Restaurant Lawyer: Top 5 “Red Flags” to Watch Out For When Buying a Restaurant Business

restaurant lawyer, restaurant attorney, small business lawyer, small business attorney, startup lawyerEver dream of owning your own restaurant?

You’re not alone. Many people do.

But before you run out and sign on the dotted line, slow down and take your time to make sure this is the right investment for you.

Restaurants are difficult and complicated investments, and they are notorious for having legal problems that crop up weeks or months after the sale closes.  Any investment in a restaurant should be done only after thorough due diligence.

There are dozens of potential hazards, but also a handful of more common “red flags” which any buyer should look out for as they’re investigating a potential restaurant purchase.

I worked in a restaurant during high school and college, and it was a great experience. It taught me to work hard and deliver customer service with a smile.

However, I also know that restaurants are typically staffed by people from all walks of life with varying degrees of sophistication and education. As a result, there’s no guarantee that all sales will be accounted for and all codes and regulations will be obeyed.

In other words, make sure you know what you’re getting before you commit to buying a restaurant.

Here are the most significant red flags you should look for as you investigate your purchase.

1) Existing Liabilities Such As Unpaid Overtime or Health Code Violations.

There are a million different ways restaurants could have incurred liability. Restaurants often employ undocumented workers or illegal immigrants who work “under the table.”  There could be health code violations, or labor code violations such as not paying overtime, or years later a female server could file a sexual harassment lawsuit because of the way she was treated. The list goes on and on.

Each of these problems could result in problems for the new buyer – even after the restaurant’s owners have sold the business and taken off.

A buyer can protect him or herself from these existing liabilities by purchasing the restaurant’s assets, but not its liabilities.  By purchasing just the assets (such as the location, equipment, name, inventory, etc.) rather than buying the entire business, the buyer avoids taking on potential liabilities which could crop up years later.

The easiest way of accomplishing this is by forming a new Limited Liability Company (LLC) and purchasing the assets of the restaurant. The employees are terminated at the end of the last day from the old business entity and are all hired by the new LLC.

The restaurant continues to operate and from a customer’s perspective, nothing appears any different.  A new LLC works well because it is a very flexible and easy business entity to maintain with few of the formalities of a corporation.

2) Existing Lease Agreement

Another source of potential problems is the existing lease. In order to purchase the business, the buyer must be assigned the existing lease.

Most commercial leases contain a provision requiring the landlord’s approval of an assignment whenever a new owner or co-owner comes in to acquire the existing restaurant.

As a requirement of approving the assignment, many commercial property owners will ask for adequate proof of financial ability to pay the rent. The owner may also require the old owner to sign a guarantee for the duration of the lease.

I have also seen commercial leases which contain a provision where a landlord may under certain circumstances (such as if there are only a few years remaining on the lease) “take back” the leased space if a tenant attempts to assign their lease. Needless to say, this can be a huge barrier to any restaurant owner attempting to sell their business, not to mention to the buyer.

To avoid this problem, buyers should contact the property owner as soon as possible to find out what information the owner will require to approve the assignment.

There is always a risk that the owner will turn down the assignment, however, if you provide adequate assurance that you will run the restaurant in a responsible manner and have financial ability to pay the rent, you have a good chance of getting approved.

3) Transfer of Liquor License

In addition to getting a lease assignment, new owners must also be approved by the California Department of Alcoholic Beverage Control (“ABC”) for a transfer of the liquor license.

Transfers of liquor licenses are not easy and can take a significant amount of time to be finalized. The ABC takes transfers of liquor licenses very seriously, and they look at the transfer closely to ensure – and this is no joke – that there is no organized crime connection, as liquor licenses have historically been used to fund mafia activities.

The average waiting period for a license transfer is 55-65 days and by law the transfer
cannot occur for at least 30 days. It is possible to receive a temporary permit that will allow the buyer to operate the restaurant pending the final approval of the transfer.

4) Nonpayment of Sales Tax

Restaurants are notorious for having a lot of unreported income. Many restaurants do not report, or severely under report, cash receipt revenues to the state, so that they have to pay less in sales tax.

The problem is this opens the owners of the restaurant up to a possible audit.  If the California Board of Equalization were to audit the restaurant, and they find that too little sales tax was paid, then it could order the restaurant to pay thousands of dollars in unpaid sales tax.

In order to be sure that you do not face this problem years after you have bought your restaurant and the previous owners are long gone, you should hire a competent small business accountant to review the restaurant’s books.

Only if you get professional advice can you receive some assurance that you are not going to buy into a major sales tax liability.

5) Make Sure Restaurant Equipment Is In Good Shape

Finally, you should look closely at the restaurant’s equipment to ensure it is owned by the seller and in good shape. Restaurant equipment can be extremely expensive to replace if it is nearly the end of its life cycle. If the restaurant contains a kitchen full of equipment that is nearly worn out, that will make a major difference in the value of the business.

Check with the California Secretary of State to see if the equipment is truly owned by the business, or if there is a creditor that has a lien on leased equipment. If the equipment is leased, then the new buyer will have to get an assignment of that lease as well.

Conclusion

The bottom line is that buying a restaurant business is far more complicated than buying a house or a car. Any restaurant has potential liability, and as a buyer you should do your best to investigate these possible liabilities thoroughly.  After you have done your due diligence then I wish you a lot of luck!

 

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Photo credit: Flickr/Unique Hotels Group

 

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