Legal Issues Related To Buying A Restaurant


So you want to buy a restaurant? I know I sure have thought about it. In all the hours of staring at contracts, reviewing leases and discovery responses, followed by great dinners at wonderful restaurants, I’d be lying to say that the thought hasn’t crossed my mind more than a few times. In addition to having these thoughts, I’ve also had the benefit of representing a few restaurant owners giving me some insight from experiencing the legal issues that my clients have faced. So if you’ve thought it’s time to follow your dreams and passion and open a restaurant, I hope this article will provide you some of the same insight I’ve had by working on the legal issues involved that have potential to derail the dream.

According to a frequently cited study by Ohio State University on failed restaurants, 60% do not make it past the first year, and 80% go under in five years. While the statistics regarding the failures of restaurants are well known and widely spouted to anyone thinking of entering into the business, the reasons for those failures are rarely discussed. This article will focus on the legal pitfalls that await an unsuspecting restaurateur looking to purchase an existing restaurant.

Owning and operating a restaurant is a dream for many out there. Some think it’s not so hard to do. If you happen to be a good home cook, you’ve probably heard a thousand times that you should open your own restaurant. This is not an article about whether you should do so or not; that’s more appropriate for a business-related article. But assuming you’ve decided that you are up for the business challenges involved with owning a restaurant, or a restaurant lifer ready to go out on your own, then ignoring the legal issues involved can render those business decisions Dead on Arrival; without considering the implications of legal issues related to owning a restaurant, one risks a total failure of the restaurant dream.

As a preliminary note, this article is not meant as legal advice and one should seek the formal advice of an attorney to discuss these issues when ready to open a restaurant business. Secondly, these issues are based on my personal experience in advising restaurant owners and budding restaurant entrepreneurs. This is not meant as an exhaustive treatise on the matter. Moreover, these issues are specific to California law with some exceptions where federal law issues take center stage. Therefore, if a reader lives outside California and is planning on purchasing a restaurant outside of California, keep that caveat in mind (and seek local counsel!). Lastly, while many of these issues are relevant to starting any business (or buying an existing restaurant business as opposed to opening your own restaurant), we will focus on those specific to purchasing an existing restaurant.

Buying An Existing Restaurant Vs. Starting A New Restaurant

So why buy an existing restaurant instead of starting one from scratch? This isn’t like deciding between using pre-made salad dressing versus making your own vinaigrette from scratch. There are many good reasons to buy an existing restaurant as opposing to building a new one from the ground up (whereas there are rarely any good reasons to buy pre-made salad dressing). For just a moment, ignore what I said earlier about this not being a business-related article. This is one of those areas where business issues are too important not to discuss.

BRANDING (also discussed further below). You may want to create your own concept. Maybe you have the next big thing in the food world. But more likely, you don’t have any idea of what to do, how to do it, and you don’t want to deal with creating a whole new brand with all the intellectual property issues involved. Do you have to trademark? Is it a concept that you can even trademark? Do you want to build the 1,000th “India Grill” in the country? Maybe you want the goodwill associated with a current restaurant. The clientele knows “Mama’s Place” and wants to keep going to “Mama’s Place” because of all the memories they have at “Mama’s Place.” This could be a lot to worry about when your expertise lies in hospitality and cooking as opposed to marketing and branding.

CONSTRUCTION Maybe you don’t want to deal with building a restaurant from the ground up. If you’ve been through any major house renovation, you may have a slight idea of what you’ll have to deal with. Permits? Contractors? Fixtures? Maybe that’s not your thing. Purchasing an existing restaurant affords you the opportunity to get a turn-key restaurant for less than the construction costs of building new thus avoiding a whole slew of legal issues related to construction (quality of work, time overruns, budget runs and so forth).

EXISTING CUSTOMERS Purchasing an existing restaurant allows you buy an existing income stream, meaning you should be generating revenue right away. You know what you’re getting (assuming you’ve reviewed the financials and they are accurate, see below).

Now that you’ve decided to buy an existing restaurant, what do you have to worry about from a legal perspective? What I really mean, is what can you expect your paid attorney to tell you to worry about when you so responsibly chose to seek one out?

Legal Entity

The concept of limited liability and what form of entity should you form? Should you form one?

Limited liability is a legal creation. Think of this legal creation like a vehicle protecting you from the outer elements when driving. With the right vehicle (which is most cars for instance), you won’t get bugs in your mouth, you’ll be safe from most types of minor accidents and the weather. And like most vehicles, each entity has different pros and cons. Some are easy to manage and drive, and others are more difficult.

There’s no need to get into the history of the corporation but one of the benefits of a corporation (or limited liability entity, either LLC or LP) is that the actual individual owner (or owners) cannot be held personally liable for debts of the limited liability entity. If someone slips and falls on your newly mopped restaurant floor, the injured person will likely have to sue the limited liability entity rather than you personally. The difference is, assuming the injured person wins a judgment, is that they can only seek recovery from the limited liability entity’s assets (usually the liability insurance policy will pay out). Barring some exceptions, the restaurant owner(s) house and personal bank accounts are safe.

Limited liability is not the only concern when picking an entity. Which form allows the best management structure? What about tax benefits? This depends on how you plan on raising capital. Are you bringing on various investors? Do they know each other? Are they individual investors or companies that invest? Are all the individuals US citizens or residents? The answers to these questions will affect what kind of entity you can use to own the business. For instance, an S-Corp can only have 100 shareholders and they can only be individuals who are US citizens or residents. For the most part, if you’re an individual who has saved some money or is borrowing money from the bank or family, and thus will be the only owner of the business, I usually recommend going with an LLC since they are easy to manage.

And here is a good spot for the usual caveat I like to give my clients with respect to taxes. Unless your attorney is a tax specialist, they should probably tell you that they’re NOT a tax specialist and should be referring you to a CPA or specialized tax attorney. The reason I say this now is that there are different tax consequences when using an S-Corp versus a LLC. In California, for example, S-Corp are charged a state franchise tax of 1.5% of the net income whereas a LLC is taxed on the total net income coming from California. The particulars are for your CPA or tax attorney to explain to you. For purposes of this article, just know that you should think about these issues when deciding between legal entities.

Real Estate Issues

When purchasing an existing restaurant, that restaurant will likely be in a static physical location. Most likely, the existing restaurant will be subject to a lease with the landlord of the physical location. This lease agreement’s rights and obligations will now be your rights and obligations assuming certain matters are considered.

Assignment of the Lease – most real estate leases have a provision for assignment. “Assignment” is the legal term describing the transfer of the lease obligations to another party. Most assignment provisions in real estate leases state that a party can’t assign the lease to another party without the Landlord’s consent. So you, as a buyer of an existing restaurant will have to be approved by the landlord. Depending on type of real estate you are dealing with, this can be an easy process or a serious vetting. Expect a landlord to review your financial viability (i.e., performing a credit check like a bank would when applying for a mortgage) and business credentials. They will analyze your experience with restaurants and try to make sure that you will not go bust within a year thereby depriving the landlord of a paying tenant.

Exclusives – does the lease you’re about to buy along with this restaurant contain exclusive rights regarding what kind of food you can serve? No, there’s no constitutional right to serve whatever food you want. Let’s say you’re buying a burger joint with a beer and wine license. This restaurant is in a shopping center with two other restaurants, a fish place and Mexican food spot. Read your lease carefully because they may have limitations regarding what kind of food you can serve at the burger joint. You can be thinking you want to put tacos on your menu but the Mexican restaurant negotiated an exclusive with the landlord that gives that restaurant the only right to serve any type of Mexican food including tacos. Same with fish. Now check and see whether the landlord is restricted from allowing another burger joint to open up in the spot next to you. Exclusives work both ways you see. If you don’t see one, you may want one before deciding to buy that restaurant. The nature of the exclusives, how broad they are, how particular they are (i.e., can a place open that only does 10% of their sales from burgers?) is something for you to get an attorney for and make sure you’re protected. Businesses that aren’t adequately protected with exclusives can fail because a bigger name place opens up next to you with a monster budget that can afford to sell cheap, commoditized food with tricky marketing (not going to name names). Therefore, you need to know what the exclusives are so you know what you can and cannot serve once you take over the restaurant.

Paying Rent and Percentage Rent – Depending on where you are buying a restaurant and what type of restaurant it is, the lease could call for a percentage rent based on the amount of sales the restaurant does. We won’t belabor the point, but big landlords will use all types of fancy formulas to calculate a rental amount based on the sales of the business. Often times, there is a threshold of sales to reach before a percentage on top of the base rent is due to the landlord. Once you figure out the formula, you can plan your accounting strategy with your CPA.

Default – You should know what rights the landlord has if you don’t pay your rent. Most of these clauses are standard and built around the California civil code. But the lease may allow for exorbitant late fees. Best not to be in a position to find out.

Liquor License

Liquor licenses are a source of great revenue for a restaurant. Many restaurants can exist without a liquor license, but certain types of restaurants absolutely need a liquor license to survive. Try having a ‘gastropub’ without a liquor license. Or a steakhouse. Forget about it. When buying a restaurant with a liquor license, your main concern should be getting it transferred as soon as possible. Yes, just because you buy a restaurant with a liquor license, doesn’t mean you don’t have to do anything further after closing the sale. You have to get it transferred to you because liquor licenses are attached to the business owner, not necessarily the business.

For more detailed information regarding the transfer process, check out the “Frequently Asked Questions about License Transfers” at the California Department of Alcoholic Beverage Control website (http://www.abc.ca.gov/questions/transfers_faq.html).

Raising Funds - Security Law Issues

How will you pay for this restaurant? The manner in which you raise the capital needed matters. Do you plan on cold-calling rich people selling them on your business plan? Are you going to ask your friends and family? If you’re reading this article, the chances are you are raising money from friends, family or strapping your boots to make it work. On the other hand, if you’re a business school grad and using your new founds skills to put together a fancy business plan along with some of your fancy business school friends who happen to know some bartenders ready to open their own bar & grill, then you should probably consult with an attorney to make sure that the fancy business plan isn’t going to get you in trouble with the law.

If you consider offering and selling securities, even if to just one person, the offer and sale of the securities must either be registered with the SEC or conducted in accordance with one of the many registration exemptions under the Securities Act. Registering an offering with the SEC would make your company a public company. However, your company’s securities offering may qualify for one of several exemptions from the registration requirements of the Securities Act. The most common exemptions are listed below.

Non-public offering (private placement) exemption

Section 4(a)(2) of the Securities Act exempts from registration “transactions by an issuer not involving any public offering. Think of this as the ‘friends and family’ exemption. You can raise money from sources or individuals who have a pre-existing relationship with the issuer.

Regulation D — Rules 504, 505 and 506

Regulation D contains Rules 504, 505 and 506, which establish exemptions from Securities Act registration. The only filing requirement under each of these exemptions is the requirement to file a notice on Form D with the SEC.

Rule 504. Rule 504, sometimes referred to as the “seed capital” exemption, provides an exemption for the offer and sale of up to $1,000,000 of securities in a 12-month period.

Rule 505 provides an exemption for offers and sales of securities totaling up to $5 million in any 12-month period. Under this exemption, your company may sell to an unlimited number of “accredited investors” and up to 35 persons that are not accredited investors. Purchasers must buy for investment purposes only, and not for the purpose of reselling the securities.

Rule 506. Rule 506 provides two different ways of conducting a securities offering that is exempt from registration: Rule 506(b) and Rule 506(c). Rule 506(b) is a long-standing rule. Rule 506(c) was added in 2013 to implement a statutory mandate under the JOBS Act.

Regulation A

Regulation A is an exemption for public offerings not exceeding $5 million in any 12-month period. If you choose to rely on this exemption, your company must file an offering statement with the SEC on Form 1-A, consisting of a notification, offering circular, and exhibits.

Accredited investor exemption—Section 4(a)(5)

Section 4(a)(5) of the Securities Act exempts from registration offers and sales of securities to accredited investors when the total offering price is less than $5 million.

Intrastate offering exemption

Section 3(a)(11) of the Securities Act is generally known as the “intrastate offering exemption.” This exemption facilitates the financing of local business operations.

Coordinated limited offering exemption under California law — Rule 1001

SEC Rule 1001 provides an exemption from the registration requirements of the Securities Act for offers and sales of securities in amounts of up to $5 million that satisfy the conditions of Section 25102(n) of the California Corporations Code.

Exemption for sales of securities through employee benefit plans — Rule 701

SEC Rule 701 exempts certain sales of securities made to compensate employees. This exemption is available only to companies that are not subject to Exchange Act reporting requirements

Employer - Employee Issues

The restaurant business is one of the industries that often violates the California Employment Law and the most common of those violations are:

Restaurant owners and managers are not allowed to take tips. – Section 351 of the California Labor Code prohibits employers and their agents from taking tips from employees serving customers, all tips left by customers belong exclusively to an employee who earned them

Employees are not responsible for customer walk-outs, register shortage, order mistakes and other business related losses. – Industrial Commission Wage Order No. 5 Section 8 prohibits an employer from making any deduction from the wage or requiring any reimbursement from an employee for any cash shortage, breakage, or loss of equipment.

Employer must pay for uniform and its maintenance. – If employers require their workers to wear uniforms as a condition of employment, employers must pay for and maintain such uniforms.

Employer must provide meals and rest periods. – All non-exempt employees are entitled to at least a 30-minute meal break for every five hours worked and for every four hours of work, all non-exempt employees are entitled to at least a 10-minut rest break.

Employers must preserve all employment records. – Under the federal law, the following records must be maintained for at least three years from the last date of entry: payroll records, including each employee’s name, address, occupation, hours worked each day and week, wages paid and date of payment, amounts earned as straight-time pay and overtime, and deductions, etc.

Employer must pay wages twice each calendar month. – With a few exceptions, California Labor Code Section 204 requires that all non-exempt employees must be paid twice each calendar month.

Intellectual Property Issues

While it is well known that a recipe can’t be copyrighted, many parts of a restaurant can be protected by United Stated intellectual property laws. When buying a restaurant, you need to make sure you are buying all the intellectual property assets along with the hard assets. These IP assets include the look and feel of a restaurant, which is characterized as retail trade dress. Retail trade dress is defined as the total image and appearance of a business including the floor plan, decor, color combinations. This is based on case law from a U.S. Supreme Court decision, which upheld a jury verdict of trade dress infringement claim under the Lanham Act in favor of Taco Cabana, a Mexican restaurant chain in Texas.

A restaurant’s brand is tied up in its IP rights and when buying a restaurant, you must make sure you know what your rights are with respect the IP. For example, I once represented a restaurant buyer who was buying a locally well-known restaurant owned and operated by well-known restaurateurs. These sellers had spent considerable effort and money in establishing a particular brand for the restaurant and because they owned and operated an even better known restaurant chain, were very concerned about the way the restaurant brand would be handled by the new owners since it was known that the restaurant and the restaurant chain were commonly owned. Also, since they considered their restaurant name and brand to be specially developed by them, they were reluctant to sell the name and IP outright. So when my client sent me the purchase documents, in addition to a fairly typical asset purchase agreement (with an exclusion for the IP assets), it also included a license agreement for the use of the name of the restaurant and associated logo(s).

It is common in licensing agreements for the licensor to exercise some control over the use of the IP being licensed. In the current example, there existed such a clause which allowed the licensor/seller the right to review the operations of the restaurant to make sure that the name and logo were being used properly. The practical effect of this clause meant that the licensor/seller had the right to inspect restaurant operations and make sure the restaurant was running according to the licensor’s/seller’s standards. The licensor/seller could basically interfere with the operations of the restaurant making the licensee’s/buyer’s life miserable because arguably anything as simple as the uniforms the food servers wore to the color of the paint on the wall could affect the brand and therefore trigger the clause.

The situation I described here may make sense in certain cases. Sometimes chain restaurants sell off their individual restaurants to various operators. In those cases, the seller will have a definite interest in maintaining brand control. Ultimately, the point for any buyer of a restaurant is to understand what IP rights you have and how those rights affect how you operate the restaurant.

Conclusion

While this may have been a long article, it is no way comprehensive as to all the issues possibly involved with purchasing a restaurant. Opening any business, restaurant or otherwise is an exciting venture but restaurants have a particular glamour associated with them nowadays. While any line cook who has sweated over a hot stove every weekend of their adult life can tell you, the glamour can blind you to the real pitfalls and headaches that come with owning and operating a restaurant. The point of this article was to highlight some of those pitfalls and headaches from a legal perspective. If you’re seriously considering purchasing or opening a restaurant, allocate a small percentage of the purchase price for hiring a qualified and competent business attorney who can guide you through these risks. Hopefully, after reading this article, you know what to ask your attorney.