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Cash Based Businesses: How Do I Confirm Cash Being Represented?

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Comments & Replies: 5     Views: 3642     Posted By: Peter Siegel MBA  Peter Siegel MBA: BizBen Founder, ProBuy/ProSell Program Director

A buyer who I have been consulting with on the BizBen ProBuy Program is looking to buy a liquor store (and possible other "cash" oriented businesses). They asked me how they should verify cash being generated by the business and how to go about conducting due diligence etc.

Topics: Buying A Business, Due Diligence     Tags: buying a business, deal structures, due diligence



A buyer who I have been consulting with on the BizBen ProBuy Program is looking to buy a liquor store (and possible other "cash" oriented businesses). They asked me how they should verify cash being generated by the business and how to go about conducting due diligence, considering that these are mostly all-cash businesses. This buyer also wanted to know if the seller's suggestion about having an observation last one week, is a long enough period of time to verify income.

My answer to this potential business buyer was basically this (but I know there are probably many other solutions to this situation that I am not aware of):

This question comes up frequently from buyers of mostly cash based businesses. They don't have the benefit of a "money trail" to examine, as do buyers who conduct due diligence on a company that sends invoices to its customers and posts all transactions in some kind of record that can then be verified with bank statements.

There is no fool-proof way to verify sales of an all-cash business unless the buyer is "stationed" on premises for several days during the time the business is open, to make note of every transaction. And even that's not a perfect method. Sellers have been known to ask friends and relatives to come to the business, pretend to be strangers, and make a purchase during the due diligence period. That tactic could give the buyer the impression the business conducts more sales and collects more money than is normally the case. And I know of a situation in which a buyer "observed" a gift shop during an unusually slow period. She didn't believe the seller's explanation that there's usually more business than occurred during the due diligence week. Another buyer with a back-up offer was able to close a deal on the business. The first buyer later learned that sales had, in fact, been slower than usual during her due diligence observation, and was sorry she didn't believe the seller's explanation.

Sellers aren't always agreeable to the idea of someone "lurking" around their place of business for a week or longer, because it can disturb customers and employees. And it might be obvious that the business is for sale if people conclude that the person is checking out the amount of sales conducted. A typical seller solution is that he or she will save each day's cash register tape, if the business has that capability, for examination by the buyer after the business closes. That's only an effective way to conduct due diligence if the seller is careful to ring up the exact amount of each transaction, and not post exaggerated amounts or ring-up "make believe" sales.

One solution a buyer proposed was that different members of his family would come to observe at different times, acting like customers. Another suggestion was that the buyer be permitted to operate the cash register, under the pretense that he was a new employee being trained, during what actually was the due diligence period. That worked well in connection with a deal for a dry cleaning plant. Due diligence began the day after the agreement was signed so the money collected, at least during the first few days, would represent work on garments and linen that had been brought in before the sales agreement. There was no chance the business had been "staged" with customers.

The seller who brags that there is more income than is shown on the books - that some of the cash goes directly into his pocket, is likely to be just as dishonest with a buyer as with the taxing authorities.

There is no established period of time over which due diligence should be conducted. The custom is a ten day or two-week period during which the buyer looks into the business more thoroughly than when he was viewing it before and during negotiations. Many, if not most deals call for a two-week due-diligence period. Sellers reluctant to let the buyer have that much time might have something to hide, but more likely just doesn't want the due diligence process to disrupt the business and "frighten" employees, customers, and vendors.

Rather than insisting on a very short due diligence period, the seller might look at that investment of time as legal insurance, reducing the likelihood of the buyer claiming there was not enough time to really analyze the business and then suing the seller for misrepresenting critical facts about the business offering.

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So fellow BizBen Users - what words of wisdom, tips would you have for buyers who are looking to buy cash based businesses - how do you deal with these types of businesses and verify their claims of income, etc? What strategies would you suggest buyers implement to verify income and feel comfortable with this type of business purchase - both in the pre-sale and due diligence stages of a possible business purchase? Please give your thoughts, examples of past deals, and ideas via the Comments section below.


This is a tough situation and all of Peter's suggestions are beneficial, depending on the situation. No one method works for all transactions and I would counsel a buyer to use a few redundant methods to be truly confident in their conclusions about the "off-books" cash.

One very important caveat is Peter's statement: "The seller who brags that there is more income than is shown on the books - that some of the cash goes directly into his pocket, is likely to be just as dishonest with a buyer as with the taxing authorities."

I have encountered additional methods that a buyer might consider if the resources exist.

Sometimes the owner won't report the income but will regularly deposit the cash in their own or a relative's personal bank account. The buyer can be shown these accounts.

One seller allegedly had several years worth of cash stashed in safe deposit boxes and offered to show any serious buyer their stacks of U.S. currency.

Some buyers will have notebooks of some kind. Frankly, the messier the better.

In other words, be very sure that these notes were actually produced contemporaneously over the years and not concocted just when a sale of the business was pending.

Final caveat: the new buyer hopefully is going to be more honest than the seller; therefore, the taxes that will be paid on this cash income will diminish the amount inuring to the benefit of the buyer. In other words, any buyer should consider the after-tax value of any heretofore unreported cash when determining the real cash flow (or SDE) and the value of the business to the new owner.

Contributor: Business Broker, Orange County

I try not to judge people, since most people who judge haven't been backed into a corner before. I'm not saying that people should do the wrong thing, but after studying the books and records of hundreds of businesses in Orange County, I can honestly say that its a tough place to make a buck. Entrepreneurs are typically survivors by nature and they will find a way because they have to.

In my experience, the larger the business the less shenanigans with the books. There are several ways to find out what's really going on in a business but you should be buying the business for what YOU can do in it because there are really no guarantees when you own your own business. One of The best ways to know what the real gross is to just focus on the receipts for the COG (cost of goods). If you can accurately be sure the COG is right, then calculate what the margin should be (because it should be too high on the P&L) then you'll know what the real income was. Just make sure you've accounted for a variation in inventory year to year.

There's huge element of chance when buying any business. Buyers who are realistic about their expectations end up being successful. A cynical buyer once gave me a good laugh when he said, "I don't think he (the seller) is lying by more then 10%, let's make an offer". If buyers look at he worst case scenario and its still acceptable, then they are going in with eyes open and they will probably land on their feet.

Contributor: Business Broker, Northern California

There is an expression in business brokerage that says that if a seller receives cash and doesn't show it on their business tax returns, then they can't expect it to be included as part of the sale of their business and therefore be paid twice.

Additionally, a bank will not lend to the buyer of a business any data that doesn't show on a tax return as they know that if the seller of the business is audited by the IRS and found to have not declared any income the business can be shut down.

A new concern for business sellers that do not report all their income but want a buyer to recognize it when selling their business is that the IRS and now the State of CA have whistle blower programs.

Replies To This Comment
 
Any prudent buyer will also look at the after-tax value of any unreported cash income claimed by the seller, if the buyer will consider it at all. By counting the cash income at its pre-tax value, sellers can have unrealistic expectations about the true value of their business.


Contributor: Business Appraisals, Valuations Advisor

When I do an appraisal on a business that may have cash income that is not on the books, I inform the client that the appraisal would be based only on the financial statements and tax returns. If there is any cash not reported it is up to the client to decide if he wants to believe it or not, but I will not include it in the appraisal. There are certain types of businesses that I avoid doing appraisals on because I don't believe I could provide an accurate appraisal.

Replies To This Comment
 
Appraisals or market evaluations of a business can only be based on verifiable facts. Bob is absolutely right--unreported cash is unverifiable and has no place in determining market value.

As a business broker, I am asked to establish a reasonable market value for the businesses I represent. I'm brutally frank with sellers claiming unreported cash income: they have already gotten their return on that money--illegal as it may be, and they will not get it a second time from a any sensible buyer. In fact, they may get even less because the buyer doesn't know how trustworthy the seller is about other matters.

My advice to business owners who have been hiding income and who now want to sell their business for top value: start reporting the income, show a dramatic increase in revenue, and sell the business a year from now.



  Helpful Resources To Assist In Selling And Buying California Businesses
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.

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.

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 800-864-0420.

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.

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.

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.


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