How to Buy Or Start A Business

How To Buy Or Start A Business To Avoid Financial Ruin – A Case Study

By Josh Foo

04 Feb 2018 

Today, I walked past a spanking, brand new Chinese Restaurant in the heart of Sydney city.   Some proud owner wanted to start a business and spared no expenses in making this restaurant its pride and joy.

On the outside, the restaurant looked beautiful and artistic.   Limestone walls, beautiful artisan shop fittings, mock-antique tables, chairs and theme equipment that was probably imported from China (and I know it isn’t cheap).

The owner had obviously wanted to start a business with the best equipment.    I could see that the kitchen had an expensive set-up.  A new smoke exhaust, posh equipment, commercial-style stove and the lot.  A commercial fridge or stove can cost $5,000 easy.  A glass display cabinet can cost $10,000.  Everything commercial costs a small fortune.

A much smaller, modest takeaway restaurant in Hurstville cost $350,000 to fit out completely.  This restaurant I estimate costs somewhere between $500,000 to $800,000 to fit out.  This restaurant used to be a bakery and was completely de-fitted and refurbished again.  There was nothing left from the bakery that the new owner could use.  I wouldn’t be surprised if it costs the new owner a million buckto start this business.

Perhaps the only saving grace is the dim ambience which meant that the owner could probably save a little on electricity.

The food is presumably delicious (I didn’t try), and I could see that there were customers.  There was no long queue like some of the other more other iconic eateries in Sydney such as Hurricanes or Mamak in Chinatown.    To its credit, the restaurant had a modest flow of customers.   Well, you’d expect that because of itsprime location.

How Do The Numbers Stack Up?

I made the bold prediction to a friend that this business wouldn’t last 18 months.  I give it 2 years tops.

When you buy or start a business, you must know your numbers and how they stack up.  If you don’t, you face financial ruin even before you start a business.

This restaurant is located on the main street in the CBD with huge foot traffic.  I know that the rent in that area goes for $4,000 to $6,000 per week (perhaps even more).  That’s a whopping $208,000 to $312,000 per year. 

I also know the bakery (the previous tenant) that occupied the premise prior appeared to have a decent turnover and had apparently decided not to sign on a new lease.  The shop premise was left vacant for weeks.  The bakery offered tasty gourmet bread and there were always customers.

However, the owner of the bakery had not sold the business and chose to vacatethe premise instead.  This led me to conclude that in all probability that the business was not hugely profitable because the high rent simply prohibited the business from making any good money.

The bakery was another obvious miscalculation.  The owner probably wanted to start a business to sell tasty gourmet bread to passing foot traffic, but the bread items were too low value and the number of sales per day needed was simply too high to make the entire business work.

Now with experience, I know that the rent should be no more than 20% of turnover for a successful restaurant.   20% is pushing it.  Most successfulrestaurants prefer to pay rent at around 10-15% of turnover.  

Under this formula, if rent is $4K to $6K per week, then turnover would need to be $1.04m to $1.56m per year.  This equates to an ideal $20,000 to $30,000 per week turnover.   

Sadly, most restaurant owners that want to start a business haven’t even got this figured out.

Most Chinese restaurants do far less than $20,000 turnover per week so in terms of risk, the stakes just got higher.

Next I turned my attention to the menu.

The menu items were on average $15-18 per item.   The menu consists of largely noodles dishes and set meals for individuals.  Most individuals wouldn’t order 2 serves of noodles or rice for themselves, hence it is incredibly difficult to push per person spend to beyond $25 per person.

If a person spends on average $20 at the restaurant, the restaurant would need to serve 143 – 215 customers a day.

I estimate the sitting area of the restaurant at approx 60-80 square metres with capacity of around 40 people.  To achieve 143 to 215 customers a day for 10 hours of trading over 7 days, the restaurant would virtually need to be almost full most of the time.  This is extremely difficult.

The brand new menu had prices crossed out and replaced with new pricing.  As an experienced broker, I can tell that the owner hadn’t really thought this through.  Perhaps the owner realised that the cost of ingredients were higher than first thought, or they needed to charge more to cover the rent – but it is now too late, the lease has been signed and the owner was already in deep water.

To start a business (or even to buy a business), you need to understand the numbers and actually know if they add up.  But most business owners go about this without much forethought.  They know that their food tastes good and presumed that this alone will guarantee success – this could well turned out to be a very costly assumption indeed.

For the restaurant, the menu is really the lynch pin to their success.  And unfortunately for them, their menu is one step in the wrong direction to some financial pain.

To Start A Business, The Owner Should Have Known This.

To serve 143 to 215 customers in a day consistently for 7 days in a week was difficult given the small sitting area of the restaurant.     Even if they could have that many customers, the owners may experience logistical issues in the kitchen and on the restaurant floor which could lead to customer dissatisfaction and decline in food quality.

Wages will also rise when more customers come through the door as more employees are needed to keep up.  And we know, wages and rent are the two primary costs for any small businesses.

I’d suggest a more realistic and comfortable sitting of 100 to 150 customers a day, with the same turnover target.    This will require a major revamp of the menu.

In the CBD city where the foot traffic is high, there will be always tourists and customers willing to spend.  Perhaps 1 in 10 will splash on a lavish meal.  However, if your menu is limited, then you are really doing yourself a disfavour.

The menu must have what I call ‘high value items’, exotic dishes that can command a big margin.  The chilli crabs at $300 per dish.  Or the scallops at $200 per kg.    Or the $40 glass of wine that cost only costs $9 a bottle.

Well, there is an interesting story to the wine actually.  I met another Chinese restaurant owner that served up an exorbitant wine menu.  He would charge$40 for a glass of wine and $120 a bottle, or so he says.  But he ‘fessed up and said that that he bought these wine cheap from the local bottle shop (like those $10-20 per bottle variety).

He told me that one time he tried to lower the price of the wine in his restaurant and sales dropped pretty much straight away.  The tourists that were his customers did not want to pay for cheap wine.   For the tourists, high prices for Australian wine equates to high quality. 

I digressed.

The takeaway (pun intended) is that, a menu that has high value items will allow a small group of your customers to spend big and drive a significant portion of your profits.

Without a substantial change to the menu, the restaurant will require a much biggercustomer foot-print to make it profitable.  This to me is the more difficult route.   In additional to the menu change, the owner will also need to apply for an alcohol licence and leverage off online ordering sites such as Menulog and UberEats.

Is the new menu infallible?  No.  Some cuisine simply cannot gravitate toward high value items.  Mcdonalds and KFC for example cannot realistically expect to sell a burger for $100.  To their credit, Mcdonald’s has successfully introduced a higher margin McCafe menu in the early 1990s, and then more recently the Gourmet Creations range.

If twigging the menu doesn’t work, then the owner may have to accept that the business concept was wrong for the location and space.

Don’t Start A Business To Financial Ruins

The future is unknown.  Perhaps the restaurant owners knew what they were doing when they decided to start a business.   Maybe the place will be a roaring success in 6 months.  Maybe the owner will find ways to make it work.

But experience tells me otherwise.  Most mistakes are made when the owner buys or start a business.  When the owners talk to me about selling their business 2-3 years later, they are just hoping I can ‘fix’ up their business mistakes by finding a greater fool to buy the business.

I may be a darn good business broker but I am not a miracle worker.  Any business broker that promises a miracle is selling something else.

Many of the business mistakes made at the start of a business are largely irreversible and difficult to rectify.  For example, signing the lease with exorbitant rent, the wrong business concept for the locality, partner disputes that are beyond reconciliation, draconian franchise agreements etc.

If the owner had spent 10 minutes with me, s/he could have saved a lot of financial heartaches.

The accountant, the finance broker, the solicitor, the lease agent and other advisers can give professional advice in their own specialisation.  This is like knowing one piece of the puzzle inside out, but perhaps only a business broker can put together all the pieces to give you a complete picture.

This is because a business broker would have seen hundreds, if not thousands of businesses.

However, when you buy or start a business, don’t expect your business broker to do the due diligence for you.   Business broker are paid by the business owners to sell their businesses and their role is to mediate between the parties, not to advise on due diligence.

It would also be a conflict of interest for the involved business broker to give due diligence advice that may persuade the Buyer in their decision to purchase (or not to purchase).   Perhaps the best method is to hire another business broker who is an outsider to the sale to review the business independently, as you would with an accountant to look through the financials.

In business, there is always an element of luck.  The trick is to do your homework that puts you on the main road to success and let luck take on the outstanding 20%.

Note:  Josh is unable to provide due diligence advice for prospective buyers of businesses managed by his agency.  For consultation on new start ups or an independent review of other businesses, please contact Josh directly.

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