It has been said that you cannot judge a man until you have walked a mile in his shoes. Over the years I have done all four functions when someone asked me to help them.
But since setting up Due Diligence Assistance for buyers six months ago I have gained a whole new respect for what knowledgeable CPAs have to work with when assisting their clients in buying a business. With very limited information they must determine if the books are cooked (false and incomplete) and if they are, by what amount.
The truth is that all small businesses have cooked books. Some are especially cooked for business buyers and others were just intended for the IRS. Books set up just to fool the IRS are considered normal set of books. Records set up to fool a buyer are considered fraud.
An Appraiser trying to work with the financial records alone is doing the impossible. Before an appraiser, auditor or due diligence expert can give any opinion as to the viability and profitability of a business he must understand what is happening with the business and industry that cannot be addressed on the financial statements alone. When this information is known the financial review becomes much quicker and in most cases becomes unnecessary.
Let’s take an example: A buyer comes to me about a game store he has in escrow to buy. The CPA was given all the books and back-up documentation. The CPA determines that the payroll records make sense, and the personal expenses written off against the business should actually be added back to the profit. The CPA then informs the buyer that the cash income must be documented and that if it can the financials are valid as adjusted.
An appraiser would value this business one of these ways: 1) He uses only what the CPA or buyer was able to document. This leaves the buyer to determine if the cash is real or not. After that has been determined the appraiser can now give the buyer a value. 2) He appraises the business based on what the Seller claims but cannot document.
Business Appraisal Pitfalls
Business Evaluator is a name that I created for the functions that a Due Diligence Expert would perform. When I did a survey of what people would call the functions of due diligence, I found that many people described what a Due Diligence Expert would do as a Business Evaluation. I now use these two titles interchangeably. Many people claim to provide due diligence service but not the specific service that I describe in this writing. A more complete description can be found on my website. There are few to none providing business evaluations for small businesses. I have found none on the Internet, but I am sure some exist.
Business Evaluators operate on the idea that it is not always about the numbers shown on the books. In fact an evaluator before doing any actual audit of the records himself or turning over the audit to the CPA, would determine if and how the non reported cash could be proven. In truth almost always there is a way to prove the cash. The difficulty is that the seller doesn’t want to prove the cash, even if he can. If he does he exposes himself to one of these three problems: The cash represented to the buyer is over-inflated.
- The buyer now has the ability to send the seller to jail for tax evasion. This is the reason given to the buyer for not being totally open about the cash income documentation.
- There is no unrecorded cash income anymore and the seller is lying. This case usually comes about because the seller, when he decided to sell his business, stops pocketing cash. From that date forward the seller puts all the cash on the books so that the financials show the best picture possible. Of course the buyers are still told that this is a cash business.
The primary function of the Due Diligence Expert is to determine why the seller wants to sell. 50% of the time, the seller really doesn’t know the true reason. It is never the reason given. Therefore don’t ask because you are liable to believe the story. The real reason always makes or breaks the sale. Real reasons include but are not limited to:
- Losing one or more big customers or losing many customers. Marketing has not been successful at finding new customers. Competitors opening up next year, down the street fits into this problem. Being undercut by imports is another.
- One or more employees are stealing and seller thinks he cannot afford to fire the staff.
- The seller was himself cheated when he bought the business and is trying to get out and recover his losses by finding a new sucker. This is the case more often then you think.
In conclusion, being a Due Diligence Business Evaluator is not about being an auditor or appraiser, even though these are part of his functions. It is about being a private investigator; and his assignment is to solve the mystery of “Why does the seller really want to sell?” When you know this, everything else begins to make sense.
Due Diligence Defined: The phrase is composed of two words. Due, which the dictionary defines as “proper or adequate”, and Diligence, which is defined as “Degree of care or caution expected of a person. Especially as a party to an agreement.” Caution: is the watchword in this definition.