Friday, July 10, 2015

[VIEWER QUESTION] Peter's question: How can I trust the information given by a business seller?

This week I answer Peter's question. How can I trust the information given by a business seller?  Take a look.

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I’m back today with another viewer question.  Peter asks, ‘When buying a business, how do I trust the information that’s provided from the seller?’ It’s a great question.  I love the quote from Ronald Regan—Trust, then verify.  

The first and best way to verify information is via third party sources.  For example if you know that in the restaurant trade that about 50% of sales are in the form of cash and 50% are in the form of credit and debit cards, then you can check the credit and debit card terminal statements and if it equals about half the sales being represented in the financials then you know that the cash sales are probably being represented fairly.

Another example would be if you were going to buy a bar in a province or state where all liquor has to be purchased from a state owned agency.  You can get records directly from them that will show what the purchases to the business have been over the course of the year. If you know the average margin on the alcohol then you can work out what the sale should be and compared that to what’s being represented in the financial statements.

When I was a business broker, I was always very clear with buyers that financial statements are nothing more than ink on paper. Just a few days ago, in fact, I was actually working on a business evaluation and the property taxes went down every year over three years.  I thought that was kind of interesting, so I asked the business owner about it. He explained that they paid the taxes monthly and that the bill hadn’t gone down, they’d just been falling further and further behind.

In this case what was being report in the financial statements was not the actual property tax, but the amount that they had paid towards a property tax.  That's not the correct way to do it at all.

The full amount of each year’s bill should have appeared on the income statement and any unpaid amounts should have been on the balance sheet as an outstanding liability.

One of the things you can look at when you're doing an investigation into a business is look at what kind of financial statements that you're being provided with.   Accountants prepare three different kinds of financial statements.
1.      Notice to Reader: This means that the accountant has taken the information provided by the business owner and formatted it so that it looks like a set of financial statements.  That’s it literally.
2.      Review Engagement: Tthe accountant does some minor review of the information to make sure that it makes sense and if something is obviously weird or out of place, the accountant might
3.      Audited:  The accountant would actually come in and do an investigation, look at numbers, etc.

Notice to reader statements might cost somebody $1,200 or $1,500 to do.  A review engagement might be $5,000, and the audited could be $20,000.  It’s very rare to find a small business with audited financial statements.

Audited statements are typically reserved for bigger entities or for some not-for-profit & public entities who probably has some pretty simple financial.  You’re not going to get an accountant to put an auditor’s opinion on a small business like a restaurant or convenience store without some very thorough investigation of what’s going on in the business. It’s simply too risky to their professional reputation to be careless. 

If we can’t have full confidence in what the sellers giving to us for information, what we have to do is work within the bounds of knowing that the information may not be correct.   The way that we protect ourselves in this situation is through the structure of the deal.

What that means is a vendor take back note or vendor financing of some portion of the purchase. Let’s take for example a business that the buyer and seller have agreed is worth $100,000.

Let’s say it’s a small restaurant or corner store and the value of the assets within the business is $60,000.  This represents the inventory, the equipment, etc. The things that we can actually put our hand on or what we call ‘tangible assets.’ This means the other $40,000 would be considered ‘goodwill.’

On the other side of the equation we have our source of funds and it also has to add up to $100,000.  You go to the bank and the bank is willing to lend you 75% of the tangible asset value of $60,000, that means a loan of $45,000.

Next, you’re going to put in some money of your own.  Let's say that you’re going to put in another $30,000, which brings us up to $75,000.

The offer that you make to the seller is on closing day I will provide you with $75,000, but I want you to finance $25,000.  We call this the vendor note.  It is also called the vendor take back or the seller financing.  

At the closing table when you buy this business, there are going to be several contracts all made up. There is going to be, perhaps, a non-compete agreement, a bill of sale for the tangible assets and the good will, assignments of leases for equipment or an assignment for a lease of the premises.   

One of those documents is actually going to be the note.  That debt instrument representing the vendor financing, also called a promissory note.  It’s going to say, ‘I, Mr. buyer owe you, Mr. seller $25,000 and I’ll make payments of $XX each month inclusive of XX% interest over XX years, etc.’

You need to be sure that this note contains a clause saying ‘subject to offset in the case of material misrepresentation or undiscovered leans.’ What that means is that if it turns out after you bought the business that the seller had been lying to you about information then you can say to him, ‘you misrepresented yourself.’

‘There is a material misrepresentation of the facts. I'm not going to pay you.’

You’re already in the possession of the business. If you stop the payments he has to:
1.       Go find a lawyer, if he wants to fight you
2.      Pay the lawyer a retainer
3.      Take you to court and prove that he gave you the proper information so you owe him the money.

If you didn't have the vendor financing and you bought the business and you paid the full $100,000 in cash. What would happen when you discovered the misrepresentation is:
1.      You would have to hire a lawyer
2.      Pay the lawyer a retainer 
3.      Find the seller
4.      Take him to court
5.      Hope that he hadn’t spent all the money
6.      Get a judgment en
7.      Have the problem of trying to collect

So what we are doing with the vendor financing strategy is we move the responsibility and the risks associated with lying from the buyer and move it to the seller.

Now the seller e has an incentive to make sure that he gives you the proper information and that he doesn't lie to you.   He needs you to be successful in the business in order to collect that outstanding vendor financing.

If you make a proposal like this to someone and they flat-out refuse to do any vendor financing it can mean one of a couple of different things.
1.      It can mean that he knows he's lying or misrepresenting something, so he's not willing to take the risk of not being paid that portion of the money –or-
2.      He doesn't think you have the ability to run the business. If he doesn’t think you can run the business, he knows he is going to have trouble collecting that money because you won't have the profits to be able to pay him.

Both of those reasons are an excellent, excellent reason not to proceed with the purchase.

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