Financial trends: A seller's marketFinancial trends: A seller's market

This year’s Restaurant Finance and Development Conference was another great opportunity for investors, companies needing capital and intermediaries to network. Based on my conversations, there is significant interest in investing in and lending to the industry. Investors largely fall into two camps: those looking for proven fast-casual chains with strong unit economics and significant green space for unit expansion, and those seeking to acquire franchisees of well-established national chains.

The former quest is spurred by several factors. Probably the most important is that the fundamentals of the fast-casual segment are very favorable. Fast casual is on trend, with the concepts providing high-quality products that are priced to provide strong value, served quickly and able to be eaten in either an attractive dining area or taken home. There is ample unit growth opportunity in most sectors of fast casual. Also, the recent successes of Noodles & Company’s and Potbelly Inc.’s initial public offerings have highlighted potential demand from investors in public equities, providing greater visibility to a liquidity event for a private equity investor.

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The high level of demand for fast-casual chains has resulted in a seller’s market for concepts with superior management teams, growth potential and financial characteristics, with some companies trading at multiples in the high teens and occasionally above 20 times cash flow. In some cases, a price was determined by discounting the value of a potential IPO.

Another consistent theme was a desire to buy franchisees of national chains; several investors expressed an interest in being a consolidator in various systems. Valuations paid for franchisees have generally been significantly lower than those for operating companies because of more limited growth potential. Nonetheless, strong demand for the most attractive situations has resulted in multiples toward the upper end of historical ranges.

The lofty multiple paid for many of these companies could create unreasonable expectations for an entrepreneur seeking to sell his business, be it an operating company or a franchise. My experience is that it is the rare owner of a business who can be objective when valuing his business relative to others.

Determining the value of a small, emerging brand is as much an art as it is a science, and paying a high multiple can still lead to an excellent return on investment. Part of the art in valuing an operating company is balancing four critical elements of a concept:

Outstanding unit-level returns are, in my opinion, the most important indicator of value and also the most objective metric. Different investors have different thresholds, but a 40-percent cash-on-cash return on investment would place the concept at an elite level.

Success in multiple geographies is another important characteristic. Investors want demonstrated appeal in several areas to lessen the risk that a restaurant’s success is not the result of unique factors in an individual market.

An on-trend, differentiable concept with open space to expand is another element critical to achieving an above-average valuation. A focus on quality, freshness and value is in keeping with current consumer trends. Differentiation can take several forms, from pricing to product, with the key being a consumer experience that separates a concept from others in its segment.

A strong management foundation should be in place that will enable the investor to build the infrastructure to achieve the concept’s expansion potential. The importance of this characteristic increases with the size of the chain. Most investors have a network of experienced executives who can fill voids in the organization and provide both strategic and practical support on the board. Judging the ability of the management team to execute growth and maintain the superior financial characteristics of the chain is very subjective, yet it is the ultimate determinant of the future worth of the company. This is the art of valuing a company at the early stages of development.

The above elements are the foundation for growth and must be present to create value for the investor.  The initial investor’s return objectives will only be realized if the company is able to become a larger and more profitable enterprise.

The attractiveness of a franchisee is largely determined by the sales trends of the franchisor and the ability of the acquirer to add restaurants. That growth can be either the result of expansion potential within the franchisee’s territory or the ability to acquire other franchisees within the system. The investor must see a path to a return on investment by growing cash flow to support a future sale at a higher valuation or a recapitalization of the business since a public offering of a franchisee is less likely than for an operating company.

Although it is currently a seller’s market, company owners must stay disciplined and focus on the elements mentioned above to maximize value. Franchisees have less control over their concept, but they need to remain realistic as to the attractiveness of their franchise system and the growth opportunity for the investor. For those that are able to keep perspective, this is a very good time to sell their businesses.

Steve Rockwell has 30 years of experience in the restaurant industry, including as an analyst and finance executive. He is a partner in the Results Thru Strategy consulting firm and can be reached at [email protected].