| Introduction: | | | | Restaurants, auto repair shops; real estate services |
| This article is written as a general discussion on the | | | | contractors, non-real estate repair/ services, and retail |
| subject of "Due Diligence". It is for informational | | | | stores.Restaurants- Non-Franchise: |
| purposes and not intended to be a definitive guideline | | | | Restaurants compose over 25% of all businesses for |
| for your exact situation. You should consult the | | | | sale. This is not because they all go broke, as the SBA |
| appropriate professionals with regard to your specific | | | | reports. It is because 28% of all retail businesses are |
| transaction or situation. Further, this article is in no way | | | | food service or food sales. It is the largest segment of |
| advocating, suggesting or implying that anyone | | | | the 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 aware | | | | independent-non-franchise food service business I |
| of when doing due diligence in buyer a business.Due | | | | have 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" which | | | | they do simple tax planning that does not require an |
| the dictionary defines as "Proper or Adequate" and | | | | MBA degree to figure out. If the business doesn't |
| Diligence, which is defined as "Degree of care or | | | | show all of its cash, or any of its cash, the expenses |
| caution expected of a person. Especially as a party to | | | | will equal the reported income. This alone makes it |
| an agreement." Caution: is the watchword in this | | | | attractive to many buyers. We will not discuss the |
| definition.Financial Statements - What to look for:Add | | | | moral 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 broker | | | | that the business is making a profit? And if it is, how |
| you should have received the business financial | | | | much?Restaurants come in two categories. 1. Fast |
| statement with a separate worksheet showing | | | | food-counter sales. 2. Sit down. Fast food restaurants |
| adjustments to those statements. These adjustments | | | | have computerized cash registers that record the |
| show the owner's benefits received from the business | | | | sales into its computer, which has a memory. This |
| besides the profit and salary he receives. These can | | | | memory has daily totals going back to the beginning of |
| also be defined as personal expenses that need to be | | | | the 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, business | | | | computer 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 office | | | | computer, in the event of an audit. I have also been |
| expenses, family cellular phones and much much | | | | told, but do not believe, that an electrical blackout can |
| more.Make the seller show you the details on some or | | | | wipe out the memory in the computer and that is why |
| all of these expenses to verify that they are really | | | | one seller said he couldn't give me access to this |
| personal and not actually business expenses that | | | | information.If we are talking about a sit down |
| shouldn't be added back to profit. Spend time asking | | | | restaurant sales information, you can use the daily |
| detailed questions with the general ledger in front of | | | | order ticket, which are then imputed into the computer. |
| you. Go through individual charges and what they | | | | This gives 3 sources: tickets, computer and daily tape |
| mean, until you fully understand what is being added | | | | totals.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 for | | | | you 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 for | | | | days per week. Then the consultant can figures out |
| current marketable product. The price you are | | | | what 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. Always | | | | sales figure, for the year.A double check procedure for |
| spot check the price and count the merchandise listed | | | | restaurant consultants is to then look at the food |
| on the inventory list. Do people put down that there is | | | | purchases 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 be | | | | was 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 check | | | | program 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 suggestion | | | | normally show up on the computerized cash |
| made by the seller or others. If you do not understand | | | | register.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 should | | | | would be very accurate because the franchise |
| be able to help you in finding someone. Do not be | | | | company gets a percentage of the gross income. The |
| cheap, and think you do not need to spend the money | | | | bigger ones connect up to the individual franchise and |
| on an expert adviser. I will take a lunch bet that they | | | | know what is happening faster then the owner. As |
| will pay for them selves many times over.The second | | | | stated above, the only sales that can be made and |
| reason for checking inventory is that if a seller doesn't | | | | not declared to the computer are catering or delivery |
| take inventory at least yearly and adjust his inventory | | | | orders, which could be done without ringing them |
| value in his accounting records, accurately, the profit | | | | up.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 on | | | | the company and the IRS. In case either comes to |
| the books, intentionally, to a lower value so as to make | | | | audit, they press the delete button on the computer. If |
| the business show a higher cost of goods sold, which | | | | you as a buyer can get access to the computer you |
| then creates a smaller taxable profit. If they do this | | | | know the numbers are correct even if they are not |
| year after year, the profit may or may not be | | | | complete. It is impossible for the staff or the owner to |
| accurate for the current year. It might take a CPA to | | | | change the computer records. The information can |
| figure this one out for you, if you do not have a | | | | only 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 the | | | | friends. 2. Employees not ringing up an order, which is |
| business. The balance sheet might, if it shows all the | | | | difficult when businesses put up signs saying, "If you do |
| equipment the company owns, give you the cost of | | | | not get a receipt, your order is free."Some sellers are |
| the equipment when it was purchased. If you are | | | | so paranoid of the IRS, they are not willing to show |
| buying assets rather than cash flow, the equipment | | | | anyone their private records or computer tapes for |
| valuation becomes more important. No one wants to | | | | fear that the buyer could be an IRS agent. My |
| overpay for used equipment. Also check that the | | | | personal opinion, and what I advice sellers to do, is to |
| equipment works and is actually being used rather than | | | | get 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 volume | | | | trick in the book. Martha Stewart didn't go to jail for |
| activities that you have observed against the daily | | | | inside trading. They got her on lying. There are legal |
| records during your "Due Diligence" to see if the | | | | ways to avoid taxes so that fraud is not necessary. If |
| volume corresponds to what was reported last year in | | | | you cannot find a good accountant, I will recommend |
| the same month. If you see income of $500 per day | | | | one.If you ask someone "Are you a government |
| but the seller shows sales of $1,000 per day, you need | | | | employee or IRS agent?" and they lie to you; that |
| to find out why. Some smart buyers sit in the business | | | | might be considered entrapment and a good possible |
| all day, watch the sales and observe the activities of | | | | defense in court. But, I ask you. Is it worth the |
| the staff. This works if the seller is not putting on a full | | | | grief?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 sales | | | | recorded records and guess as to how profitable the |
| activity levels? Sellers who keep poor records or no | | | | place really is. This is a very difficult situation for the |
| records, many times, suggest the buyer doing a 15-day | | | | brokers and buyers, since sellers do not price their |
| visual inspection. This helps but it is very dangerous to | | | | business based on these reported numbers but base |
| rely solely on physical inspections alone because the | | | | their price on the real numbers.I hope this is of some |
| seller can still defraud the buyer. Here is the most | | | | help to you in doing due diligence on a restaurant you |
| famous of the stories I have heard over the | | | | might be interested in buying.Auto Repair Shops: |
| years.Seller owns a dry cleaner. The buyer and seller | | | | Auto repair shops are almost as bad as restaurants |
| have opened escrow and the deal is subject to a | | | | when it comes to under-declaring cash. The normal |
| 15-day physical observation period. The seller doesn't | | | | procedure for most, I have run across, is to declare |
| want the buyer to find out that business volume is | | | | only the checks and credit card charges. The cash |
| very slow. The seller tells all his friends to bring their | | | | they put into their pocket. The good thing, in doing |
| dry cleaning in to the shop for a two-week period, at | | | | audits is that almost every one of these owners |
| no charge. They bring in the clothing, get it cleaned, pick | | | | keeps their work orders-invoices. These are kept in |
| it up and pay for it. Later the business owner meets | | | | monthly manila folders and put into a drawer or file |
| the customers and reimburses all of them for the cost | | | | cabinet. They never tell you that they keep these |
| of their dry cleaning. The day after escrow closes all | | | | records, 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 his | | | | they 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 for | | | | income becomes simple. Since the sellers keep them in |
| the cost of their meals.Actual time sellers spends | | | | a 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 known | | | | Equalization" report says and calculate what |
| number of hours of work. Make sure the seller isn't | | | | percentage of the total was declared. If you do this for |
| working 80 hours and telling you he is only working 40 | | | | a few months, a pattern will develop. Some sellers |
| hours, per week. I had an absentee fast food owner | | | | have even run a calculator tape of the month's |
| tell the buyers and me that he worked part time - 5 | | | | activities and/or written it in a private ledger. You can |
| hours per week. Closer inspection showed he was | | | | check 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. Inspection | | | | It is a hard life when you own your own business; you |
| found he was working 30 hours a week (4 plus hours | | | | work long hours. Many people feel that is better than |
| every night, and 8 hours on Saturdays).Find out what | | | | the 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 of | | | | years of hard work, never have anything to show for |
| them bookkeeping? Sometimes the wife does the | | | | it all.If you are going to buy a business with your hard |
| books part time and this is never said. Again you may | | | | earned money, you want to make sure you get what |
| find the owner does the bookkeeping, at home, every | | | | you paid for. Many people believe it is all right to cheat |
| night, for an extra hour. In an auto repair shop, you may | | | | the 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 a | | | | comes along. Don't be a sucker, do your due diligence |
| buyer, will never be able to duplicate. You need to be | | | | and get what you paid for.Then build your new |
| sure you know how to do every job function that the | | | | business into something you can be proud of and |
| seller does or learn them. The time to find out what | | | | enjoy. While building your new business make a point |
| technical knowledge you need to have to take over | | | | to 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 things | | | | College 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 not | | | | believe 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 the | | | | your business, you can ask top dollar and get it. This |
| truth on their tax returns. In fact, when I am talking | | | | because a buyer can do a simple due diligence and |
| about small retail or service businesses that deal with | | | | know that your business is doing exactly what your |
| the public directly, I find it is over 90%. "Will the people | | | | books say you are doing.DO YOUR DUE DILIGENCE |
| with an honest set of books, please leave the | | | | and buying your own business can be a pleasant and |
| auditorium. There are two golf carts outside waiting to | | | | rewarding experience!Willard Michlin is an Investor, |
| chauffer you home. You do not need to hear this."The | | | | Business Broker, California Real Estate Broker, |
| balance of this article will discuss how a buyer might | | | | Accountant, Financial Distress Consultant, Well known |
| do their "Due Diligence" for different types of | | | | Public speaker and Administrative/Business Consultant. |
| businesses. These types of businesses include | | | | |