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Uncover Hidden Problems In Due Diligence When You Buy A Small Business


Uncover Hidden Problems In Due Diligence

When someone is trying to buy a small business in California, he or she usually wants the opportunity to examine the books closely in order to make sure the seller's claims about the company's performance are accurate. The majority of buyers understand that once there is an agreement in writing, the buyer will be permitted to meet with the seller's accountant to look at the books.

This is important in the due diligence part of a transaction. Many buyers are not aware, however, of the ways the seller might present the company in a manner that passes quick inspection, but does not readily reveal some of the problems with the business.

Among those issues to look out for are:

1. Cost of goods statement does not accurately reflect what is happening - Henderson was prepared to purchase a retail store from a baby boomer ready to retire. He knew in that business's particular industry that it was customary to mark up each item for resale 100% - a retail price twice what it cost when purchased from the wholesale suppliers. The company's records showed cost of goods, which had been 48% of total revenues a few years before, declining each year to its most recent financial statement showing 28%.  The seller said the lower costs could be attributed to smart negotiating with suppliers and boosting mark-ups on popular items. Henderson's accountant noticed a substantial decline on another part of the financial - the balance sheet - in the amount of inventory held for resale in each of the last five successive years. Upon further examination, Henderson and his accountant discovered the main reason for the decline in cost of goods sold is that the seller, wanting the business to look profitable, was drawing down on his inventory to make sales. But was not replenishing his stock. This made it appear, incorrectly, that the cost of goods was declining.

2. Receivables reveal the truth - the prospective buyer of an industrial parts supply company is another Californian who insisted on examining the firm's balance sheets, not just the profit and loss statements. The P&Ls showed consistent profit over the past several months. But it took just a quick review of the balance sheets to notice how the receivables figure was growing with each month's report.  After some more investigation and close questioning of the seller, the buyer determined that the company might be showing a profit, but if it was not collecting much of what was owed by customers, the profit figures were meaningless. The profit showed only on the P&L, but never made it to the bank statement.

3. Understanding non-cash expenses, such as depreciation - The seller of a Southern California machine shop had several interested buyers. The one who secured a purchase agreement with him, contingent on due diligence, was particularly excited to complete the purchase because he had ideas for expanding the business. There was little profit shown in the company financials, but the seller pointed out the substantial sum allocated to the depreciation item in the column of business expenses. And the seller said: "Everyone knows that depreciation gets added back when you total up the real earnings for an owner." The problem with this explanation was that much of the equipment had outgrown its value. If it was to continue to be viable, the company needed more modern machinery equipped to respond to computer instructions.  And several items on the equipment list were not really used because they no longer worked properly. The two parties did come to an understanding about a sale, but it involved a much lower price, so the buyer would have the cash needed to invest in new equipment.

4. Suspicious payroll figures - The hopeful owner of a Central California mini-market was satisfied with his review of the business records during his due diligence after reaching an agreement about price and terms with the seller.  Fortunately, the due diligence professional working with him was not so easily fooled. She wondered how the business could function with a labor cost that equaled only 17% of gross sales. The seller insisted that all employees, including his wife and daughter, were paid wages that were standard in the industry. The due diligence expert conducted some quick calculations using number of shifts per employee per month and the total amount paid out in labor costs for the same period. The results showed that employees were working for an average of about five dollars per hour. It was finally determined that family members were not receiving money for their long hours behind the cash register. The buyer decided to look elsewhere for a business to buy.

5. Sweetheart deals - The smart due diligence professional, and a smart buyer for that matter, looks closely at the customer makeup of a business being considered for purchase. It usually is not a good sign when a company is selling its products and services to a small market of just a few people. And it's particularly worrisome if a large source of its business originates with someone who has a close personal relationship with the seller. That was the case with an ad agency that derived half of its income from a manufacturing company owned by the brother-in-law of the ad agency seller. The prospective buyer was not informed about this relationship, but became suspicious when learning the ad agency had signed service agreements with all of its clients, except for the manufacturing company. The buyer feared that once she took over the business, half of its income could disappear without warning.

These seem to be obvious factors that reveal a business is not as profitable and solid as suggested by the P&L statements. But these and other examples demonstrate that some buyers, in their excitement about becoming business owners, don't always see what should be obvious. The smart buyer avoids being fooled when he or she works with a due diligence expert and looks thoroughly to find out if there is a different truth behind the figures.

Peter Siegel, MBAAbout The Author: Peter Siegel, MBA is the Founder & Advisor (ProBuy & ProSell Programs) at BizBen.com. He works with potential business buyers, business sellers, brokers, agents, investors, & advisors. Reach him direct at 866-270-6278 to discuss strategies regarding buying, selling, (or financing a puchase of) small to mid-sized businesses.


Categories: BizBen Blog Contributor, Buying A Business, Deal And Escrow Issues, Due Diligence Issues, How To Buy A Business


Comments Regarding This Blog Post


An important an often overlooked due diligence matter is expenses of the business - labor, materials, or services - that have been paid outside the business by the owners, whether by check or by cash. These unreported, unrecorded expenses are really reductions in profit - and they can be substantial, sometimes wiping out the purported profit completely.

Contributor: Due Diligence, Valuations Advisor

Meeting with the sellers accountant and particularly getting bank statements and tax returns for 3 years is, in my experience, the only sensible way to go about this. Even then it is not going to guarantee success in the due diligence process.

For example many small to mid- market operations file their tax returns on a cash basis and keep books on an accrual basis. If the seller holds bank deposits at the end of a particular year to save taxes (illegal but it happens) and does not do the same in the following year then the cash basis income in the second year is pumped up substantially. The business shows stellar growth in cash flows going into the year of sale. And cash flows not accrual based profits are the name of the game.

Also regardless of whether the business is using cash basis or accrual based accounting the revenue represented should flow through the bank sooner or later, or there is a problem. Some types of enterprises deal in cash. Sometimes (read all the time) the cash does not find it's way to the bank. The question then is did it get passed around to labor or suppliers. Benchmarking the P and L should help with that process. If the entity is a restaurant and it is a franchise the franchisor might be able to provide information for benchmarking.

Finally, depreciation is REAL and not just a tax thing. The tax code is out of sync with the economic value of most types of equipment. However, the equipment will sooner or later have to be replaced.. Better to recalculate depreciation on an economic life basis, and take it into account, than just ignore the concept.


  Helpful Resources To Assist In Selling And Buying California Businesses
Diane Boudreau-Tschetter: Escrow And Bulk Sale Services

California Business Escrow, Inc. is a full service independent escrow company serving all of California and has expertise in a wide range of escrows. Our team prides itself on providing an exceptional escrow experience. For more info phone Diane Boudreau-Tschetter at 888-383-3331 or 209-838-1100.

Mark Chatow, Esq.: Legal Services For Buying, Selling Businesses

Mark has a broad range of small business purchase & sale experience from analyzing potential acquisition targets to successfully guiding buyers and sellers through the purchase & sale of small businesses. Mark can assist with contracts, negotiations, legal matters, etc. Reach Mark at 949-478-8393.

Willard Michlin, CPA, Certified Fraud Examiner, Due Diligence Services

Willard Michlin, CPA #106752, offers buyers step by step training & assistance in doing Due Diligence Services when they are thinking of making an offer, or are in process of investigating a business purchase. He helps to determine the actual net profit even when there is cash. Call 805-428-2063.

Brad Steinberg, Broker - Laundromat Specialists

Laundry specialists - founded in 1968 by three laundry professionals, PWS is a family-owned corporation. Through the years it has grown to become the largest vended laundry equipment distributor in the United States. Call Brad Steinberg at 323-721-8832 to sell or buy a coin or card laundromat.

Janet Carrera - Escrow & Bulk Sale Services - SF Bay Area

Redwood Escrow Services, Inc. is a full service, licensed independent escrow company. We are EAFC Fidelity bonded, fully insured & licensed with the Department of Corporations. Committed to offering our clients the most comprehensive variety of escrow services available. Phone Janet at 510-247-0741.

Helen Yoo: Escrow & Bulk Sale Services - Southern California

New Century Escrow, Inc. is a fully licensed & bonded independent escrow company. Over 20 years combined experience in handling bulk escrow transactions. Multi-lingual staff that speaks your language, including Korean, Chinese, Vietnamese. Call Helen Yoo direct at 626-890-1151.

Elizabeth McGovern: Escrow Services - SF Bay Area

McGovern Escrow Services, Inc., is a leading independent escrow company. We are a trusted partner with our clients, assisting them through the tangled bulk sale & liquor license transfer process. We provide attentive, quality & innovative customer service. Phone Elizabeth McGovern at 415-735-3645.


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