The Legal Aspects of Purchasing or Selling a Restaurant

The Legal Aspects of Purchasing or Selling a Restaurant are Critical to the Success of the Transaction.

The mistake that many people make when either purchasing or selling a restaurant is to limit the steps to simply signing a letter of intent (LOI) followed by a sales contract followed by a closing. While those are important aspects of such a transaction, they should not be all that is done. It is important that both the seller and purchaser delve into the details of exactly what is and is not being sold and how ownership is being transferred. That can mean the difference between success and failure for the transaction.

The following is a list of six frequently asked questions (FAQ) along those lines. They should generally be considered at the earliest stage of the contemplated transaction.

FAQs — Frequently Asked Questions About the Purchase or Sale of a Restaurant

FAQ #1 – What does “due diligence” mean in terms of a restaurant sale, and how does one go about performing it?

The first thing to keep in mind at the outset is that the law is unforgiving when it comes to ambiguities about such details as the legal ownership of the entity being sold. Therefore, the purchaser should always start by performing “due diligence.” It is not possible to list all the items that need to be reviewed in this process, since they often can change based upon the particulars of the transaction. Nevertheless, the following four are a good starting point in most cases:

• There are search portals on the internet in certain states that can be utilized to obtain a limited liability company’s certificate of formation or a corporation’s certificate of incorporation. The key is to obtain a certificate of good standing, which is important for a number of reasons, one of which is that it generally cannot be obtained if the government has determined that taxes have been due and owing for a significant period of time (which varies state by state). Notably, if the restaurant is owned by a partnership, the partnership agreement may not be part of any governmental file, but instead would need to be requested from the seller’s attorney.
• Judgment Searches are necessary to determine whether any litigation was instituted involving the restaurant that reached a disposition and what that disposition was.
• Uniform Commercial Code (UCC) searches are critical because they will disclose the identity of creditors who may be secured in the very assets that the restaurant is selling.
• A public records request is also a good idea to ferret out any government records, especially on the local level, that relate to violations of state law or local ordinances by the restaurant or the landlord that rents the property on which the restaurant is situated.

FAQ #2 – What is the best way to set a price for the restaurant?

Once again, there is no one right answer, but there are definitely certain principles that apply uniformly. One of them is to admit that neither the buyer nor the seller “know what they don’t know.” In other words, most people who run restaurants do not purport to be trained valuation experts.

Accordingly, often the better way of setting a fair price is to hire a certified valuation appraiser to prepare a report. This person usually will have both a financial background and be familiar with the industry itself. They generally will (a) evaluate the competition, i.e. the other restaurants in the area, (b) determine whether there are any financial or other problems that are creating a cash flow crunch for the business, (c) review the status of any loans that either are existing and will need to be paid off or will need to be taken out to fund the transaction, and (d) in general, ask all sorts of rather detailed questions. Nevertheless, utilizing a valuation expert is essential to determining whether a price that appears to be fair actually is.

FAQ #3 – How does one handle the contracts that were entered into by the current owner of the restaurant and will need to be enforceable by the new owner?

This is really a two-part issue: first, are there contracts for all the critical aspects of running the restaurant, and second, are they assignable? It is amazing how many restaurants operate on a handshake when it comes to obtaining delivery of food, employing key personnel, and even renting the space on which the restaurant is situated. It is critical for the buyer to not only review the contracts that have been signed, but also determine the contracts that should have been signed and were not.

The question often becomes whether it is viable to enter into a new contractual undertaking before the restaurant is sold or whether the new buyer will need to take ownership of the restaurant as is. Additionally, as to any contracts that are already in existence, the buyer must determine whether they are assignable. Essentially, this means that the buyer must know whether they can be given the rights under those contracts by simply signing a document transferring them from the current owner to the new one. If not, the party to the contract other than the restaurant owner may need to be brought into the discussion and possibly sign an addendum to the original contract or even a new contract entirely.

FAQ #4 – How can the buyer be sure the key employees will continue to work in the restaurant after it is sold?

The short answer is that it is extremely difficult to hold employees to the requirement that they not leave the business once it is sold (or even beforehand). In the normal course, the parties will often use a carrot rather than a stick: in other words, provide a financial incentive in the form of a bonus or other benefit that gives the employee a reason to stay for a certain period of time. There is a variation that does not involve providing extra compensation: when the key employees are given an ownership interest in the new entity. This may be an exceedingly small share, but under the heading of “better something rather than nothing,” it also may be the first time the employee will ever have been in a position of ownership.

If that is not possible, at the very least the parties should explore the possibility of having the employee sign a restrictive covenant (noncompete). However, that is not a panacea since the clear movement of the law regarding the applicable federal and/or state statutes and regulations is to either marginalize their enforceability or, in many cases, render them null and void entirely. The key point is that the evolving law on this issue must be thoroughly researched if the enforceability of a restrictive covenant is a key consideration for the sale.

FAQ #5 – What role does financing play in the sale of a restaurant?

Whether the financing concerns an existing loan that will need to be satisfied in order to allow the sale to proceed or new debt that will be undertaken by the buyer so that the purchase price can be provided to the seller, it is absolutely essential to nail down whether the possibility of obtaining financing is in the cards. The difficulty of obtaining financing for a business sale is compounded by the complication that restaurants generally operate on a very narrow financial margin, i.e., they are not as profitable as many other businesses. This makes sense, insofar as there is a tremendous infrastructure that is the financial lifeblood of the business: one that can purchase, store, cook, present, and serve the food.  Compared that to a personal services business in which someone might simply be performing a service within their professional level of expertise without any major infrastructure—such as a business consultant of some sort. The net value of two such hypothetical businesses with the same gross revenue may be widely divergent;  obtaining financing for a restaurant with a much higher overhead might be a far greater challenge.

Accordingly, there is an important basic distinction that the parties to a restaurant sale need to discuss at the outset: whether the buyer’s financing will be obtained through a third-party lender, such as a bank or whether the seller will finance the transaction itself. The latter will normally necessitate an agreement on three basic aspects: setting a price, having the buyer pay it over many months with interest, and providing the seller with a collateral security interest in the assets of the restaurant (so that if the debt is not paid those assets can be seized).

FAQ #6 – How do the parties address the need for the buyer to obtain licenses, permits and other governmental authorizations to run the restaurant?

Given the fact that states and localities differ in their requirements for operating a restaurant, there is no one answer. But one rule of thumb is that the task of obtaining local permits and inspections should be first on the list. Given the fact that restaurants serve food, local health inspectors will almost always be involved in certifying that the restaurant can operate safely. Local zoning officials will also generally need to provide their authorization for the intensity of the parking and placement of signage and such. Assessing whether these sorts of approvals are needed in a given instance can take a great deal of time, and obviously hold up the transaction if not commenced early enough.

In addition, there may be federal and state authorizations that are necessary to run the restaurant. These may range from the payment of taxes related to employment, business registrations and even trademarks and copyrights that will need to be changed when the new owner takes over. Once again, a discussion of these issues should usually not be left to the end of the transaction, but instead be dealt with at the outset. After all, government approvals and compliance issues may be the aspect of the transaction that is least in the parties’ control.

The Nissenbaum Law welcomes inquiries from persons who are planning on buying or selling a restaurant.

The Nissenbaum Law Group welcomes inquiries from both buyers and sellers of restaurants regarding potential representation. We suggest our firm be contacted, if possible, before the contract of sale—or even memorandum of understanding, letter of intent, or term sheet—is finalized. Please click the following links to learn more about Purchasing or Selling a Business or explore our Business Succession Planning practice page.