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

Introduction:this."The balance of this article will
discuss how a buyer might do their "Due
This article is written as a generalDiligence" for different types of businesses.
discussion on the subject of "Due Diligence".These types of businesses include
It is for informational purposes and notRestaurants, auto repair shops; real estate
intended to be a definitive guideline forservices contractors, non-real estate repair/
your exact situation. You should consult theservices, and retail stores.Restaurants-
appropriate professionals with regard to yourNon-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 inbusinesses 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 bebecause 28% of all retail businesses are food
aware of when doing due diligence in buyer aservice 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 orservice business I have been into shows zero
Adequate" and Diligence, which is defined asprofit on the books. Some even go overboard
"Degree of care or caution expected of aand show a tax loss. It is because they do
person. Especially as a party to ansimple tax planning that does not require an
agreement." Caution: is the watchword in thisMBA degree to figure out. If the business
definition.Financial Statements - What todoesn'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 amany buyers. We will not discuss the moral
business broker you should have received theissues of this attitude; it is what it is.
business financial statement with a separateWhat we have to discuss is how do you, the
worksheet showing adjustments to thosebuyer, can prove that the business is making
statements. These adjustments show thea profit? And if it is, how much?Restaurants
owner's benefits received from the businesscome 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 personalhave computerized cash registers that record
expenses that need to be added back to thethe sales into its computer, which has a
profit. Depreciation, incomes taxes, interestmemory. 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 autohistory. Most owners close out their cash
expenses, owner life insurance, owner healthregisters at the end of the day and print out
insurance, business entertainment that wasthe tape of each day's activities. This does
not really spent on clients, business tripsnot automatically wipe out the information
not really for business, home officefor the day. The computer does, I am told,
expenses, family cellular phones and muchhave a delete button on it allowing the owner
much more.Make the seller show you theto wipe out the full memory in the computer,
details on some or all of these expenses toin the event of an audit. I have also been
verify that they are really personal and nottold, but do not believe, that an electrical
actually business expenses that shouldn't beblackout can wipe out the memory in the
added back to profit. Spend time askingcomputer and that is why one seller said he
detailed questions with the general ledger incouldn't give me access to this
front of you. Go through individual chargesinformation.If we are talking about a sit
and what they mean, until you fullydown restaurant sales information, you can
understand what is being added back anduse 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 betotals.When this information is not
checked for two reasons. One is you have toavailable, for any reason, an experienced
pay for it. Be careful, you do not want torestaurant consultant can tell you the sales
buy merchandise that is old, worthless andactivities just by inspecting the restaurant
not saleable anymore. Only pay for currentand counting the number of customers eating
marketable product. The price you are supposeat 4 key times in a day, and on several key
to te pay for the inventory is the seller'sdays per week. Then the consultant can
cost. The price for old slow inventory isfigures out what the average sales ticket
negotiable. Always spot check the price andamount is. With this information like magic
count the merchandise listed on the inventorythe consultant knows the gross sales figure,
list. Do people put down that there is threefor the year.A double check procedure for
of an item when there are only two? Ofrestaurant consultants is to then look at the
course, especially when they think no one isfood purchases and its costs and can confirm
going to be checking them out. Comparingthat it matches the actual sales figures.
prices from purchase invoices is how youOne consultant that was hired to review a
check prices. You cannot check every itemJohnny Rocket restaurant for $7,000 did the
against the actual cost but you can do 5% ofaudit and put together a marketing program
the items. Pick at random, not by anyfor the buyer. The marketing program included
suggestion made by the seller or others. Ifdelivery and catering. Both of which do not
you do not understand how marketable thenormally show up on the computerized cash
inventory is that you are buying, hire anregister.Restaurants  -  Franchise:
expert, from that industry. Your broker
should be able to help you in findingYou would imagine that franchise restaurants
someone. Do not be cheap, and think you dorecords would be very accurate because the
not need to spend the money on an expertfranchise company gets a percentage of the
adviser. I will take a lunch bet that theygross income. The bigger ones connect up to
will pay for them selves many times over.Thethe individual franchise and know what is
second reason for checking inventory is thathappening faster then the owner. As stated
if a seller doesn't take inventory at leastabove, the only sales that can be made and
yearly and adjust his inventory value in hisnot declared to the computer are catering or
accounting records, accurately, the profitdelivery orders, which could be done without
figure you are receiving will not beringing them up.Some franchises do not hook
accurate. As a rule, the higher cost of goodsup to the individual franchise computers and
sold, the lower the profit. Some businessdo not do audits regularly. This allows the
owners reduce the inventory value on thefranchise to report reduced income to the
books, intentionally, to a lower value so ascompany and the IRS. In case either comes to
to make the business show a higher cost ofaudit, they press the delete button on the
goods sold, which then creates a smallercomputer. If you as a buyer can get access to
taxable profit. If they do this year afterthe computer you know the numbers are correct
year, the profit may or may not be accurateeven if they are not complete. It is
for the current year. It might take a CPA toimpossible for the staff or the owner to
figure this one out for you, if you do notchange 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 theemployees can only be in the form of 1.
real, current value of the equipment you areEmployees that give free food to friends. 2.
buying with the business. The balance sheetEmployees not ringing up an order, which is
might, if it shows all the equipment thedifficult when businesses put up signs
company owns, give you the cost of thesaying, "If you do not get a receipt, your
equipment when it was purchased. If you areorder is free."Some sellers are so paranoid
buying assets rather than cash flow, theof 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 isagent. My personal opinion, and what I advice
actually being used rather than sittingsellers to do, is to get their books legal
behind the building with other junk.Cashand 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 salesto jail for inside trading. They got her on
volume activities that you have observedlying. There are legal ways to avoid taxes so
against the daily records during your "Duethat fraud is not necessary. If you cannot
Diligence" to see if the volume correspondsfind a good accountant, I will recommend
to what was reported last year in the sameone.If you ask someone "Are you a government
month. If you see income of $500 per day butemployee or IRS agent?" and they lie to you;
the seller shows sales of $1,000 per day, youthat might be considered entrapment and a
need to find out why. Some smart buyers sitgood possible defense in court. But, I ask
in the business all day, watch the sales andyou. Is it worth the grief?The normal action
observe the activities of the staff. Thisof sellers, in this situation, is to require
works if the seller is not putting on a fullthat the buyer take the business based on the
fledge production fraud for you therecorded 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 currentbuyers, since sellers do not price their
sales activity levels? Sellers who keep poorbusiness based on these reported numbers but
records or no records, many times, suggestbase 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 relydiligence on a restaurant you might be
solely on physical inspections alone becauseinterested  in  buying.Auto  Repair  Shops:
the seller can still defraud the buyer. Here
is the most famous of the stories I haveAuto repair shops are almost as bad as
heard over the years.Seller owns a dryrestaurants when it comes to under-declaring
cleaner. The buyer and seller have openedcash. The normal procedure for most, I have
escrow and the deal is subject to a 15-dayrun across, is to declare only the checks and
physical observation period. The sellercredit card charges. The cash they put into
doesn't want the buyer to find out thattheir pocket. The good thing, in doing audits
business volume is very slow. The selleris that almost every one of these owners
tells all his friends to bring their drykeeps their work orders-invoices. These are
cleaning in to the shop for a two-weekkept in monthly manila folders and put into a
period, at no charge. They bring in thedrawer or file cabinet. They never tell you
clothing, get it cleaned, pick it up and paythat they keep these records, but they do.
for it. Later the business owner meets theThey even tell me, as the broker, that all
customers and reimburses all of them for thebackup documents have been destroyed, but
cost of their dry cleaning. The day afterthey are not. When I insist that they cannot
escrow closes all that business trafficsell their business without providing these
stops. Think it never happens? The same isinvoices, they tell me of their
true of restaurants. Seller tells all hisexistence.With the sales invoices an audit of
friends to bring all of their friends in forincome becomes simple. Since the sellers keep
a free meal. Customers pay the bill and somethem in a manila folder by months, you only
time later or at home, the business ownerhave to pick monthly folders at random and
reimburses all the customers for the cost oftotal the actual invoices. Then compare them
their meals.Actual time sellers spendsto 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 reallyfew months, a pattern will develop. Some
works. You are buying an income stream basedsellers have even run a calculator tape of
on a known number of hours of work. Make surethe month's activities and/or written it in a
the seller isn't working 80 hours and tellingprivate ledger. You can check the actual
you he is only working 40 hours, per week. Iinvoice tapes against the private ledger
had an absentee fast food owner tell therecords to confirm the private ledger
buyers and me that he worked part time - 5information  is  correct.Conclusion:
hours per week. Closer inspection showed he
was working 25 hours per week. One autoIt is a hard life when you own your own
repair seller, we'll call him Bob, said hebusiness; you work long hours. Many people
never was at the business, because he had afeel that is better than the alternative,
second full time job. Inspection found he waswhich is to work for someone else, pay high
working 30 hours a week (4 plus hours everytaxes, never know if you will be laid off and
night, and 8 hours on Saturdays).Find outafter 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 sellerwant to make sure you get what you paid for.
does. Is one of them bookkeeping? SometimesMany people believe it is all right to cheat
the wife does the books part time and this isthe taxman but otherwise are very honest
never said. Again you may find the owner doescitizens. Others feel it is all right to
the bookkeeping, at home, every night, for ancheap any poor sucker that comes along. Don't
extra hour. In an auto repair shop, you maybe a sucker, do your due diligence and get
find the owner is doing auto body repairwhat you paid for.Then build your new
work, personally, on Saturdays, which is workbusiness into something you can be proud of
that you, as a buyer, will never be able toand enjoy. While building your new business
duplicate. You need to be sure you know howmake a point to study everything you can
to do every job function that the seller doesabout Tax planning, tax avoidance and
or learn them. The time to find out whatreducing taxes legally. I started in College
technical knowledge you need to have to takelearning about the tax codes, and there are
over the business is when you are doing yourso many ways to save taxes legally, you would
investigation, not the day after escrownever believe it. You will sleep better at
closes.Verification of things that are not onnight, 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 dobuyer can do a simple due diligence and know
not record all of their income on theirthat your business is doing exactly what your
financial statements. Yes, this is true. Manybooks say you are doing.DO YOUR DUE DILIGENCE
people do not, in fact, report the truth onand buying your own business can be a
their tax returns. In fact, when I am talkingpleasant and rewarding experience!Willard
about small retail or service businesses thatMichlin is an Investor, Business Broker,
deal with the public directly, I find it isCalifornia Real Estate Broker, Accountant,
over 90%. "Will the people with an honest setFinancial Distress Consultant, Well known
of books, please leave the auditorium. TherePublic speaker and Administrative/Business
are two golf carts outside waiting toConsultant.
chauffer you home. You do not need to hear



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