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

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.

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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.


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.

I've had buyers who mainly rely on "visual observation" for their due diligence, because they would estimate the average ticket price (receipt per purchase) and then multiply by how many people walked through the door, and some are so good that they have it within a few hundred dollars. The buyers, say for a coffee shop, will then look at the inventory receipts to see if the seller really does buy enough milk, or other product to do the business they say they are doing. The buyer will look at inventory billing receipts going back a year to eighteen months, because the seller could possibly be "upping" their purchases because they know a buyer would look, but doubtful they would be eating a huge cost for eighteen months or so, too expensive. Inventory billing receipts plus visual observation, and yes, they could have family or friends try to increase sales, but many buyers can tell over a number of days, because they look for a natural flow of customers, and can tell. The art of visual observation is really only something that a seasoned business owner can do, and are buying a business that is like or as one they previously owned.

Contributor: Business Broker: Southern California
It's very easy for a Seller to say they take an additional $10K in cash per month out of the business. It's much harder to prove it - if they even want to go down that path. And given the number of credit card/debit card transactions these days, I think the days of 50% of your sales as unreported cash are gone.

That said, I think it boils down to a couple of things:

1. Does the unreported cash makes sense given the type of business and industry norms? For example, if a small pizza shop is doing $300K per year in revenues, showing 25% food cost ($60K), and shows a book profit of $60K per year, that makes sense. But if the seller says he is taking another $100K out per year in cash, look at what those unreported revenue does to the food cost. Basically the seller is saying revenues are really $400K, but since his actual food costs dollars spent didn't increase, how that $60K in food costs represents 15% of revenue. Pizza food costs are low, but you have to ask yourself is that even possible? I think each case of unreported cash needs to pass the "sniff test."

2. As a broker, I have three rules regarding unreported cash. First, the Seller must sign off on the advertised net which would include the cash. I am not going to represent any number that the seller will not sign off on themselves. Second, I don't want to be involved with the due diligence on unreported cash. The buyer and seller can meet and discuss anything they like, but I don't want to be a part of it. And Third, if there is an outside lender involved, I will NOT be part of it. It's one thing for a buyer who is paying cash, or doing a deal with seller financing, to make a decision about the viability of a business that has unreported cash. But quite another to be involved with a transaction where the lender is a third party and likely using the SBA guaranteed loan program. Its just not worth it!

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.

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.

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.

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.

BizBen Blog Contributer Buying a Business

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