Start a Coffee Shop or Buy an Existing Shop?

So you want to get into the coffee shop business? Maybe the thought of a coffee shop start up is not amusing you. Sure you know you are going to work hard whether it is in starting a coffee shop or working in and/or managing one that you are going to buy. But which one do you choose to do?

Maybe you don’t want all of the heartache and stress that comes with starting a business. Maybe you just want the heartache and stress that comes with buying a business! Whatever your decision is be sure that you are well informed. Hopefully I can give you some direction as to what to look for and what to expect.

Many people have asked me if buying an existing shop is a good idea. I have actually looked at many shops for sale but the biggest issue I always see is that most owners think their shop is worth two or three times more than it actually is. The reason for this phenomenon is that we become emotionally attached to our stores. That is not a bad thing, as it normally keeps us in check.

However, most owners put the store up for sale and even end up selling when they NEED to and their back is up against the wall. The need to sell is for various reasons like divorce, default on notes, lack of enthusiasm, poor sales, there are as many reasons to sell as there are shops for sale. They often have to sell before the business has reached maturity and they try to get what they have invested in it, which is usually more than it is worth. The objective is to sell when they have an offer, as most often the offer will come from an observer that has been watching the business day after day and has a general idea of what is going on and wants to make an awesome offer.

Having said all of this, if you happen upon a shop for sale be observant and make a few visits before you know much. It will tell you a lot. I have been involved in a lot of discussions about buying an existing coffee shop. You have to take into effect the age of the business and the time left on the lease (w/renewal options). That is where half of the worth is at. There is always the case that someone may see value where others do not as well.

You will need to get the financial information from the owner or the broker to get an accurate valuation. A good rule of thumb is that 50% of the yearly gross is the approximate worth of a business. Of course the only way to actually find the fair market value is a valuation done by a business valuator but sometimes these are not accurate either. But that is the seller’s responsibility. I like the following method. It is usually the best way to valuate a coffee shop:

Figure out what the seller's true discretionary cash flow is: Take the owner's salary, add back anything a new owner may not spend money on yearly (these are called add backs) like a car lease, a lawsuit, use of a big CPA firm, health insurance for the owner and his kid etc. That resulting number is the true cash flow of the business. That number can be multiplied from 1 through 6 times to get your asking price or value of the business. The scale of 1-6 is mostly proportionate to the age of business and the time left on premises lease. If the business is only two years old, then the price should reflect the lower end of the spectrum and vice versa.

I keep mentioning time left on the lease because it is very important. You could buy a business that was cash flowing nicely, and then the lease is up in a year and the landlord decided for whatever reason to not renew it. You are not in a good position! Having renewal options on the lease and time left on it is very important. If the lease is about up, renegotiating it or signing a new one in your favor may be an option for you if the cash flow is worth it.

Keep in mind that as a new owner, you have to use that discretionary income to base what your debt service is going to be. Debt service is what a new owner can comfortably spend every month on paying off the note to buy your business, including a recoup of the down payment. The objective for buying a business is opposite of buying a house being that it should be paid off ASAP, three years max, so the price should also be in line with future debt service.

I say this because most people do not have the cash to buy a business outright. There will almost always be some seller financing involved, which is good news for you! Most owners consider owner financing with terms to make it more appealing because getting a loan to buy a business is very difficult, even with stellar credit and assets for a prospective buyer. Banks do not see a business as an asset because there are too many working and movable parts, and the equipment is usually not worth what was paid for it.

If you want to figure out what the debt service is for this business, take the true discretionary cash flow and divide it by 33%, as the most a buyer should pay yearly on debt service is 33% of their cash flow. That number is then divided by 12 for the year. The result is the most that your business can afford to pay monthly, including a recoup of a down payment and still pay an owner, and remain solvent.

Here is an example: Let's say you are dealing with a true discretionary cash flow of $75k per yr. The calculation should be as follows:

$75,000 divided by 3 = $25,000 divided by 12 = $2080 (approx). This is what should be spent monthly, P&I (principle and interest) on debt service. This does not include the down payment recoup, which should come out of the buyer’s pre-tax discretionary cash flow AFTER debt service. As a buyer, getting the down payment back should take 12-24 months based on the business growth and future potential. So say that your final sales price is $150k. The buyer should recoup $75k down payment within 24 months via the discretionary cash flow.

Another thing working in a buyer’s favor is that businesses are not flying off the market right now. If you really want to buy a shop and its solvent, you can make the owners a much lower offer than they would expect, but without being insulting. They just may surprise you. A good place to start is contacting a business broker in your area.

You must also qualify as a prospective buyer. The reason for this is the same as looking for a house: A broker is not going to waste theirs or a seller’s time on a prospective ‘buyer’ that does not have two dimes to rub together. Be prepared to divulge your financial status with documented proof and sign a non-disclosure statement as well. Of course, you are prepared to put down 50% of the purchase price, and have plenty of working capital, right?

If you do buy an existing coffee shop, as a first time shop owner I’d be sure it is not a failing one. The worst thing to happen is to try and turn around a failing shop when you have no working experience yourself in a profitable one. Look for a shop making money, but also be prepared to not change much, if anything if you do buy it. Reality is, if you do change what is working and making money you can open yourself up to losing business. That would not be good!

Then again, it’s always a gamble buying an existing business because what an owner says, what’s on the tax returns, and what is reality may be completely different things. That is where a trained eye and lots of observing come in real handy.

A good way to do a visual valuation is to watch the day to day operations and actually count the customers daily, foot and vehicle traffic over at least a month’s time. Yes, count. Sit inside the store but don’t be obvious. Observe and count! You will become a ‘regular’. This will also give you the opportunity to not only see the customer flow but also get an approximate of what the actual sales are. Sit close enough to hear what customers order and keep a generic tally. That will give you a little more vision of what IS reality.

If this truly interests you, work with a business broker. However, be sure you know what you are getting into by buying or starting a coffee shop business. Have a coffee shop business plan in either case to plan your course by and for ultimate possibilities of success! Good luck in your endeavor of specialty coffee!