Salon Business Due Diligence
In most of my writing, I talk about fraud and misrepresentation by sellers to buyers. I have come to realize that the problem is much deeper than I thought. The buyer’s and business names below are real.
Dr. Charles Partito is an experienced business buyer. He reports that he has bought eight businesses over the years. Of those, five of the purchases were what he expected and paid for. Two of the three bad deals, he had hired a professional to assist with due diligence, but he did not get what he thought he was paying for.
The first story is about a real estate broker that he hired and paid $4,000 as a down payment for research and other due diligence on a piece of Arizona property he wanted to buy. The broker took his money and never did a single thing. Dr. Partito sued in small claims court and received a judgment. He has now turned the judgment over to an attorney for collection.
Make Sure the Person Who is doing Your Due Diligence is what he Claims to be.
The second story I find quite interesting. Dr Partito lives in the Lake Arrowhead area and he entered escrow on the Kenneth George Salon, Inc. in Santa Monica. Charles’s wife Shirley looked in the yellow pages under accountants/accounting to help do an audit of the business books. She found an accounting firm we’ll call “Cutting Edge Accounting” (not the real name). Shirley explained to the accountant what she wanted. The accountant responded with “That is exactly what I do.”
The accountant then asked if they would also like a business valuation to determine the appraisal value of the subject business. Shirley responded in the affirmative and hired the Cutting Edge firm to do the business valuation and audit the sellers company. Dr. Partito was given Business Valuation Report (BVR), which was given to me to review.
This report clearly states that the accountant did a detailed financial review, including comparing the bank statements to the financial reports. It also says that the business was clearly worth more than the buyer was paying for it. The report is signed by the accountant. The report says that assuming the assumptions in the report were correct the business was worth more than the $300,000 purchase price. Since the accountant did a detailed financial review, Cutting Edge was setting up the assumptions based on the financial review.
The buyer purchased the business and proceeded to spend money to upgrade the salon. He did no other review or evaluations on his own, because he had hired an expert to watch his back. Shortly after he bought the business he realized something was wrong. He discovered that the payroll figures reported by the seller were wrong. He discovered this because the seller had hired a major payroll service to write payroll and file quarterly and annual payroll tax returns. The accountant never asked for the payroll records, and could not have looked at the quarterly payroll returns. The seller reported that payroll was 40% of the gross income. The payroll returns showed 70%.
The 30% difference in payroll caused the $300,000 in profit to become a loss. One indication that the business was always in trouble became clear only at the close of escrow. The IRS attached all the sellers’ funds to pay back taxes. You might ask or should ask: How does someone doing a detail financial review or audit miss this kind of an critical problem? How can this kind of error occur? Because of legal liability, I cannot express an opinion in print. You have to reach your own conclusion.
After one year of pouring more money into the salon attempting to save it, the doctor closed the business. He then went to attorney John Wurm, who was very positive upon hearing the story. John took a $3,000 retainer and reviewed all the documents and wrote a letter to Cutting Edge Accounting. Cutting Edge had their attorney respond claiming no legal responsibility for the report being inaccurate. John Wurm then informed the doctor that the cost of litigation would be so excessive, and the low probability of collecting – even if the case was won – didn’t make economic sense. Not being an attorney, but based on my research and experience, the attorney was probably correct on that count.
When Charles Partito called me, I went through my usual questions and asked for the Business Valuation Report (BVR) . The doctor told me a CPA had done the audit and valuation report. My research quickly showed that Cutting Edge was not a CPA. The designation on the report said CTP, which I venture to guess means Certified Tax Planner. But, I found nothing to show me what this designation meant. The web site shows they do tax returns, not detail financial reviews or audits. Charles was led to believe he hired a CPA. Even when I told Charles that Cutting Edge was not a CPA, he did not believe me. He had to have his wife call the firm to check.
The BVR is a preprinted standardized form that anyone selling these reports just fills in the blanks and lets the program tell them what the conclusion should be. The standardized report is not designed for doing audits of companies, but only to value a business based on true data being presented.
Sellers usually hire consultants to do these kinds of reports so that they know what the value is that should be used for a selling the business, divorce, gift taxes, death taxes, or just to convince a buyer. People believe that if it is in a written report that it is true.
A report like this is only as good as the person filling it out and the numbers fed into it. Garbage in still produces garbage out. Also the valuation method used in the report is based on net profit and gross sales only and therefore different types of businesses are not valued differently. This report was not based on Fair Market Value, which is determined from comparables of closed transactions, of only hair salons. Residential real estate is appraised on market comparables for valuations. A hair salon is not worth the same as a manufacturing company or retail store. The program used by Cutting Edge does not take this into account.
Dr Partito has taken his losses and is going on with his life. Next time he will do a complete due diligence on the people he hires to do due diligence.
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