Introduction:
This article is written as a general discussion on the subject of “Due Diligence”. It is for informational purposes and not intended to be a definitive guideline for your exact situation. You should consult the appropriate professionals with regard to your specific transaction or situation. Further, this article is in no way advocating, suggesting or implying that anyone engages in any type fraudulent activities whatsoever. These are simply the things a buyer should be aware of when doing due diligence in buyer a business.
You spent months finding the right business. The seller says that you cannot go by what the tax return shows but the business is making a lot of money, and he can prove it. Your inspection of the profit and loss statement shows that sales have been increasing slightly in the last few years. Most important, and the best news of all is; the price is right! Does it sound too good to be true? I am sorry to tell you this, it probably is.
I think it was Benjamin Franklin who said, “A fool and his money are soon parted.” Mr. Franklin must have known a lot of business buyers. When buying appliances that break in a month, it costs you a few dollars. When you go to a swap meet and are cheated because the solid gold watch is really gold plated, it costs you a few hundred bucks. When a used car salesman cheats you, by selling you a lemon, where the speedometer has been turned back 100,000 miles, it costs you a few thousand dollars. Getting cheated buying a business can cost you many thousands to hundreds of thousands of dollars. The only investment or purchase that I know of where you can be cheated out of more money is in the area of real estate. Real Estate fraud can runs into the hundreds of millions of dollars and does. You would be shocked at all the people between 1875 and 1950 who saw ads for prime real estate in Florida and bought swamp land. What about prime Louisiana beach front with Alligators living outside your front door? I have written a series of articles on fraud and it keeps getting bigger and bigger.
I hope that the point is made. Never buy a business on someone’s word. Actually, you should never buy anything on someone’s word. Confirm everything, believe nothing and understand that you are still going to find out things, after the close of escrow, which is going to surprise you. A similar example is one known by every employer. A staff worked for a company for 4 months and complained to the personal officer that the job was just too difficult. He kept complaining that he needed more training and lower quotas. You feel sorry for him. You talk to him and talk to him about it. You listen and believe all the excuses he gives you for poor production. Finally he quit, blaming you for something that you did, this just before you were going to give up and fire him. Then you started to take over the work of finishing his incomplete projects. You are shocked, as you always re, at what he did wrong and what he had covered up, that he was not doing. This is what happens when you buy a business. You find out all the actions that the seller, not his staff, had stopped doing, from the day that he decided to sell the company.
Many businesses are doing well. Sometimes the owners have personal things going on in their home life. Sometimes they have medical problems. Many times the business is not doing well and the seller is frustrated. It is very common for a seller to work hard to build his business, but because of many reasons, it doesn’t produce what the seller wants. He gets frustrated and one day he gives up. That is usually the day he calls that business broker he met and asks the big question. How long will it take you to get me out of this place? In his mind, he is gone. He just counts the days until he physically walks out.
Have I scared you? Good. There is a plus side. It is worth all the grief that you go through to buy a business when you get in to the drivers seat, put all the marketing actions into place and start driving your own business.
In 2000 I had a client buy a car wash soap manufacturing business for $2 Million dollars. The seller swore it was making $500,000 profit per year. Due Diligence showed it was only making $300,000. When presented with the auditors report, the seller claimed the audit was wrong. The buyer bought the company, knowing he was overpaying for the business. Why? He had done his research on the production department and sales department. He went out on the deliveries with the drivers, and met customers. He determined that he could double the sales and profit within one year. After he bought the business he found two things to be true. The profit was $300,000, as my audit found. He could double the sales and profit within 12 months, and did. The seller tried to screw the buyer, but in the end, justice was served. The seller screwed himself more than he screwed the buyer by not running his business correctly. If he had he could of sold it for a lot more than $2 Million dollars.
Ok, enough with the fun stories for now. Lets get down to the details of what to look for when doing “Due Diligence.”
Due Diligence Defined:
The phrase is composed of two words. “Due” which the dictionary defines as “Proper or Adequate” and Diligence, which is defined as “Degree of care or caution expected of a person. Especially as a party to an agreement.” Caution: is the watchword in this definition.
Financial Statements – What to look for:
Add Backs:
If you bought the business through a business broker you should have received the business financial statement with a separate worksheet showing adjustments to those statements. These adjustments show the owner’s benefits received from the business besides the profit and salary he receives. These can also be defined as personal expenses that need to be added back to the profit. Depreciation, incomes taxes, interest expense are add backs that are not personal. Personal includes such things as family auto expenses, owner life insurance, owner health insurance, business entertainment that was not really spent on clients, business trips not really for business, home office expenses, family cellular phones and much much more.
Make the seller show you the details on some or all of these expenses to verify that they are really personal and not actually business expenses that shouldn’t be added back to profit. Spend time asking detailed questions with the general ledger in front of you. Go through individual charges and what they mean, until you fully understand what is being added back and why.
Inventory:
Inventory of resale merchandise must be checked for two reasons. One is you have to pay for it. Be careful, you do not want to buy merchandise that is old, worthless and not saleable anymore. Only pay for current marketable product. The price you are suppose to te pay for the inventory is the seller’s cost. The price for old slow inventory is negotiable. Always spot check the price and count the merchandise listed on the inventory list. Do people put down that there is three of an item when there are only two? Of course, especially when they think no one is going to be checking them out. Comparing prices from purchase invoices is how you check prices. You cannot check every item against the actual cost but you can do 5% of the items. Pick at random, not by any suggestion made by the seller or others. If you do not understand how marketable the inventory is that you are buying, hire an expert, from that industry. Your broker should be able to help you in finding someone. Do not be cheap, and think you do not need to spend the money on an expert adviser. I will take a lunch bet that they will pay for them selves many times over.
The second reason for checking inventory is that if a seller doesn’t take inventory at least yearly and adjust his inventory value in his accounting records, accurately, the profit figure you are receiving will not be accurate. As a rule, the higher cost of goods sold, the lower the profit. Some business owners reduce the inventory value on the books, intentionally, to a lower value so as to make the business show a higher cost of goods sold, which then creates a smaller taxable profit. If they do this year after year, the profit may or may not be accurate for the current year. It might take a CPA to figure this one out for you, if you do not have a background in retail.
Equipment value:
Next thing to check on the financials is the real, current value of the equipment you are buying with the business. The balance sheet might, if it shows all the equipment the company owns, give you the cost of the equipment when it was purchased. If you are buying assets rather than cash flow, the equipment valuation becomes more important. No one wants to overpay for used equipment. Also check that the equipment works and is actually being used rather than sitting behind the building with other junk.
Cash Sales:
If all income is being reported, check sales volume activities that you have observed against the daily records during your “Due Diligence” to see if the volume corresponds to what was reported last year in the same month. If you see income of $500 per day but the seller shows sales of $1,000 per day, you need to find out why. Some smart buyers sit in the business all day, watch the sales and observe the activities of the staff. This works if the seller is not putting on a full fledge production fraud for you the buyer.
Fraud:
How does a seller defraud a buyer on current sales activity levels? Sellers who keep poor records or no records, many times, suggest the buyer doing a 15-day visual inspection. This helps but it is very dangerous to rely solely on physical inspections alone because the seller can still defraud the buyer. Here is the most famous of the stories I have heard over the years.
Seller owns a dry cleaner. The buyer and seller have opened escrow and the deal is subject to a 15-day physical observation period. The seller doesn’t want the buyer to find out that business volume is very slow. The seller tells all his friends to bring their dry
cleaning in to the shop for a two-week period, at no charge. They bring in the clothing, get it cleaned, pick it up and pay for it. Later the business owner meets the customers and reimburses all of them for the cost of their dry cleaning. The day after escrow closes all that business traffic stops. Think it never happens? The same is true of restaurants. Seller tells all his friends to bring all of their friends in for a free meal. Customers pay the bill and some time later or at home, the business owner reimburses all the customers for the cost of their meals.
Actual time sellers spends working:
Determine how many hours the seller really works. You are buying an income stream based on a known number of hours of work. Make sure the seller isn’t working 80 hours and telling you he is only working 40 hours, per week. I had an absentee fast food owner tell the buyers and me that he worked part time - 5 hours per week. Closer inspection showed he was working 25 hours per week. One auto repair seller, we’ll call him Bob, said he never was at the business, because he had a second full time job. Inspection found he was working 30 hours a week (4 plus hours every night, and 8 hours on Saturdays).
Find out what job functions the seller does:
Get a list of functions that the seller does. Is one of them bookkeeping? Sometimes the wife does the books part time and this is never said. Again you may find the owner does the bookkeeping, at home, every night, for an extra hour. In an auto repair shop, you may find the owner is doing auto body repair work, personally, on Saturdays, which is work that you, as a buyer, will never be able to duplicate. You need to be sure you know how to do every job function that the seller does or learn them. The time to find out what technical knowledge you need to have to take over the business is when you are doing your investigation, not the day after escrow closes.
Verification of things that are not on the Financial Statements:
It is a common occurrence that businesses do not record all of their income on their financial statements. Yes, this is true. Many people do not, in fact, report the truth on their tax returns. In fact, when I am talking about small retail or service businesses that deal with the public directly, I find it is over 90%. “Will the people with an honest set of books, please leave the auditorium. There are two golf carts outside waiting to chauffer you home. You do not need to hear this.”
The balance of this article will discuss how a buyer might do their “Due Diligence” for different types of businesses. These types of businesses include Restaurants, auto repair shops; real estate services contractors, non-real estate repair/ services, and retail stores.
Restaurants- Non-Franchise:
Restaurants compose over 25% of all businesses for sale. This is not because they all go broke, as the SBA reports. It is because 28% of all retail businesses are food service or food sales. It is the largest segment of the consumer market. Because it is a retail consumer business, it deals in 33% cash. Every independent-non-franchise food service business I have been into shows zero profit on the books. Some even go overboard and show a tax loss. It is because they do simple tax planning that does not require an MBA degree to figure out. If the business doesn’t show all of its cash, or any of its cash, the expenses will equal the reported income. This alone makes it attractive to many buyers. We will not discuss the moral issues of this attitude; it is what it is. What we have to discuss is how do you, the buyer, can prove that the business is making a profit? And if it is, how much?
Restaurants come in two categories. 1. Fast food-counter sales. 2. Sit down. Fast food restaurants have computerized cash registers that record the sales into its computer, which has a memory. This memory has daily totals going back to the beginning of the computer’s history. Most owners close out their cash registers at the end of the day and print out the tape of each day’s activities. This does not automatically wipe out the information for the day. The computer does, I am told, have a delete button on it allowing the owner to wipe out the full memory in the computer, in the event of an audit. I have also been told, but do not believe, that an electrical blackout can wipe out the memory in the computer and that is why one seller said he couldn’t give me access to this information.
If we are talking about a sit down restaurant sales information, you can use the daily order ticket, which are then imputed into the computer. This gives 3 sources: tickets, computer and daily tape totals.
When this information is not available, for any reason, an experienced restaurant consultant can tell you the sales activities just by inspecting the restaurant and counting the number of customers eating at 4 key times in a day, and on several key days per week. Then the consultant can figures out what the average sales ticket amount is. With this information like magic the consultant knows the gross sales figure, for the year.
A double check procedure for restaurant consultants is to then look at the food purchases and its costs and can confirm that it matches the actual sales figures. One consultant that was hired to review a Johnny Rocket restaurant for $7,000 did the audit and put together a marketing program for the buyer. The marketing program included delivery and catering. Both of which do not normally show up on the computerized cash register.
Restaurants - Franchise:
You would imagine that franchise restaurants records would be very accurate because the franchise company gets a percentage of the gross income. The bigger ones connect up to the individual franchise and know what is happening faster then the owner. As stated above, the only sales that can be made and not declared to the computer are catering or delivery orders, which could be done without ringing them up.
Some franchises do not hook up to the individual franchise computers and do not do audits regularly. This allows the franchise to report reduced income to the company and the IRS. In case either comes to audit, they press the delete button on the computer. If you as a buyer can get access to the computer you know the numbers are correct even if they are not complete. It is impossible for the staff or the owner to change the computer records. The information can only be deleted. Again catering and take out may not be on the computer. Theft from employees can only be in the form of 1. Employees that give free food to friends. 2. Employees not ringing up an order, which is difficult when businesses put up signs saying, “If you do not get a receipt, your order is free.”
Some sellers are so paranoid of the IRS, they are not willing to show anyone their private records or computer tapes for fear that the buyer could be an IRS agent. My personal opinion, and what I advice sellers to do, is to get their books legal and honest and hire themselves a top notch CPA, like Donald Trump, and use every legal trick in the book. Martha Stewart didn’t go to jail for inside trading. They got her on lying. There are legal ways to avoid taxes so that fraud is not necessary. If you cannot find a good accountant, I will recommend one.
If you ask someone "Are you a government employee or IRS agent?" and they lie to you; that might be considered entrapment and a good possible defense in court. But, I ask you. Is it worth the grief?
The normal action of sellers, in this situation, is to require that the buyer take the business based on the recorded records and guess as to how profitable the place really is. This is a very difficult situation for the brokers and buyers, since sellers do not price their business based on these reported numbers but base their price on the real numbers.
I hope this is of some help to you in doing due diligence on a restaurant you might be interested in buying.
Auto Repair Shops:
Auto repair shops are almost as bad as restaurants when it comes to under-declaring cash. The normal procedure for most, I have run across, is to declare only the checks and credit card charges. The cash they put into their pocket. The good thing, in doing audits is that almost every one of these owners keeps their work orders-invoices. These are kept in monthly manila folders and put into a drawer or file cabinet. They never tell you that they keep these records, but they do. They even tell me, as the broker, that all backup documents have been destroyed, but they are not. When I insist that they cannot sell their business without providing these invoices, they tell me of their existence. With the sales invoices an audit of income becomes simple. Since the sellers keep them in a manila folder by months, you only have to pick monthly folders at random and total the actual invoices. Then compare them to what the “State Board of Equalization” report says and calculate what percentage of the total was declared. If you do this for a few months, a pattern will develop. Some sellers have even run a calculator tape of the month’s activities and/or written it in a private ledger. You can check the actual invoice tapes against the private ledger records to confirm the private ledger information is correct.
Real Estate Services/Repairs Contractors:
Real estate service contractors include new construction general contractors and sub-contractors, contractors that come to your house to offer repairs on your house (plumbers, heating and air-conditioning contractors, gardeners, landscapers, termite companies
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