods is in line with industry standards.

• Marketing and Customer Base:

  • Brand Reputation: Analyze the restaurant's brand, online reviews, social media presence, and customer feedback.

  • Customer Demographics: Understand the target customer base and whether it aligns with your vision.

  • Marketing Efforts: Review the marketing budget and effectiveness of past campaigns.

D. Commercial Due Diligence

The forward-looking aspect as to the restaurant's prospects is covered by commercial due diligence, which involves evaluating the restaurant's market position and future prospects.

• Location and Market:

  • Location Analysis: Assess the location's strengths and weaknesses, including foot traffic, visibility, and competition.

  • Market Trends: Research local dining trends, demographics, and any planned construction or development in the area that could affect the business.

• Reason for Selling: Understand the seller's motivation for selling the business. Is it retirement, burnout, or financial problems? A legitimate reason for selling is a good sign, but be wary of vague or misleading answers.

• Non-Compete Clause: Ensure the seller is willing to sign a non-compete agreement to prevent them from opening a competing restaurant nearby.

The results of such restaurant due diligence must be scrutinized in determining whether the restaurant acquisition will advance and, if so, on what particular terms, which in turn builds on one's overall assessment as to the pros and cons of acquiring an existing restaurant business, together with the pros and cons of buying into a franchised restaurant system.

When it comes to the legalities of restaurant business mergers & acquisitions, that is when the law firm of Neufeld Legal P.C. comes into play. Such that when your company is seeking knowledgeable and experienced legal representation in orchestrating and completing business mergers, acquisitions and divestitures, contact us at 403-400-4092 [Alberta], 905-616-8864 [Ontario] or Chris@NeufeldLegal.com.