1. Structure of a Typical
Expansion Model for
Restaurants
It is not uncommon for a new restaurant to
be financed through a limited partnership,
raising capital from high net worth
individuals who will be looking for an
annual cash return and eventual return
on investment through capital gains. The
general partner (“GP”) contributes funds
for its GP interest, usually 1% and some
percentage of the LPs’ interest. The GP
provides the management, accounting,
and training of staff and managers to
the individual limited partnerships. The
limited partnership, holding one store,
distributes cash flow but has no rights to
the use of the name unless conferred by
the GP, as the trademark of the restaurant
is commonly owned in a separate entity.
Future stores are built with a combination
of debt and equity and are controlled by the
same GP. The limited partnership pays a
fee to the entity owning the trademark and
uses the name and logo of the restaurant
for such fee. In this structure, the GP
maintains control of the name and the
operations of the restaurant without having
to own more than 50% of the entity. In this
structure, the LPs are commonly paid a
high percentage of the cash returns until a
certain payout threshold is met, after which
point profits are shared 50/50. The typical
ownership structure is depicted in Figure 1.
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©2016
Note: [a] The GP normally owns a percentage of each LP.
Trademark Entity
General Partner [a]
Founding Family
Members
Third Party
Investors
LP #1
LP #2
LP #3
LP #4
LP #5
100%
100%
1.0% 99.0%
Figure 1
The
Restaurant
Roll-Up
Transaction

2. VALUATION | THE RESTAURANT ROLL-UP TRANSACTION
Limitations to the Individual
Store Financing Model
This model of expanding new locations has the benefit of low
cost capital, not diluting the founders of the company, avoiding
excessive leverage, and providing income to the investors. The
model also has some important limitations.
Since the free cash flow from the individual stores is
typically distributed to the partners, there is limited
cash flow to fund any expansion.
The ability to raise equity capital is severely limited
since the business and operations of the limited
partnerships cannot be used as collateral.
There is a point of diminishing returns to utilizing the LP
structure to grow. Even if future growth is anticipated to be
slow and steady, increases in the cash flow at the store level
will not be available and trying to satisfy the limited partners
return expectations will be difficult. Any industry that utilizes
this structure usually reaches a point at which growth becomes
constrained. The fact that only a fraction of cash flow generated
can be reinvested in the business will inhibit expansion, financing,
and the ability to acquire as a method of growth. If all of the
LPs own the same percentage of each partnership, an unusual
condition, the analysis becomes one of relative contribution to
the new entity (“Newco”). This is an easy analysis other than for
the stores that are losing money or are not yet profitable and
the value of GP fees and trademark entity. When proportionality
does not exist, all entities need to be valued to determine their
interest in Newco. Regardless of the circumstance, the valuation
considerations and methodology we use are detailed next.
Valuation Considerations
As is the case with all going concern valuations for operating
companies, there are three valuation approaches, some or all of
which are used for determining indications of value based on the
facts and circumstances as will be discussed in this section.
The approaches are the Income Approach, Market Approach,
and Asset Approach.
I. Income Approach
The Capitalization of Earnings method under this approach
involves capitalizing (dividing a sustainable level of cash flow
at a capitalization rate) a single period of free cash flow by a
rate that deducts an expected long-term growth rate. In order
to implement this method, careful analysis of the historical
financial statements should be conducted in order to exclude
the effects of any nonrecurring amounts of income or expenses.
A normalized level of cash flow should also reflect potential
changes in minimum wages, rents, deferred maintenance,
and required franchise remodeling, just to name a few. Future
demand drivers of restaurants include surrounding demographics,
consumer tastes, disposable income levels, and brand
recognition. This method is most applicable to companies that
face predictable and constant growth, such as single location
restaurants in a mature growth stage. For most restaurants
considering a roll-up transaction, it is likely that the existing
limited partnerships have reached a mature state in which future
cash flows are relatively predictable. Thus, this method can likely
be utilized for roll-up transactions.
The Discounted Cash Flow method involves the discounting
of expected future net cash flows for a predictable period into
the future and a terminal value (based on either capitalizing
earnings or applying a multiple) at an appropriate risk adjusted
rate. This method is most applicable to restaurants that
are new, have expectations to open additional units, or in a
location that is expected to experience a significant change in
economic condition. In a roll-up transaction, a Discounted Cash
Flow method may be necessary for newer locations that may
experience a varying level of revenue and net cash flow prior to
reaching a stable level.
Under either of these methods, the discount rate can be
determined either by the build-up method or by using the Capital
Asset Pricing Model (CAPM) by utilizing data of publicly-traded
comparable companies or SIC code data. As discussed in the
following section, careful consideration should be given to select
companies with comparable concepts and metrics.
II. Market Approach
The Market Approach, also known as the Guideline Company
Approach, involves the determination of indicated values derived
from either developing a group of companies in the same or
similar line of business or those with similar risk characteristics.
The Comparable or Guideline Company Analysis method starts
with a search for comparable companies using a database
such as CapitalIQ in order to find publicly-traded companies
similar to the subject company. It is important to consider the
restaurant’s concept and specific characteristics rather than an
all-inclusive list of restaurants that are too dissimilar. Important
factors to consider in the selection of comparable companies
include the following (i) restaurant concept (casual, coffee/
brewery, fine dining, family, fast casual, sandwich, pizza, etc.);
(ii) demographics; (iii) average ticket amount per person; (iv)
franchise vs. non-franchise; (v) growth expectations; (vi) size; and
(vii) geographic locations.
The Precedent M&A Transactions method also involves a search
using a database (such as CapitalIQ for larger transactions and
PrattStats for private, smaller transactions) for transactions
involving comparable restaurants in order to gauge purchase
multiples. Larger deals often have EBITDA multiple premiums. In
order to implement this method, it is important to consider the
date of transaction, as dated transactions may not be meaningful
as markets change in response to economic and industry
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3. VALUATION | THE RESTAURANT ROLL-UP TRANSACTION
conditions. Make sure to compare the subject company to
comparable companies for size, leverage, risk, profitability, and
growth prospects. It should be noted that PrattStats database
is useful for similar small companies, although may be lacking
some of the data necessary for drawing conclusions as
information is not as readily available for private companies.
III. Asset Approach
This approach is not generally applicable to going concern
valuations as this method does not capture intangible value.
However, there is a use for this method when a restaurant
location is owned by the company versus leased. In those
situations the value of the land, which may be worth more
than when purchased, needs to be captured in the value. The
approach usually involves treating the land as a sale leaseback
transaction wherein the land is sold subject to a long term
triple net lease, with the sales proceeds included in the going
concern value as a non-operating asset.
Figure 2 shows how all three valuation approaches
could be implemented in order to derive the total value
of a restaurant company.
As previously stated, assuming that the LPs and their
percentages in the individual stores are different, each location
will have to be valued separately. For profitable locations that
lease their real estate, the Income and Market Approaches
will be most commonly used. Unprofitable stores that have the
prospect of success will be based on future cash flow. Locations
that are unprofitable should be valued on an Asset Approach.
For the locations that own real estate, we utilize a combination
of approaches wherein the real estate is treated as if a sale/
leaseback transaction occurred. Rent equal to long term
lease rates is substituted for ownership and then the market
value of the land is added to the going concern value as a
non-operating asset.
The GP and LPs are treated equally for their ownership in existing
stores. What distinguishes the GP and the trademark entity
valuation is the continuing value that derives from their income
related to future stores. The GP and trademark represent the
infrastructure needed to grow. After the roll-up of the locations,
the LPs will participate in future growth while under the pre-
transaction structure they can only grow based on the revenue
and cash flow from the locations they own. That is to say that
they cannot open a store in that entity.
In restaurant valuations, the primary valuation considerations and
drivers consist of geographic demographics (including average
age, number of families, and consumer preference trends),
surrounding disposable income levels, the economic conditions
of the geographic region of the subject restaurant, the technology
and systems in place, and the ability to control costs and
eliminate commodity price risk. More specifically, we consider the
restaurant concept since each concept has different drivers and
faces different risks. The restaurant concept generally determines
the hourly sales (table turns) and average ticket amount. As the
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Important Valuation
Do’s and Don’ts
 Abide by the standard of value — fair market value,
fair value, investment value, etc.
 Normalization adjustments — this includes adjusting
for market level compensation, market level rents,
and eliminating non-recurring income and expense
items.
 Consideration of adequate levels of cash and working
capital to fund ongoing operations.
 Borrowing base (higher if restaurant owns the
building instead of lease) — this is important as a
higher assumed borrowing base could capture the
real estate value in addition to operating value.
 Don’t rely solely upon rules of thumb — it is
common in many industries, but it is not a valuation
methodology.
Figure 2
Income
Approach
Market
Approach
Total Value -
Newco
Asset
Approach
Income
Approach
Business EV Real Estate

4. VALUATION | THE RESTAURANT ROLL-UP TRANSACTION
restaurant industry is subject to consumer trends, such as gluten-
free cuisines and having a larger online/social media presence
for viewing menus and making reservations, we also incorporate
the subject’s restaurant adherence to these trends in our cash
flow models.
Obstacles to Getting
Full Acquiescence
In order for the roll-up to be successful, most of the LPs must be
willing to exchange their cash flow, or most of it, in exchange for
the growth opportunities that will exist in the stock of Newco.
The LPs initially invested primarily for income and
not for capital gains and as a result might be resistant to
swapping ownership interests. It is generally necessary to
have discussions with the largest investors, at a minimum,
to assure that there will be a critical mass of investors willing
to change investment strategy.
Unhappy minority investors are always a potential landmine.
Those that have no interest in participating should be
allowed to sell their interest at the values determined during
the valuation process if they choose to do so. The major
investors should be given the opportunity to ask questions
and to have input into the final exchange ratios. Newco
management should consider distributing some of its free cash
flow so that the limited partners can have some return in
addition to the capital gains opportunity.
The allocation itself and the values ascribed to the individual
stores, the GP, and the trademark entity are themselves a
potential bone of contention. Therefore, careful consideration of
the future cash flows allocable to the GP and trademark entity,
such as the selection of an appropriate royalty rate that should
be used to determine future cash flows to the trademark entity,
is critical to the analysis. As the value allocated to these two
entities will not be allocated to the LPs, the valuation of both
entities needs to be thorough and defendable.
Alex W. Howard, CFA, ASA
Managing Director
Valuation & Financial Opinions
713.221.5107
ahoward@srr.com
Ronak P. Shah, CFA
Senior Vice President
Valuation & Financial Opinions
713.221.5103
rshah@srr.com
This article is intended for general information purposes only and is not intended to provide, and
should not be used in lieu of, professional advice. The publisher assumes no liability for readers’
use of the information herein and readers are encouraged to seek professional assistance with
regard to specific matters. All opinions expressed in these articles are those of the authors and
do not necessarily reflect the views of Stout Risius Ross, Inc. or Stout Risius Ross Advisors, LLC.
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