August 2010
How NOT to buy a business
This is a sad tale about
misplaced trust, disappointment and the proverbial “should-a
could-a.” It’s an account that offers a very valuable
lesson on how NOT to buy a business.
While some of the details have
been altered to protect the victims, the story is factual in
all other respects.
The setting was somewhere in
the Southwest, but it could have been anywhere. The owner
of the storage facility felt the need to give me a ride to
the airport. He was attempting to mitigate a loss I had
incurred while my vehicle was stored at his location. While
his effort didn’t work, what he explained to me on the way
to the airport may be useful to you - it will give you an
opportunity to learn from the mistakes of another.
I asked the owner (we’ll call
him John) “How’s business.” I had been storing my vehicle
at his facility for several months. During that time my
wife had grown friendly with the desk clerk. On a number of
occasions the clerk expressed frustration with the
facility’s tight budget. It seemed that there were simply
not enough revenues. My question to John, “How’s business,”
was designed merely to break the silence in the car although
I sensed he was overly concerned about his finances and
would welcome the opportunity to vent a little.
John explained that he had
purchased the assets of the facility a couple of years back.
The terms of the deal were based upon the representations
of the seller. It seems the seller had prepared financial
statements that reflected cash basis lease revenues which
appeared to be all supported by a file full of documentation
on the individual leases – names, addresses, phone numbers,
storage unit numbers and monthly rentals. John said
everything looked in order except for the seller’s income
tax returns. The returns, it seemed, showed cash basis
lease revenues that were significantly less than those on
the financial statements. John said the seller described
the difference as the “cash” transactions that were not
claimed on the tax returns. John indicated that the
seller’s explanation seemed plausible, yet he knew what the
seller was doing wasn’t quite “right.”
The deal was all cash – no
seller financing. John was able to secure a loan, however
his father had to co-sign and pledge his personal residence
as collateral. In effect, John and his father were
personally liable on the obligation. The business real
estate was also used to secure the debt.
John was represented by an
attorney. The attorney was engaged to review the
purchase/sale agreement and make sure all the documents were
in order.
John said he felt comfortable
with his decision.
However, soon after the closing
John realized that his revenues were less than anticipated.
And, when he tried to contact the delinquent tenants, he
discovered they were fictitious. John knew then he had been
snookered.
Attempts to contact the seller
were unsuccessful. What’s worse, John had gotten his father
tied up in the mess and felt responsible for burdening his
dad with the “lemon.”
John decided there was no
choice but to deprive himself of a salary, cut his personal
expenses to the bone and try to make it work. Though his
dream was shattered he seemed committed.
I wished him well and boarded
my flight.
I never told John I was a CPA –
there would not have been a purpose. The damage was done
and there was nothing I could do or say that would lessen
his misfortune. However, I knew I could have saved him and
his family a bundle if I had been engaged from the
beginning.
Preferring not to rub salt in
his wound I did not tell him the things he “could have” done
to prevent his loss. But for you, I will list some of them
below.
-
If you are considering the acquisition of a business –
large or small – engage a qualified CPA at the outset.
Find one that has experience in business valuations,
acquisitions and formations, along with due diligence.
John did not engage a CPA. It was apparent that he
thought his attorney would protect his interests.
-
The IRS has estimated that on an annual basis more than
$300 billion (with a “b”) in taxable income goes
unreported. If you suspect you are doing business
with a tax cheat, be extra careful. If he is willing to
cheat the IRS, he is probably willing to cheat YOU.
With regard to John, when the seller explained the
difference between the revenues on the financial
statements and those on the return, the alarm should
have sounded and the deal should have considered an
escrow provision that called for the release of funds in
line with the realization of anticipated revenues.
-
While John could have reached an agreement on price and
terms based upon the seller’s initial representations,
there should have been a time period reserved for due
diligence. Among other things due diligence
procedures, designed and performed by a qualified CPA,
would have included tests to determine the validity of
leases and revenues. Yes, the CPA would have charged a
fee but think of it as a one-time insurance premium to
protect against a significant long-term risk. John
gambled and lost.
Owning your own business can be
both exciting and rewarding. However, while you might feel
comfortable operating the business, you probably will
benefit from professional guidance during the acquisition
process. Unless you’re a pro you should not “try this at
home.”
If you would like to learn more please feel free to call
James E. Traester, LLC, CPA 203.932.2931.
~~~~~~~~~~~~~~~~~~
