| Introduction: | | | | this."The balance of this article will |
| | | | discuss how a buyer might do their "Due |
| This article is written as a general | | | | Diligence" for different types of businesses. |
| discussion on the subject of "Due Diligence". | | | | These types of businesses include |
| It is for informational purposes and not | | | | Restaurants, auto repair shops; real estate |
| intended to be a definitive guideline for | | | | services contractors, non-real estate repair/ |
| your exact situation. You should consult the | | | | services, and retail stores.Restaurants- |
| appropriate professionals with regard to your | | | | Non-Franchise: |
| specific transaction or situation. Further, | | | | |
| this article is in no way advocating, | | | | Restaurants compose over 25% of all |
| suggesting or implying that anyone engages in | | | | businesses for sale. This is not because they |
| any type fraudulent activities whatsoever. | | | | all go broke, as the SBA reports. It is |
| These are simply the things a buyer should be | | | | because 28% of all retail businesses are food |
| aware of when doing due diligence in buyer a | | | | service or food sales. It is the largest |
| business.Due Diligence Defined: | | | | segment of the consumer market. Because it is |
| | | | a retail consumer business, it deals in 33% |
| The phrase is composed of two words. "Due" | | | | cash. Every independent-non-franchise food |
| which the dictionary defines as "Proper or | | | | service business I have been into shows zero |
| Adequate" and Diligence, which is defined as | | | | profit on the books. Some even go overboard |
| "Degree of care or caution expected of a | | | | and show a tax loss. It is because they do |
| person. Especially as a party to an | | | | simple tax planning that does not require an |
| agreement." Caution: is the watchword in this | | | | MBA degree to figure out. If the business |
| definition.Financial Statements - What to | | | | doesn't show all of its cash, or any of its |
| look for:Add Backs: | | | | cash, the expenses will equal the reported |
| | | | income. This alone makes it attractive to |
| If you bought the business through a | | | | many buyers. We will not discuss the moral |
| business broker you should have received the | | | | issues of this attitude; it is what it is. |
| business financial statement with a separate | | | | What we have to discuss is how do you, the |
| worksheet showing adjustments to those | | | | buyer, can prove that the business is making |
| statements. These adjustments show the | | | | a profit? And if it is, how much?Restaurants |
| owner's benefits received from the business | | | | come in two categories. 1. Fast food-counter |
| besides the profit and salary he receives. | | | | sales. 2. Sit down. Fast food restaurants |
| These can also be defined as personal | | | | have computerized cash registers that record |
| expenses that need to be added back to the | | | | the sales into its computer, which has a |
| profit. Depreciation, incomes taxes, interest | | | | memory. This memory has daily totals going |
| expense are add backs that are not personal. | | | | back to the beginning of the computer's |
| Personal includes such things as family auto | | | | history. Most owners close out their cash |
| expenses, owner life insurance, owner health | | | | registers at the end of the day and print out |
| insurance, business entertainment that was | | | | the tape of each day's activities. This does |
| not really spent on clients, business trips | | | | not automatically wipe out the information |
| not really for business, home office | | | | for the day. The computer does, I am told, |
| expenses, family cellular phones and much | | | | have a delete button on it allowing the owner |
| much more.Make the seller show you the | | | | to wipe out the full memory in the computer, |
| details on some or all of these expenses to | | | | in the event of an audit. I have also been |
| verify that they are really personal and not | | | | told, but do not believe, that an electrical |
| actually business expenses that shouldn't be | | | | blackout can wipe out the memory in the |
| added back to profit. Spend time asking | | | | computer and that is why one seller said he |
| detailed questions with the general ledger in | | | | couldn't give me access to this |
| front of you. Go through individual charges | | | | information.If we are talking about a sit |
| and what they mean, until you fully | | | | down restaurant sales information, you can |
| understand what is being added back and | | | | use the daily order ticket, which are then |
| why.Inventory: | | | | imputed into the computer. This gives 3 |
| | | | sources: tickets, computer and daily tape |
| Inventory of resale merchandise must be | | | | totals.When this information is not |
| checked for two reasons. One is you have to | | | | available, for any reason, an experienced |
| pay for it. Be careful, you do not want to | | | | restaurant consultant can tell you the sales |
| buy merchandise that is old, worthless and | | | | activities just by inspecting the restaurant |
| not saleable anymore. Only pay for current | | | | and counting the number of customers eating |
| marketable product. The price you are suppose | | | | at 4 key times in a day, and on several key |
| to te pay for the inventory is the seller's | | | | days per week. Then the consultant can |
| cost. The price for old slow inventory is | | | | figures out what the average sales ticket |
| negotiable. Always spot check the price and | | | | amount is. With this information like magic |
| count the merchandise listed on the inventory | | | | the consultant knows the gross sales figure, |
| list. Do people put down that there is three | | | | for the year.A double check procedure for |
| of an item when there are only two? Of | | | | restaurant consultants is to then look at the |
| course, especially when they think no one is | | | | food purchases and its costs and can confirm |
| going to be checking them out. Comparing | | | | that it matches the actual sales figures. |
| prices from purchase invoices is how you | | | | One consultant that was hired to review a |
| check prices. You cannot check every item | | | | Johnny Rocket restaurant for $7,000 did the |
| against the actual cost but you can do 5% of | | | | audit and put together a marketing program |
| the items. Pick at random, not by any | | | | for the buyer. The marketing program included |
| suggestion made by the seller or others. If | | | | delivery and catering. Both of which do not |
| you do not understand how marketable the | | | | normally show up on the computerized cash |
| inventory is that you are buying, hire an | | | | register.Restaurants - Franchise: |
| expert, from that industry. Your broker | | | | |
| should be able to help you in finding | | | | You would imagine that franchise restaurants |
| someone. Do not be cheap, and think you do | | | | records would be very accurate because the |
| not need to spend the money on an expert | | | | franchise company gets a percentage of the |
| adviser. I will take a lunch bet that they | | | | gross income. The bigger ones connect up to |
| will pay for them selves many times over.The | | | | the individual franchise and know what is |
| second reason for checking inventory is that | | | | happening faster then the owner. As stated |
| if a seller doesn't take inventory at least | | | | above, the only sales that can be made and |
| yearly and adjust his inventory value in his | | | | not declared to the computer are catering or |
| accounting records, accurately, the profit | | | | delivery orders, which could be done without |
| figure you are receiving will not be | | | | ringing them up.Some franchises do not hook |
| accurate. As a rule, the higher cost of goods | | | | up to the individual franchise computers and |
| sold, the lower the profit. Some business | | | | do not do audits regularly. This allows the |
| owners reduce the inventory value on the | | | | franchise to report reduced income to the |
| books, intentionally, to a lower value so as | | | | company and the IRS. In case either comes to |
| to make the business show a higher cost of | | | | audit, they press the delete button on the |
| goods sold, which then creates a smaller | | | | computer. If you as a buyer can get access to |
| taxable profit. If they do this year after | | | | the computer you know the numbers are correct |
| year, the profit may or may not be accurate | | | | even if they are not complete. It is |
| for the current year. It might take a CPA to | | | | impossible for the staff or the owner to |
| figure this one out for you, if you do not | | | | change the computer records. The information |
| have a background in retail.Equipment value: | | | | can only be deleted. Again catering and take |
| | | | out may not be on the computer. Theft from |
| Next thing to check on the financials is the | | | | employees can only be in the form of 1. |
| real, current value of the equipment you are | | | | Employees that give free food to friends. 2. |
| buying with the business. The balance sheet | | | | Employees not ringing up an order, which is |
| might, if it shows all the equipment the | | | | difficult when businesses put up signs |
| company owns, give you the cost of the | | | | saying, "If you do not get a receipt, your |
| equipment when it was purchased. If you are | | | | order is free."Some sellers are so paranoid |
| buying assets rather than cash flow, the | | | | of the IRS, they are not willing to show |
| equipment valuation becomes more important. | | | | anyone their private records or computer |
| No one wants to overpay for used equipment. | | | | tapes for fear that the buyer could be an IRS |
| Also check that the equipment works and is | | | | agent. My personal opinion, and what I advice |
| actually being used rather than sitting | | | | sellers to do, is to get their books legal |
| behind the building with other junk.Cash | | | | and honest and hire themselves a top notch |
| Sales: | | | | CPA, like Donald Trump, and use every legal |
| | | | trick in the book. Martha Stewart didn't go |
| If all income is being reported, check sales | | | | to jail for inside trading. They got her on |
| volume activities that you have observed | | | | lying. There are legal ways to avoid taxes so |
| against the daily records during your "Due | | | | that fraud is not necessary. If you cannot |
| Diligence" to see if the volume corresponds | | | | find a good accountant, I will recommend |
| to what was reported last year in the same | | | | one.If you ask someone "Are you a government |
| month. If you see income of $500 per day but | | | | employee or IRS agent?" and they lie to you; |
| the seller shows sales of $1,000 per day, you | | | | that might be considered entrapment and a |
| need to find out why. Some smart buyers sit | | | | good possible defense in court. But, I ask |
| in the business all day, watch the sales and | | | | you. Is it worth the grief?The normal action |
| observe the activities of the staff. This | | | | of sellers, in this situation, is to require |
| works if the seller is not putting on a full | | | | that the buyer take the business based on the |
| fledge production fraud for you the | | | | recorded records and guess as to how |
| buyer.Fraud: | | | | profitable the place really is. This is a |
| | | | very difficult situation for the brokers and |
| How does a seller defraud a buyer on current | | | | buyers, since sellers do not price their |
| sales activity levels? Sellers who keep poor | | | | business based on these reported numbers but |
| records or no records, many times, suggest | | | | base their price on the real numbers.I hope |
| the buyer doing a 15-day visual inspection. | | | | this is of some help to you in doing due |
| This helps but it is very dangerous to rely | | | | diligence on a restaurant you might be |
| solely on physical inspections alone because | | | | interested in buying.Auto Repair Shops: |
| the seller can still defraud the buyer. Here | | | | |
| is the most famous of the stories I have | | | | Auto repair shops are almost as bad as |
| heard over the years.Seller owns a dry | | | | restaurants when it comes to under-declaring |
| cleaner. The buyer and seller have opened | | | | cash. The normal procedure for most, I have |
| escrow and the deal is subject to a 15-day | | | | run across, is to declare only the checks and |
| physical observation period. The seller | | | | credit card charges. The cash they put into |
| doesn't want the buyer to find out that | | | | their pocket. The good thing, in doing audits |
| business volume is very slow. The seller | | | | is that almost every one of these owners |
| tells all his friends to bring their dry | | | | keeps their work orders-invoices. These are |
| cleaning in to the shop for a two-week | | | | kept in monthly manila folders and put into a |
| period, at no charge. They bring in the | | | | drawer or file cabinet. They never tell you |
| clothing, get it cleaned, pick it up and pay | | | | that they keep these records, but they do. |
| for it. Later the business owner meets the | | | | They even tell me, as the broker, that all |
| customers and reimburses all of them for the | | | | backup documents have been destroyed, but |
| cost of their dry cleaning. The day after | | | | they are not. When I insist that they cannot |
| escrow closes all that business traffic | | | | sell their business without providing these |
| stops. Think it never happens? The same is | | | | invoices, they tell me of their |
| true of restaurants. Seller tells all his | | | | existence.With the sales invoices an audit of |
| friends to bring all of their friends in for | | | | income becomes simple. Since the sellers keep |
| a free meal. Customers pay the bill and some | | | | them in a manila folder by months, you only |
| time later or at home, the business owner | | | | have to pick monthly folders at random and |
| reimburses all the customers for the cost of | | | | total the actual invoices. Then compare them |
| their meals.Actual time sellers spends | | | | to what the "State Board of Equalization" |
| working: | | | | report says and calculate what percentage of |
| | | | the total was declared. If you do this for a |
| Determine how many hours the seller really | | | | few months, a pattern will develop. Some |
| works. You are buying an income stream based | | | | sellers have even run a calculator tape of |
| on a known number of hours of work. Make sure | | | | the month's activities and/or written it in a |
| the seller isn't working 80 hours and telling | | | | private ledger. You can check the actual |
| you he is only working 40 hours, per week. I | | | | invoice tapes against the private ledger |
| had an absentee fast food owner tell the | | | | records to confirm the private ledger |
| buyers and me that he worked part time - 5 | | | | information is correct.Conclusion: |
| hours per week. Closer inspection showed he | | | | |
| was working 25 hours per week. One auto | | | | It is a hard life when you own your own |
| repair seller, we'll call him Bob, said he | | | | business; you work long hours. Many people |
| never was at the business, because he had a | | | | feel that is better than the alternative, |
| second full time job. Inspection found he was | | | | which is to work for someone else, pay high |
| working 30 hours a week (4 plus hours every | | | | taxes, never know if you will be laid off and |
| night, and 8 hours on Saturdays).Find out | | | | after years of hard work, never have anything |
| what job functions the seller does: | | | | to show for it all.If you are going to buy a |
| | | | business with your hard earned money, you |
| Get a list of functions that the seller | | | | want to make sure you get what you paid for. |
| does. Is one of them bookkeeping? Sometimes | | | | Many people believe it is all right to cheat |
| the wife does the books part time and this is | | | | the taxman but otherwise are very honest |
| never said. Again you may find the owner does | | | | citizens. Others feel it is all right to |
| the bookkeeping, at home, every night, for an | | | | cheap any poor sucker that comes along. Don't |
| extra hour. In an auto repair shop, you may | | | | be a sucker, do your due diligence and get |
| find the owner is doing auto body repair | | | | what you paid for.Then build your new |
| work, personally, on Saturdays, which is work | | | | business into something you can be proud of |
| that you, as a buyer, will never be able to | | | | and enjoy. While building your new business |
| duplicate. You need to be sure you know how | | | | make a point to study everything you can |
| to do every job function that the seller does | | | | about Tax planning, tax avoidance and |
| or learn them. The time to find out what | | | | reducing taxes legally. I started in College |
| technical knowledge you need to have to take | | | | learning about the tax codes, and there are |
| over the business is when you are doing your | | | | so many ways to save taxes legally, you would |
| investigation, not the day after escrow | | | | never believe it. You will sleep better at |
| closes.Verification of things that are not on | | | | night, I promise you. Then 10-20 years from |
| the Financial Statements: | | | | now when you want to sell your business, you |
| | | | can ask top dollar and get it. This because a |
| It is a common occurrence that businesses do | | | | buyer can do a simple due diligence and know |
| not record all of their income on their | | | | that your business is doing exactly what your |
| financial statements. Yes, this is true. Many | | | | books say you are doing.DO YOUR DUE DILIGENCE |
| people do not, in fact, report the truth on | | | | and buying your own business can be a |
| their tax returns. In fact, when I am talking | | | | pleasant and rewarding experience!Willard |
| about small retail or service businesses that | | | | Michlin is an Investor, Business Broker, |
| deal with the public directly, I find it is | | | | California Real Estate Broker, Accountant, |
| over 90%. "Will the people with an honest set | | | | Financial Distress Consultant, Well known |
| of books, please leave the auditorium. There | | | | Public speaker and Administrative/Business |
| are two golf carts outside waiting to | | | | Consultant. |
| chauffer you home. You do not need to hear | | | | |