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Due Diligence 101 or What You Do not Know Can Kill You!

Introduction:

This article is written as a general discussion on the topic: "Due Diligence". It is for informational purposes only and does not undertake a definitive guideline for your specific situation. See the appropriate professionals to advise on your specific transaction or situation. Additionally, this article is to be welcomed in any way suggesting or implying is that every in any type fraudulent activities whatsoever intervenes. These are simple things that should a buyer, unless the due diligence in buyer a company aware.

They spent months, the right deal. The seller says that you can not go by what the tax return shows but the business is thus a lot of money, and he can prove it. Their control of the profit and loss statement shows that sales have increased slightly in recent years. Most importantly, and the best news of all is the price is right! Sounds too good to be true? I am sorry to tell you, it probably is.

I think it was Benjamin Franklin, who said: "A fool and his money are soon separated." Mr. Franklin must have known a lot of business buyers. With the purchase of equipment, the break in a month, costs You a few dollars. If you go to a swap meet and cheated, because the watch is made of solid gold really gold plated, it costs a few hundred dollars. If a used car dealer She cheats, turned back by selling you a lemon, where the speedometer was 100,000 miles it will cost you a few thousand dollars. Cheated buying a business can They cost many thousands, hundreds of thousands of dollars. The only investment or purchase as far as I know where you can be cheated out of more money in real estate. Real Estate Fraud may run into the hundreds of millions of dollars and does. They would be shocked by all the people from 1875 to 1950 saw the ads for high-quality homes in Florida purchased and marshes. What about prime Louisiana beach with Alligators living outside the door? I have written a series of articles on fraud and it is getting bigger and larger.

I hope that the point is made. Never buy a shop floor person. Actually you should never buy anything on the word of one person. Confirm Everything, believe nothing and understand that you are not yet complete, to find out what the end of trustees, which is going to surprise you. A similar Example is a well-known by all employers. An employee works for a company for 4 months and complained to the personal officer that was the job easy too difficult. He complained that he needed more training and lower quotas. You feel sorry for him. You talk to him and talk to him about it. You hear and believe all the excuses he gives you for poor production. Finally, he left the blame on you for something, what you have done, this would only imagine that you to give him to shoot. Then you began to participate on the work of finishing his incomplete projects. They are shocked, as you repeatedly that, what he did wrong and what he is covered up, that he did not. This is what happens when you buy a business. Find out all the actions that the seller is not his Employees who had ceased to do, from the day that he decided to sell the company.

Many companies are good. Sometimes the owners have personal Things in her life at home. Sometimes they have medical problems. Often, the companies have is not good and the seller is frustrated. It is very common for a seller too hard to build his business work, but because of the many reasons not to produce it, what the seller wants. He frustrated and one day he will bailing out. This is usually the day when he demands that business broker he met and asks the big question. How long will it take to get me out of this place? In his mind, he's gone. He counts the days until he physically goes out.

Am I afraid of you? Well. It is a plus side. It's worth all the suffering you go through a company when you take a buy in the driver's seat, the marketing activities in place and start driving your own business.

In 2000 I had a client buy a car Soap manufacturing business for $ 2 million U.S. dollars. The seller swore it was U.S. $ 500,000 profit per year. Due diligence showed that it is making only $ 300,000. When presented with the auditors in their report, the seller gave the test was wrong. The buyer bought the company, know that he was paying too much for the business. Why? He had his research on the production and distribution done. He went on supplies made with the drivers and customers. He noted that, during the sales and profits one year could be doubled. After he bought the business, he found two things to be true. The profit amounted to $ 300,000, because my test showed. He managed to raise sales and double profits within 12 months, and did. The seller tries, screw the buyer, but in the end, served justice. The seller screwed himself more as he runs his business by the buyer screwed properly. If he could he sold them for much more than $ 2 million U.S. dollars.

OK, enough with the fun stories for today. Let's get to the last detail, what to do, because search as a "due diligence."

Due diligence is defined:

The set consists of two words. "Due" which the dictionary defines as "right or reasonable", and diligence, as "care and caution is defined expectations of a person. Mainly because 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 make it with the financial statement have received a separate worksheet showing adjustments to those statements. These adjustments show the owner of the services received from the business besides the profit and salary, the he receives. These can also be defined as personal expenses, which must again be included in the profit. Depreciation, income taxes, interest expense are add Backs, which are not personal. Personnel includes such things as family auto expenses, owner of life insurance, health insurance owners, business entertainment, not really used on the clients, business travel is not really for business, home office expenses, family cell phones and much more.

Share the seller to show you the details about some or all of these costs to verify whether they are really personal and not actually business expenses that do not return benefit received. Spend time asking detailed questions with the General Ledger before you. Go through individual charges and what they mean, until you understand what is added back and why.

Inventory:

Inventory of merchandise to be reviewed for two reasons. One is, you must pay for it. Be Careful you do not want merchandise that is too old to buy worthless and no longer salable. Only pay for current marketable product. The price that you want pay for the stock, the seller is cost. The price for old slow inventory is negotiable. Always spot check the price and the quantity of the goods listed on the inventory list. Have people put that there were three one element, if it only two? Of course, especially if they think no one is to check it out. By comparing the prices of Purchase invoices, as you check the prices. You can not point to any actual costs, but you can do 5% of the goods. Choose They randomly, not by any suggestion by the seller or others. If you do not understand how marketable the inventory is that you rent, buy, an expert from that industry. Your broker should be able to help you find someone. Do not be cheap, and you do not think they need to spend the money on an expert. I take a lunch to bet that they pay, it is itself a multiple.

The second reason for the control of the stocks is that if a seller no inventory to make at least once a year and adjust its asset value in its accounts, just that the profit margin you receive will not be accurate. As a rule, the higher cost of goods sold, the lower the profit. Some entrepreneurs reduce the value of stocks on the books, intentionally reduced to a value to make the business show a higher cost of goods sold, which then creates a smaller taxable profit. If, in this year that can benefit or just not even for the current year. It might take a CPA to them for you a picture if you do not have a background in retail.

Equipment Value:

Next thing to check on the finances of the real, the current value of the equipment that you buy with the business. The balance sheet could, if you own any of the company, enter the cost of the equipment when it was purchased. If you buy assets as cash flow, the device Review important. Nobody wants to pay too much for used equipment. Also check that the device works and is actually used, instead of sitting behind the building with other garbage.

Cash Sales:

If all income is reported, check sales activity that you are against the to see daily notes during the "due diligence", said whether the volume corresponds to what was reported last year in the same month. If you an income of $ 500 per day to see, but proves the seller must have a turnover of USD 1,000 per day, you find out why. Some smart buyers sit in the Industry throughout the day, watch the sales and observe the activities of employees. This works if the seller does not fly on a full implementation Production fraud for you the buyer.

Fraud:

How does a seller to cheat buyers at the current sales activity? Sellers who always have a little or no records, many times, beating the buyer a 15-day visual inspection. This helps, but it is very dangerous leave alone, solely on the physical controls, because the seller nor the buyer to defraud. Here the best known of the stories is that I over the years listen.

Seller owns a dry cleaning. The buyer and seller have opened escrow account and the transaction is subject to a 15-day physical Observation period. The seller does not want the buyer to know that the volume of business is very slow. The seller says all his friends, their chemical Cleaning in the shop for a two-week time limit, without costs. They bring in the clothing, get it cleaned, they shall be paid for. Later, the operator takes the customers and reimburses all of them for the cost of cleaning. The day after escrow everything closes business anymore. Think it never happened? That same holds true for restaurants. Seller says all his friends to bring all their friends to a free meal. Customers pay the bill and some time later or at home, reimburse the contractor, all customers pay for their meals.

Actual time spent at work, providers:

Determine how many hours the seller really works. You buy a revenue stream based on a limited number of hours of work. Make sure that the seller does not work 80 hours and tell you, he is only working 40 hours per week. I'd almost say an absent-food owner, the buyer and me that he worked part time – 5 hours per week. Closer examination showed that he worked 25 hours per week. An auto repair seller, we'll call him Bob, said he never had the business, because he had a second full-time job. Inspection, he was working 30 hours per week (plus 4 hours every night, and) 8 hours on Saturdays.

Find out which tasks shall be the seller does:

Get a list of functions that the seller does not. Accounting is one of them? Sometimes the woman is making the books for Part-time and it never said that. Here too, the owner can be found does the bookkeeping, at home, every night for an hour. Can in a garage, find the Ownership does bodywork repairs, personally, on Saturday, the work that is you, as buyer, never, be able to duplicate, to. You must be sure be, you know, like every job function that the seller to get them or not to do. The time to find out what technical knowledge you need to get the business assume, if your investigation is not done, the day after escrow closes.

Review of the things that are not on the consolidated financial are:

It is a common occurrence that businesses do not record all of their income on their financial statements. Yes, that's true. Many people in the Indeed, not to tell the truth about their tax returns. In fact, when I'm talking about small retail or service companies that are directly related to the public, I think it is over 90%. "Will the people with an honest set of books, please leave the auditorium. There are two golf cart waiting outside to your home chauffeur. You do not need to hear. "

The balance of this article will discuss how a buyer of its "due diligence could do for different types of businesses. These types of businesses including restaurants, car repair, property services contractors, non-real estate repair / services and retail stores.

Restaurants-Non-Franchise:

Restaurants produce more than 25% of all businesses for sale. This is not because they all go bankrupt as the SBA reports. It is because 28% of all retail outlets food service or food sales are. It is the largest segment of the consumer market. Since it is to a retail consumer business, is in 33% cash. Each independent non-franchise food service business I have in shows zero profit on the books was. Some go even overboard and show a tax loss carryforwards. It is because they simply do not tax planning does not mean that do not require an MBA to figure out. If the Companies are not all his cash, or one of its cash will be equal to the amount of reported income. This alone makes it attractive for many buyers. We do not discuss the moral issues of this attitude, it is what it is. What we have to discuss is how you know that the buyer can demonstrate that the company will make a profit? And if so, how much?

Restaurants are available in two categories. 1. Fast-Food-counter sales. 2. Sit down. Fast-food restaurants have computerized cash registers, recording the sales into the computer that has a memory. This memory has daily totals going back to the beginning of the history of the computer. Most of the owners to close their accounts at the end of Day and print out the tape of the activities each day. This does not mean automatically deletes the information for the day. The computer does, I am told, have a button "Delete" to destroy it allows the owner to the full memory in the computer in case of an audit. And I have said, but I believe not want to extinguish an electrical blackout computer memory and can therefore said a salesman, he could not me access to this information.

If we are talking about a restaurant selling information sit, you can use daily for tickets, which are then imputed into the computer. This is obtained 3 sources: Tickets, computer and daily tape totals.

If this information is unavailable for any reason, an experienced restaurant consultant can provide you the sales activities only through the inspection of restaurants and counting the number of customers eating at 4 key times in one day, and on several important day per week. Then is the number of consultants, what can the average sales ticket amount. With this information, like magic the consultant knows the gross turnover for the year.

A dual control procedures restaurant consultant, it is then up to the purchase of food and see the costs and can confirm that corresponds to the actual sales. A consultant was commissioned, a Johnny Rocket restaurant review for $ 7000, examination, and together a marketing program for the buyer. The Marketing Program including delivery and catering. Both of which do not normally show up on the computerized cash register.

Restaurants – Franchise:

You would imagine, that franchise restaurants records would be very accurate because the franchise business is a percentage of gross income. The larger connection of up to the individual Franchise and know what is happening faster than the owner. As already mentioned, that the only sales channel can be made without explanation, the computer are catering or delivery, without the ring until it could be done.

Some franchises do not hook up to do not to the individual franchise computers and tests regularly. This allows the franchise to report reduced income needs in society and the IRS. In the event comes to audit, they press the button "Delete" on the computer. If you as a buyer, you can access to the computer that you know the figures are correct, even if they are not complete. It is impossible to change for the staff or the owners of the computer records. The information can only be deleted. Also catering and take It may not be on the computer. Theft by employees can only take the form of 1 Employees give free food to friends. 2. Employees not to call, um, what is difficult is when businesses put up signs with the words "If you will not get a receipt, your order is free."

Some sellers are so paranoid the IRS, they are not willing to show anyone their private records or computer tapes for fear that the buyer could be an IRS agent. My personal opinion and what I advice sellers to do that is to their books legal and honest, and hire a top notch CPA, like Donald Trump, and use every legal trick in the book. Martha Stewart did not go to jail for inside trading. They got her on lying, even if it is not any. There are legal ways to avoid taxes, so that fraud is not required. If you would not find a good accountant, I recommend.

If you ask someone: "Are you a government employee or IRS agent? 'and they lie to you, that could be considered in compression and a good way to defend in court. But I beg you. Is it worth the In the pain?

The normal action of the seller, in this situation it is necessary that the buyer's business on the basis of the documents recorded to take, and guess how profitable the place really is. This is a very difficult situation for the brokers and buyers, since sellers do not price their business based on these numbers reported, but base their prices on the real numbers.

I hope this is of some help to you due diligence on a restaurant in do you think of interest to you.

Garages:

Auto repair shops are almost as bad as restaurants when it comes to cash under-declaration. The normal procedure for most, I've run over, only the checks and credit card charges to explain. The cash, which they in their pocket. The good thing here Audits is that almost every one of them keeps their work orders to invoices. These are kept in manila folders and monthly in a drawer or cabinet file. You never say you think, that these records, but they do. They even tell me how the brokers that all backup documents have been destroyed, but they're not. When I insist that they do not sell their business without having put these bills, they tell me of their existence. With the sales invoices an audit of income becomes simple. As the seller, they retain in a file folder by months, you must select only monthly folders at random and total the actual invoices. Then compare it with what the "State Board of Equalization "report says, and calculate what percentage of the total declared. If you do this for a few months, will develop a pattern. Some sellers have also run a calculator tape of the activities of the month and / or written it in a private ledger. You can check the invoice date strips against the private ledger records to confirm the private ledger information is correct.

Real Estate Service / Repair Contractor:

Real estate Service contractors include construction contractor and subcontractors, contractors who come into your house to offer repairs to your house (plumbing, heating and air conditioning Contractors, gardeners, landscapers, termite companies, roofers, carpet cleaners, cabinet re-modelers, carpet / drapes stores, tile stores, Pool service, pool installation contractors, landscapers, etc. The contractor) if the owner is not the work itself, keep the job tickets, invoices, after they are paid for their services are in cash. If the company has service men, then the owner is usually the dispatcher or other administrative person. Have considered in this situation seller, most likely, all his bills in order to be able to look history records of their customers. You could have not been included on the income of their records, but they will provide the basic files. Theses records may in a total mess, but the records . there If they do not, then buy at the store, the seller can prove to you, or what can be reasonably on what percentage of companies They think based estimate is based cash. What are they only go to prove to you the sum of the checks and credit card fees, which is what the seller to the tax return was declared.

Non Real Estate Repair / Services:

Non-real estate repair / service companies include such things as large and small appliance repairs, barbers / hairdressers, nail shops, massage parlors, health clubs, pet grooming, wedding photographers and movie theaters. These companies usually do not even Leave until a ticket so unless a central cash register for recording income there is no record is ever used. Again this is like a restaurant with cash tapes. If the work is done at the customer site, then studied the soldier Truck schedule. If you work only a few records, some work done out in the field, You can determine what the average repair dollar volume is and then when you calculate how many calls are made on an average day, must You just multiply the two numbers yet.

When we talk about hair salons, nail shops or barber shops, we can receive information about how many chairs will gather there, how many chairs are for rent on a weekly basis and rents, which brings the owner. If the technician is not paying rent, then they are on a commission basis divided. If you know the rental income and the income split you are well on the way to determining the real profit for this type of business. Remember, the income the owner since you as a hairdresser or barber would not ignore the non-owner of the income of the old owner. The old owner will probably rent space from you, that you only add another rented chair to the income.

Retail:

A dealer is a business that maintains a stock of of products that they resale. Sometimes they offer installation, which could then in the service company instead of sitting in retail. The main difference is that they to sell a product, rather than a service. This includes everything from Home Depot, pet shops, clothing stores, souvenir shops, supermarkets, vitamin stores, Shops and sign. Retail stores have cash and daily tapes of their turnover. This is handled much like a restaurant and is likely in the same Thus be examined. (See Restaurant Section Above) In addition to the funds you have information, records, analyzes the buying to the cost of Goods determined as a percentage of the sale price is. This relationship is known to share the cost of the sales price, you can either calculate the cost of goods sold or gross sales, if you either start with. A few smart owners buy a product for cash, to take a tax auditor from it by using the same Preventing manner. If the seller does so, he will confess to you if you ask.

When All Else Fails With a Retail Business:

The only way to protect yourself is disclosure so that you grounds to sue for fraud. Ask the seller put the real sales figures Cost of goods percentage and any other information you're there and can not document on a sheet of paper and then have the seller sign and date the paper. If after completion of the escrow, you can find the seller lied to you, the document type be grounds to sue any fraud or deception. The important thing is in the Be able to show a judge in writing what the buyer tells you, and be able to show that he do so in writing. If the seller said, but Never has it in writing, you can not prove. "If it is not written, it is not so"

Medical Professions and Non Medical Professionals:

Professionals are a form of service business except that they charge a higher hourly rate and to keep them patient / client files. Most People pay their professionals by credit card or check, because these costs are usually tax deductible as medical or financial advice. If the seller not explain the entire income, ask what is a backup copy of records available. Customers always receive receipts for services and payments. There are plates, and find you will have to include all income.

If all else fails in Figuring Cash Income:

When you consider all the previous advice to the documentation, followed by cash income and, in truth, no documentation, you're in big trouble. You may have reached the end of the rope. You now have two options open. 1. Walk away. 2. If you still want to buy this business that I am only one last suggestion. It is not foolproof, but it is a method. Cash is at about 30% -35% Of total sales. You could come this assumption with an actual total mass. Then 50% of the sales on the books, this amount from the credit card to review and distribution. This is not an exact science, it is only an accurate assessment. Cash sales might actually anywhere between 25% and 35%. I never thought that to close it.

Cash expenses Verification:

If you think of unreported cash transactions, which we normally think of undeclared income. Undeclared income is the largest category, but not the only one. The other is non-cash expenses deducted on the books. The largest expense item in this category is cash payroll.

Unrecorded Cash Payroll:

In an attempt to billing, reduce, entrepreneurs will pay some of the payroll of their employees in cash. Why would they do that? Workman's Compensation Insurance, FICA Taxes-Employer and employee portion – federal and state income taxes. Any accountant would be his client: "You are screaming to miss on a legal tax deduction." Let me to explain why one of the tax write-off of expenses would forgo cash.

If you pay an employee $ 100.00 per day, on the books, the worker receives about $ 70.00 net to his account. If you give him $ 80.00 in cash, he is happy. He does not know about going into a higher tax bracket to attend.

An employer must pay to about 10% to cover the employers FICA Federal Employment Agency and other taxes. You as an employer and the workers of the Compensation insurance premium. When we talk about auto repair mechanics compensation insurance alone costs 15%. When we speak, new homes builders, we can talking a cost rate of 25% to 120%. A roofer's compensation premium is greater than his gross salary. Lets what ordinary income tax expense for an employee. The Auto Mechanic insurance in the amount of 25% to the Federal Republic of wages has increased by 10%, give us an output that corresponds to 135% of wages. This comes with the Employer for a payment of $ 135.00 and the employee receives $ 70.00. There is a loss of $ 65.00 per day per employee. Some employers prefer and save $ 65.00 Get the no income tax deduction for the cost. Even with all the unrecorded cash show business, it is not important to have a loss on the pounds, there is no To reduce the need for additional tax deductions. The business is not paying any taxes already.

Then there is the risk that an employee could be injured, and file a claim under worker's compensation insurance, it is common for small companies to show a portion of wages on the books and the balance in cash. This means that a worker earning $ 40,000 a year $ 18,000 could have taken on a W-2 form, creating a very low federal tax rate or no tax due date for all. Since the worker is paid part of his wages on the books when he refers to the work that he fully insured for accidents with injured State Workman's Fund, State Disability Funds, State unemployment insurance and all benefits under Social Security. This is a win-win situation for employers and employees, even if not for the government. As a buyer, you have to calculate all that, and adjust the expenses accordingly.

Unrecorded Operating Expenses:

As an owner to collect as much money, they need a place to spend it. If you make a major purchase, you can pay not only on foot and in cash for a car. The IRS will be notified of this cash transaction. Owner with a lot of cash to pay for all repairs, gardeners and everything for the home, which costs less than $ 10,000 in cash. Why $ 10,000? This is cut off the recording, that a seller or a bank is required to report when receiving funds in cash. If a Entrepreneurs still has too much money, sellers will start paying operating expenses. You start with the cost when the service man gives a discount for cash. I found two restaurants, paid for the hood cleaning in cash, partly because they get a discount for paying in cash. While you can ask the right questions to find out what you pay in cash.

Unrecorded Labor:

Since we are talking about small businesses, the woman comes into the business full-time or part time. One the children can come into a part-time. You need these people who are not paid or consciously. This is another form of cash wages. If this Replace those with paid employees, these costs must be included in the restated profit and loss account calculated. .

Sometimes the members are paid some Wages but not full market value. The adaptation is still needed, but in this case only the difference between the actual payroll in the fair market Amount.

Conclusion:

It's a hard life when you own your own business, you work long hours. Many people feel that is better than the alternative of working for someone else, pay high taxes, never know if you are laid off, and after years of hard work, have never to show for it all.

If you intend to buy a company with your hard-earned money, you want to make sure that you get what you paid. Many people think it's ok to cheat the tax office, but otherwise very honest citizens. Others believe it is all right to cheap any poor sucker who comes along. Do not be a sucker, do your due diligence and get what you paid.

Then build your new business in something that you can be proud of and enjoy. Apart from forming a new company to make a point to everything can, what you are studying, through tax planning, tax avoidance and reducing taxes legally. I started in college learning about the tax codes, and there are so many ways to save taxes legally, you would not believe it. You will sleep better at night, I promise you. Then 10-20 years from now if you want to sell your company, you can ask top dollar and get it. This because a buyer can be a simple due diligence and white that your company is doing exactly what you say and do your books.

Their due diligence and purchase their own business can have a very pleasant and rewarding experience!

About the Author

Willard Michlin is an Investor, Business Broker, California Real Estate Broker, Accountant, Financial Distress Consultant, Well knew Public speaker and Administrative/Business Consultant. He can be contacted at his Ventura, California office by calling 805-529-9854 or by e-mail at Broker@kismetbusinessbrokers.com See other articles by Willard at http://www.kismetbusinessbrokers.com

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