Despite stringent disclosure rules which aim to even things up between the supposedly rapacious seller and the innocent purchaser, it’s very easy for a buyer of a small family business to be caught by buying a dud.

If you’re stuck with a dud business as a result of being deliberately deceived you certainly can take them to court. But you don’t need me to tell you of the costs of litigation, the time it takes (years!), and the very real chance you may not succeed anyway.

This article is the third in a series on how to detect the traps and uncover the secrets the seller may be hiding from you.

Even though many disclosure requirements say that the seller must produce a set of audited figures, I know as an accountant that this does not mean the figures are either accurate or complete.

So I did what I always do when I am checking out a business. I asked for the last three years tax returns for the business, and the personal returns of the owners (I’ll explain later why it has to be three years).

Most sellers don’t like being asked for their tax returns, but I always insist and you should too. Some will say you should rely on the audited figures, others will say they have other assets and income they do not want to disclose, and others again will ask you to sign a purchase contract first.

If you have real problems, enlist the help of your accountant. The sellers will usually then cave in on the promise by your accountant that they will keep the extra non-business information confidential.

Trap 9. Hidden Extra Running Costs:

Very interesting. All the figures I had been presented with appeared accurately on the business tax return (which was a partnership, but could also have been a corporation or company). But in their personal returns each of the partners had also claimed extra business expenses against their share of the net partnership income.

They had paid them from their personal bank accounts, but they really were business expenses and if shown as such would have reduced the net profit I was shown.

Another check to make is to take the latest monthly rent and weekly payroll cost,  annualise them – and then compare with the figures you have been given. Sometimes only eleven months rent is paid in a particular year, or some wages are paid by cash and not shown. This check will also pick up rent or pay increases partway through the year.

Trap 10. Buying Stock Through a Second Business:

But what was really an eye-opener was it turned out that they also owned another GRB Shop in a nearby suburb. It had its own bank account and a completely separate set of figures.

A few quick calculations later confirmed what I suspected. The purchases of stock in the second business were significantly higher than the first one on a % basis.

Could it be that they were buying stock for the first shop and paying for it out of the second? It certainly could, and it appeared to me that it certainly was!

If where you are there is no law saying the figures must be audited, it’s all the more important to check the tax returns.

Trap 11. Understating Payroll Costs

In calculating the “true” profit in a sale situation it is quite legitimate to leave out (or “add back”) certain expenses such as financing costs that belong to the seller and depreciation (tax allowances for the annual reduction in value of plant and equipment etc).

But it’s another matter altogether to for instance not show wages paid to an employee on the basis that the seller only works part-time and so you, as the purchaser, won’t need to pay those wages if you work full time. It may or may not be true, but you need to know these wages are being paid so that you can make that decision.

One thing you can pretty well guarantee. All of the expenses will be there on the tax returns. This means you can easily see what the seller has left out.

Trap 12. Manipulation of Stock and Creditors Figures:

I would rank this as the most serious trap of all for a small business buyer. It is beyond the scope of this article to explain just how easy it is for a seller to deliberately overstate the profits of a business by manipulating the inventory or creditors figures or both. Not only that, it may be virtually undetectable (or at least unprovable) as it is often the previous years figures that are altered. However you can do something about it and at the very least get a solid indication that it has taken place

The message from this article is to always, without exception, insist on seeing the last three years tax returns, business and personal. If they have not owned the business for three years, ask to see the figures they were presented with when they bought it. If they insist on you signing a purchase contract first, make sure you have a solid get-out clause. If they refuse to provide the returns, walk away!

This article was written by Brian K Fitzgibbon CPA.

Brian is an experienced accountant and small business consultant. He runs his own business, lectures extensively on small business topics and has checked out and valued many hundreds of small businesses for buyers.

Brian is also the author of the highly acclaimed and invaluable
"How To Value A Business And Buy It Without Fear"
A do-it-yourself guide for first-time and experienced buyers alike.

To download a FREE Chapter from Brian's book please follow this link: "HowToValueBusiness.com"

July 21st, 2009 | Tags: accountants valuation, business valuations, buying a business, buying a dud business, checking out a business, checking the figures, dangers of business valuations, disclosure rules on buying a business, diy business valuations, due diligence on a small business, expense of business valuations, goodwill valuation, how to buy a business, how to check a lease, how to value a business, selling a business, tips on buying a business, traps to avoid in buying a business, using business brokers, valuing a business for sale, valuing franchises | Category: articles | Subscribe to comments | Leave a comment | Trackback URL  |