How to Buy Or
Start A Business

And Avoid Financial Ruin - A Case Study



By Josh Foo,
Founder

UPDATED:  August 02, 2019

Today, I walked past a spanking, brand new Chinese Restaurant in the heart of Sydney city.   The proud owner had obviously wanted a 'first-class' 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 seemingly wanted to start the business with the best equipment.    I could tell that the kitchen was an expensive set-up.  A new smoke exhaust, posh equipment, commercial-style stove and the lot.  A commercial fridge or stove can cost $5-10K easy.  A glass display cabinet can cost $10K.  Anything commercial costs a fortune.

A much smaller, modest takeaway restaurant in Hurstville costs $350,000 to fit out.  This restaurant probably costs somewhere between $500,000 to $800,000 to fit out.  This premise 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 it cost a million dollars to start this business.

The food is presumably good enough (I didn’t try) because I could see some 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 has a modest flow of customers.   Well, you’d expect that because of its location.  

Chinese Restaurant MenuA new Chinese restaurant has sprung up in the heart of Sydney city. Photo: Pixabay.com

How Do The Numbers Stack Up?


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

Before you buy or start a business, you must know the numbers that matters and how they stack up.  If you don’t, you face the possibility of financial ruin before you even begun. 

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 previous tenant had apparently left the premise and decided not to continue.  The shop was left vacant for weeks.  The previous tenant was a bakery and they had a consistent flow of customers. 

However, the previous tenant did not, or could not sell the business, but chose to vacate the premise instead.  This highly suggests that the business was not sufficiently profitable because the rent expense was too high. 

The bakery was a poor business decision.  Each item in the bakery were of too low value and spending per customer were not high enough to keep up with the rent.  They need a huge amount of traffic to make this work and unfortunately there just wasn't enough customers for the bakery. 

Generally speaking, rent should be no more than 20% of turnover for a successful restaurant.  Most successful restaurants prefer to pay rent at around 10-15% of turnover.  I look to the ATO benchmark for more precise analysis. 

Under this formula, if rent is $6,000 per week, then annual turnover would need to be somewhere around $1.5 million.  This equates to $30,000 per week turnover. 

While you can use high tech AI analytical tools to work out the foot traffic, the other option is to simply watch the traffic.  From the traffic, you can estimate the number of customers per day and the estimate spend per customer base on your menu offering.  Then plug this number into your Profit & Loss template and see if you could make a decent profit.  (This is the bare minimum.  You should also analyse the demographics and cultural congruence to the type of cuisine you offer and the competition).

However, most restaurant owners rarely get this down padded.  Typically, they make illogical decisions such as choosing a restaurant site because it is 'convenient' or 'close to home'.   Or signing a lease with very high rental expense because it is 'the market rate' - without consideration to their proposed business concept and whether their concept can sustain the rental expense.

Many restaurants have sales of less than $20,000 per week so a site with high rental expense often makes the business untenable. 

How Do The Numbers Stack Up?Make sure the numbers stake up. Photo: Pixabay.com


Back to this restaurant. Next up is the menu. 

The menu items were on average $15-20 per item.   The menu consists of individual noodle dishes or set meals. It would be incredibly difficult for a customer to spend more than $25 per person.    

If a person spends on average $25 at the restaurant, the restaurant would need to serve around 165 customers a day to meet an expected $1.5 million turnover per year (assuming 7 days trading with 2 days off per year)

I estimate the sitting area of the restaurant to be approximately 60 square metres with capacity of around 50 people.  If seating is constricted to 50, then they can't possibly scale the business up.  But in my observation, the restaurant is rarely full anyway.    

Looking at the menu, they had prices crossed out and new prices hand-written in.  To the experienced eye, I can tell that the owner hadn’t really thought this through properly.  The owner probably worked out that his prices can't really meet his expenses and the only option is to "up" the prices.   The rent expense is probably the chief antagonist but it is now too late.  The lease agreement has been signed and the owners have sealed their fate.

To start or buy a business, you need to know your number and understand how they add up.   Regrettably, most business owners go about this without much forethought.  Just because they think that they can cook up a good meal doesn't mean that the business will be successful.   All things being equal, the type of items being offered in the menu and the prices charged are still absolutely critical to success.  


Restaurant MenuYour restaurant menu can make or break you. Photo: Pixabay.com

You Must Know This


To serve 160 customers a day consistently for 7 days a week is challenging, least of all given the small sitting area of the restaurant.   Even if they had that many customers, the kitchen may experience logistical issues given the space (or there lack of)  

The more customers you have, the more employees you will need.  However, customer traffic can fluctuate badly but employees do not.  Wages are a fixed-cost, so if you cannot maintain some level of consistent customer traffic, your wage cost will become a problem.

To solve this problem, you will need to re-design the menu so that customers have the option to spend more per person and you can meet the same turnover target with less customers.

In the CBD city where the foot traffic is high, there will be always a broad spectrum of customer types.  Most will not splash out on a lavish meal, but a small minority would - only if you offer it to them.  But if your menu is limited to low-mid value items, then you are really not doing yourself any favour.

Menus must have 'high value items' that reach out to the small group of customers that will splurge.  All good restaurants does it, even McDonalds.   McDonalds have the classic burgers but also the more expensive gourmet range.  McDonalds also offers McCafe to sell high-value beverages.

A Chinese restaurant should have high value menu items that can command $150-200 per item, such as premium seafood dishes.   And also wine that they can sell for $15-100 per glass.

I once met a Malaysian restaurant owner who bought his red wine at Liquorland for $10 a bottle and sold it at $40 per glass and $120 a bottle.  Feeling guilty at the exorbitant profit margin, he dropped his wine prices and demand tapered off sharply.  He said that Asian tourists wanted to pay more for Australian wine because of the perception in quality.  When he dropped his alcohol prices, the tourist-customers weren't interested.  This is the ideal reverse demand curve - the higher prices you charge, the greater the demand.  (Side story:  There is always a queue at the LV store on George Street no matter the time of day.  Year on year, LV has raised their prices but this has seemed to fuel  demand even further.  Point made)

The lesson here is the 20/80 rule.  20% of your customers will generate 80% of your sales.   Without high value items, the 20% that would like to spend more at your restaurant can't, because you haven't offered it to them.  

Without high value items, the restaurant will require a much bigger customer traffic flow to meet the same turnover target.  This to me is the more difficult route.  

The type of cuisine must also match the demographics of the location.  Put simply, you must appeal to their taste-buds.   If you get this wrong at the start, then it is an up-hill battle to make the business work.  

Financial RuinDon't walk down the path to financial ruin before you even started. Photo: Pixabay.com

Avoid Financial Ruin


The future is unknown.  So most aspiring restaurant owners hope for the best and 'dream' of roaring success.  But experience tells me otherwise.  Most problems in businesses are created typically before they buy orstart the business. 

Some business owners talk to me about exiting their "problem" in the business by finding a 'greater fool' to takeover.   This is not a reliable exit strategy.  Some of these problems can be alleviated.  But some can't, especially those deeply rooted and those that are "fundamentally & structurally" flawed.  

Some mistakes made at the beginning are irreversible, such as poor site selection or a bad lease agreement.  For this reason, it is priceless to have an independent business broker  "in the trenches" tell you honestly and exactly how he/she sees it.

If you already have an accountant and a solicitor to give you advice, having an independent business broker on your team lets you see the business from another angle to create a complete picture.  

It is important you find an independent business broker that will act in your interest - such as a broker from another agency that is not involved in the sale.    Or a business broker that is paid by you to give you expert advice and to help you find the right business.    It may cost you a little but it is a worthy investment that can reap huge returns and save yourself a lot of pain in the future.

The truth is, most business brokers are paid by the seller (owner of the business) when the business is sold.  Therefore you cannot rely on the business broker handling the sale to give you impartial advice.   They are paid a commission to sell the business to you so there is already an existing conflict of interest.   They are unlikely to give you independent advice if it means sinking the sale, nor should you rely on their advice completely without doing your own homework. 

The role of the business broker that is paid a commission upon the sale is to mediate between the parties.  They are sales people.   As a buyer, you cannot delegate the responsibility of due diligence to sales people or to anyone for that matter. 

For any business, there is a recipe for success.  Seek advice from proper advisors and do your homework to avoid financial ruin **


Josh Foo contributed to this article

** The content is general information only.  The author, founder and contributors do not assume any liabilities or make any representations or warranties with regards to its accuracy.  You should not rely on this information in anyway.  


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