tax returns
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 100000 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 someones word. Actually you should never buy anything on someones 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 doesnt 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 $500000 profit per year. Due Diligence showed it was only making $300000. 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 $300000 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 owners 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 shouldnt 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 marketa