Due Dilegence 101 Or What You Do Not Know Can Kill You! - Part 1

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