Cafe Accounting Episode 1

 
     You're an expert in your field.  You have been working as a barista for several years now, you know your craft, and all of the details and procedures necessary to run a successful cafe.  Your current boss trusts you with the keys, the security codes, the cash register and their customers...for good reason.  Every day you show up early, eager to calibrate your espresso grind and pull some shots so that when the first customer arrives, you can confidently look them in the eye and boast "I made this...for you".  Every shift offers new challenges, mechanical,  procedural, staffing, quality control and customer interactions, but you are up to it and deal with everything like a pro.  There are things about the business that you don't quite understand yet, but that's what keeps you eager to show up early and master whatever presents itself.

Everything about you says "I'm ready to run my own espresso bar" except one thing...money, how to track it and how to make it, after all, you can't make espresso unless you make money.

You know what your boss charges for coffee, heck, you even know what Starbucks charges for coffee, and they both seem to be making lots of cash.  How hard can it be?  You know that customers LOVE the drinks you prepare and how you serve them and you are confident they'll come if you had a store of your own.

If this sounds a little like you, then I hope to provide you with the financial knowledge and confidence to leverage your skills into running your own shop.  In the next few posts I'm going to produce a narrative that I hope will be easily understood for even the most timid budding masters of coffee business.

I'm going to make this series as easy to read as possible (even a bit corny), with very few Financial Terminologies, and a lot of common words and phrases so that you completely grasp the concepts used in EVERY business financial statements.  This is not going to be a post, but instead, a series of long posts walking you through the steps a new cafe owner would take in Mastering the Finances of their business.  I expect to edit this many times once it is posted, to make it flow better, include some details that readers notice are missing, or add things that I should have noticed on my own.  This series is intended to give you power over your own business finances, and if I am happy with the result, I hope to work this into a presentation which I hope to debut at a coffee industry event in 2014.  I hope this in helpful.

Here we go:

You've got a great idea to open your own espresso bar, fortified with several years of experience as a barista and a few more as a store manager.  There is a great spot that opened up in a promising neighbourhood (not too close to the shop you manage), and you think this is the time to finally act on your dream of owning your own shop.  You've been saving up your tips and even have some money that your grandparents gave you for a graduation present.  All together you've $20,000 of hard earned cash as seed money for the rest of your life.  This money represents countless hours of dedicated work, great customer service, not to mention the hopes and wishes entrusted to you by close family...it is a significant amount of money and not something to be committed without planning and diligence.  If you are going to dedicate this money as your seed money for your dream business you had better find a way of keeping track of it.  It represents your business hopes and you want to know it is safe. To keep track of it you write your investment down on paper.  On the left side of the paper you write:

That feels great.  Twenty grand is a lot of cash and it looks even better on paper, but hey, did you notice that the 2 sides equal each other?  Why?  

On the left side of the paper we record the valuable things the business has, and on the right...who owns those things.  Just because the business "has" things, doesn't mean it owns those things.  In this case, the Owner's Investment is something to be used by the business...but make no mistake, you own it.  At the bottom of this page you add up all of the items in each side and create a Total, with equal numbers on each side...What The Business Has, and Who Owns It.  Balanced, just like a BALANCE SHEET.  This is the first financial term you will become familiar with.  Get comfortable with it,  Balance Sheet...What the Business Has (Left Side), Who Owns It (Right Side).

Now just because you are new to business doesn't mean you are foolish or unrealistic...in fact the opposite.  You are careful, thoughtful, and diligent because this is your dream we're talking about.  You've penciled out an equipment list along with some quotes from local tradesmen, and you know for a fact that you will need at least another $80,000 to start your business.  While you've been saving and planning for years, you are still very short of the money needed to start your shop, but good news arrives just in time.  All that planning has paid off when your application for a bank loan attached to a government sponsored program to encourage new business is approved!   The faith the bank and the government has placed in you and your business is well founded.  The experience you bring to the table, and your own investment seals the deal for you, but we now need to record these new funds in your new BALANCE SHEET.

Now THAT is impressive, $100,000.  On the left side of the sheet the business has $100,000 to use to get the business off the ground.  On the right side of the sheet you record the $20,000 that belongs to you, and $80,000 which belongs to the Bank.

The Left Side = The Right Side...Balance Sheet.

Now is the time to introduce two new Financial Terms, Assets and Liabilities.

We are going to replace "What the business has" with Assets.

Assets are things that the business can use that have value ie Cash

We are going to replace "Who Owns it" with Liabilities.

Liabilities are things that the business Must pay back ie Loans

When an owner makes an investment in their own business it is also something which the business Owes, but most owners don't draw on this money until the business is making enough money to pay it back.  So instead of simply recording it as "Owner's Investment" like a Loan we are going to place it under the Heading "Owners Equity".  Equity means:  Owner's Share.  In this case, the owner's share of the $100,000 = $20,000.  Got it?  So let's re-do the Balance Sheet to reflect these changes.

Now is the time to introduce you to the most important rule of Accounting.

ASSETS = LIABILITIES+OWNERS EQUITY

Memorize this, it is the equivalent of "the sun rises in the east" for accounting.

Now that you've accounted for the new Bank Loan and introduced some fancy new accounting terms you're feeling pretty good about yourself.  You've begun to feel some power and ownership over this enterprise and you are developing a sense of control.  All of the preparation time and effort is paying off when your contacts within the coffee industry come through by telling you about a relatively new cafe that has closed its doors, having run out of money and stopped paying its rent.  The landlord, after seized the equipment, is offering the equipment and fixtures for sale and is willing to take an amount roughly equal to 50% of the original purchase price.  For the grand total of $30,000, you take possession of a lightly used espresso machine and grinder, a bean grinder and scale, 10 tables, 20 chairs, blender, signage, some small wares, two refrigerators plus an awesome display refrigerator.  You know that there are many things you will still need to buy before you open your shop, but this is a great find and you close the deal with a handshake.  A handshake is all it takes because you are good to your word.  You arrange with the landlord to pick up the items (after preparing a certified cheque for 

$30,000 payable to the landlord) and talk your parents into storing the items in their garage until your beautiful new space is ready.  Lets now make an entry to reflect the changes.

Notice how our Balance Sheet has changed.  On the Assets side, we have exchanged $30,000 in cash for $30,000 in equipment.  The total value of everything has not changed at all...you still have $100,000 in Assets.

Notice that nothing has changed on the Liability Side of the Balance Sheet.  Everything remains the same.  The total must equal $100,000 because remember, we are working on a BALANCE SHEET.  The left side always equals the right side, and when that happens:

ASSETS = LIABILITIES+OWNERS EQUITY

While negotiating your bank loan, sweet talking your parents, high fiveing your buddies and scoring big on the equipment purchase, you also found time to get a great deal on a 5 year lease for that awesome corner spot you've had your eyes on.  After reading a blog on the subject, (see my post on Negotiating a Lease) you decided to ask the landlord for a contribution to renovating the space.  You're not sure whether it was your steely gaze, you playing hard to get, or the landlord's faith in you and your concept, but whatever it was, the landlord decided to contribute the equivalent of 3 months rent ($7,500) to the renovation plus grant you 2 months free rent to get the space ready to open.  All together, the landlord is contributing $12,500 to getting your business open.  This is a HUGE deal for you since the plumber has informed you that the City Building Department has notified him that you need to install handicapped accessible washrooms which will increase his estimate by approximately $2,500.  The cabinets are also going to cost you more than expected mostly because you have decided to install marble countertops to match the table tops which came with the tables you bought from the failed business liquidation.  All together you will be spending $60,000 to renovate your awesome space, including electrical, plumbing, refinished hardwood floors, new cabinets and counters, framed in handicapped washrooms, storage room, drywall, paint, a prominent outdoor lighted sign, plumbing and electrical fixtures.  One of the biggest hassles proves to be the permits required, but the process of producing architectural drawings by a professional firm proves to be a great investment, easing the permit process by providing all of the documents and drawings required by the City Building Department. 

Lets now make an entry to reflect the new expenditures.

The Balance Sheet has changed resulting from the money spent on renovations and the landlord's contribution to the expenses.  In order to reflect these changes on the ASSETS side we have reduced the Cash by $52,500 and created a new line called "Fixed Assets" which contains all items which are considered "fixed or attached" to the building, like cabinets, toilets and sinks.  The other $7,500 needed to make up the $60,000 comes from the "Landlord's offer to pay for some expenses" as an inducement for you to sign a lease.

On the LIABILITIES side we have created a new line called "Landlord Contribution" totalling $7,500.  Both sides total $107,500 and of course are BALANCED.

The building process is now almost complete and you are creating a lot of buzz in the neighbourhood after placing a sign in the papered up windows proudly declaring "Coming Soon...My Awesome Espresso Bar".  It is time to start assembling the goods you need in order to open.  These include, milk supplies, coffee and tea supplies, cups and lids, take away bags and trays, and find a dessert supplier.

You've been in the coffee business for several years and have selected a local roaster who happens to employ one of your best buddies.  They have a great reputation and have even offered to work with you to create an espresso blend just for you!  Since you are new to business, and the roaster has been around a while and seen companies come and go, they ask you to pay for your first order BEFORE they ship.  These terms are similar to every other supplier except the cool local baking company who offers you terms of Net 7 Days. (The bill must be paid within 7 days of invoice).

You've thought of everything needed and place orders with all of your suppliers totalling $5,000 PLUS a baked goods order of $100 for the first day.

Let's make an entry to reflect these changes.

Notice what we've done.  We reduced the Cash balance by 5,000 but create a new line called "Inventory", and simply converted Cash into Inventory.  Inventory are things the business sells to make money.  In inventory we also add $100 which represents the baked goods that we have but don't need to pay for until 7 days have passed.  On the Liability side, everything remains the same EXCEPT we have created a new line called "Accounts Payable" where we record the $100 that you need to pay to the local baker in a week.  This is a subtle but important point:  Notice how the totals have increased by $100.  This represents the value of the baked goods and it increases the Balance Sheet Total but doesn't really make the business wealthier.  Don't confuse a big number in the Balance Sheet Total with a Valuable Company.  The increase simply means that the baker contributed to the value of the baked goods (Assets) that company can use to make money, but the other side of the Balance Sheet (Liabilities) clearly shows that the company owes that money to the baker as an Account Payable. 

You have done your planning, saved your pennies, borrowed a great deal of money, and with it, made your dream a reality.  The contractors finished on time (due mostly to a great deal of pushing and prodding from you), and tomorrow you are ready to open the doors!  You haven't hired any staff yet because you want to save as much money as possible and think the demand may take a few weeks, even months to grow.  While your cafe can comfortably seat 20, you expect to slowly fill those seats.  Offering very simple baked goods will help you to keep service requirements minimal, so you can focus on preparing the best coffee in town.  Early on you expect to do about 100 transactions per day, which is no problems since that is about half of what your previous employer's shop did in a morning.  Working alone doesn't worry you either, sure the restroom breaks might be a little challenging, but your buddies said they would stop by and give you a break, free of charge, just to get you on your feet.

Your cash register is nothing more than your 2 year old ipad with Square Register loaded on it, a simple cash box made from an old fishing tackle box, and a data plan for your ipad so you can process transactions.  You are ready!  Tomorrow you open for business, so the priority is to get a good nights sleep and arrive like you always do...early for your shift.

Structuring the Sale of a Company

I wanted to create a quick and timely post to fill in some blanks about how a company might structure an investment from say, a Private Equity Fund. Reading my description of a Balance Sheet may help.
First, let's assume that if you are large enough to attract the attention of a PE Fund, then you are already Incorporated with an existing Share Structure. This Share Structure typically has two classes of shares, Common and Preferred. Common Shares are voting shares and usually where the value of a company is reflected as price per share.
Preferred Shares are non voting shares, but in some instances (especially involving outside investors) can contain all of the company value in the form of asset backed interest bearing shares that must be paid before any dividends are paid to common shareholders.

If a PE Fund wanted to invest in an existing incorporated coffee company, they would set up a separate corporation with a common share structure that reflects the final ownership percentage. The fixed assets of the original corporation would be held within this company as security to offset the cash investment of the PE. For example, if the ownership is 50/50, and the value of the company is determined to be $1,000,000 and the PE fund wanted to invest a further $1,000,000 , the common shares would be split 50/50, and the preferred shares would be set up so the cash infusion of $1,000,000 would be offset by a balance sheet entry of equal Preferred Share Value, and the Fixed Assets brought into the new corporation would also be offset by $1,000,000 balance sheet entry of Preferred Shares.

If the PE fund wanted to invest more than the value of the company, but the existing owner didn't want to give up more than 50% ownership, the common shares could still be distributed 50/50, but the PE fund could have more (even all) Preferred Shares. The value of the Preferred Shares would be secured by the balance sheet assets and a Shareholder Agreement drawn up to protect the investment by precluding dividends until Preferred Shares are converted to Treasury Shares or retired. The original owner could also completely cash out the value of the original company balance sheet by selling the assets to the PE fund, and the transaction reflected by placing the whole value in Preferred Shares owned by the PE fund. The common shares could still be distributed 50/50. In this instance, the PE fund may also have provisions written into a Shareholder Agreement that would permit the conversion of Preferred Shares into Common Shares if some "triggering" event should occur. Last, some investors may look to have a "shotgun" clause written into a deal which permits either party to submit an offer to purchase the other party's shares which must either be acted upon, or the recipient of the offer becomes compelled to purchase the other party's shares under the same terms that were offered.

Believe me, the Devil in any deal is in the details. No matter what anyone says, only the parties involved actually would know how any deal is structured, but more often than not, the stroke of a pen leads to unintended consequences.

Negotiating a Lease Part 2

I wanted to provide an important update to my Negotiating a Lease post. The inspiration for this was provided by an old friend who suggested I structure a new lease offer differently in order to reduce depreciable long term assets in the form of leasehold improvements on the balance sheet in favour of rent which is expensed. The math goes like this:

Lets say we're looking at leasing a 2000' space for $20 per square foot and the space requires $100,000 in leasehold improvements. The rent on this space would equal $40,000 per year. If we're working from a 5+5 year lease, the improvements represent $5 per square foot over the course of 10 years. As mentioned in my first post on Negotiating a Lease, landlords sometimes offer tenant allowances for leasehold improvements and in this case asking for a $50 per square foot allowance covers the improvements. This is relevant because having the landlord pay for the improvements allows us to keep it off our balance sheet as a long term asset which we must depreciate over 5 years. By paying a little bit more per month over 10 years, you have effectively financed your build, avoided having long term debt and long term assets on the balance sheet, and instead structured it as an expense that reduces our tax at the end of the year.
Win, win, win.

Goodwill and How to Value a Company

Goodwill appears as an item on our Balance Sheet usually as a Non Current Asset and is essentially the value a company attaches to intangibles that it purchases. Having Goodwill on your Balance Sheet may be an indication that you have overpaid when acquiring another company or it's assets.
Under current accounting rules companies are not expected to amortize the Goodwill, but are expected to provide fair market value based on future profits generated by the acquired company. If for example the Goodwill was valued at 300k based on Net Profits of 60k per year over 5 years and the net profit drops, the value of the Goodwill needs to be reduced accordingly. If the Net Profit increases, it needs to be adjusted upwards.

For example:

Let's say a company decides to purchase another. Usually the purchaser will require that it be permitted to perform "due diligence" and inspect the sellers financial statements, and more importantly it's tax returns. (Companies sometimes lie to themselves, but lying to the Government is fraud) In return the seller will likely ask for a non disclosure/confidentiality agreement. If satisfied that the company's financials are in order and verified, the purchaser will usually obtain an equipment and asset list in order to fix a value on those items.
So imagine that the selling company has net assets of $200,000 and is asking $500,000 from the purchaser for it's business. Everything over the $200k is considered Goodwill, which in this case equals $300k. There are many ways of determining whether the amount of Goodwill is appropriate for the purchaser to spend but it is normally a calculation based on Net Profit multiplied by a number of years, usually 4-5. In this case, as the purchaser we would expect that Net Profit is somewhere around $60-75k per year in order to value the company's Goodwill at $300k.

Existing coffee companies purchase others for many reasons and we don't have to look to long to see some recent examples. Intelligentsia's purchase of Ecco Caffe is a private business matter where only the principals and their lawyers really know the details, but certainly a great deal of the purchase price would have been valued as Goodwill due to the excellent distribution, customer list, reputation and name brand associated with Ecco Caffe. In this case acquiring the facilities and hard assets of the Ecco Caffe may have been less enticing than the Goodwill itself, but for individuals starting out in the coffee business, beware.

If you are looking at purchasing an existing coffee company, remember that everything above the value of the Net Assets is Goodwill and that you should be very very careful purchasing anything you can't see.

Balance Sheet Simplified

The Balance Sheet is always in balance.(Refer to Balance Sheet Page and Sample Balance Sheet to familiarize yourself with terms and look of Balance Sheet)
The Balance Sheet is comprised of:
1. Assets (things we own); Current and Long-term
2. Liabilities (things we owe); Current and Long-term plus Equity (shares owned by shareholders/owners)

The reason Equity is a Liability is that the company owes money to the shareholders if and when they decided to sell their shares in the company. For most coffee businesses, there are likely between 1-5 shareholders who have each contributed funds in exchange for a percentage ownership. The percentage ownership is reflected in number of shares owned by each individual. For example, in our Sample Balance Sheet Page, there exists 100 common (voting) shares. If a partner owns 20% of the company, they own 20 common shares. (I will post more on Common and Preferred Shares soon)

The most important thing to know is the following equation:

ASSETS = LIABILITIES + EQUITY

ASSETS are for our purposes:
Short Term; cash on hand, bank accounts, investments and receivables
Long-term; equipment (tables, chairs, coffee makers and espresso machines) and leasehold improvements (things you've done to the space you rent, but cannot remove when you leave, ie cabinetry, flooring, washrooms)
When we add these things together we know, because we are working on a Balance Sheet, that the Liabilities plus Equity will equal this figure.

LIABILITIES are:
Short Term; accounts payable under 1 year(suppliers, rent, utilities, taxes payable)
Long-term; bank loans (note: there is usually a note listed in the Financial Statements outlining the terms of any outstanding loans, and lease agreements)

Example: In this simple example, our Balance Sheet is truncated, but clean and clear. We have $2,000 in cash, 20k in the bank, 50k in equipment and 72k in total assets. On the other side of the Balance Sheet, we owe 5k to suppliers, are making payments on a 20k bank loan, and as an owner we have 47k in value built up in the company.

ASSETS
cash 2,000
bank account 20,000
equipment 50,000
total 72,000
LIABILITIES
accts payable 5,000
bank loan 20,000
equity 47,000
total 72,000

If we decide to upgrade some equipment and take a bank loan for $20,000 out to do this, our new Balance Sheet will look like this.

ASSETS
cash 2,000
bank account 20,000
equipment 70,000
total 92,000
LIABILITIES
accts payable 5,000
bank loan 40,000
equity 47,000
total 92,000

Our Balance Sheet has grown, but the shareholders didn't profit, in fact cash flow will now need to be diverted to service the new debt, thereby reducing the profit at the end of the year. There are many different ways we could have acquired the equipment without taking on a new loan, lease, lease to own, pay cash, or issue preferred shares. Each has a cost associated with them, some more costly than others.
A very important factor I have omitted is the fact that new equipment depreciates the moment we take possession. (think new cars) This depreciation always happens at a constant rate determined by Generally Accepted Accounting Principles, normally 10-20% per year. This means that we need to reduce our ASSET equipment account by 20% of 70k each year, and if we do that, we need to reduce our LIABILITIES account by the same amount because we are working on a Balance Sheet. If we are reducing the value of equipment by 20% per year, and we are not paying off the equipment by more than 20% per year, we need to reduce the equity account by the difference to keep the sheet balanced. This means less value for the owners.
Play around with these concepts, apply them to your own situation and let me know if you find this helpful.