Business Brokers: Problems with Financials

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Funky Financials

Well, I’m a day late on this post and I apologize. Things have been a bit hectic out here in Paradise but I’m catching up, little by little. I should be back on schedule next Monday, but let’s get on with the Case of the Funky Financials; what are business brokers to do?

If you’re a professional business broker, you know that one of the thrills of being in this business is receiving “clean” and organized financial information from a client, especially if that client’s business is in the Main Street category in terms of size. Unfortunately, we’ve found that the owners of most smaller businesses do not take the time to keep their books current – let alone organized. And, if they make any attempt at all, they generally use a bookkeeper rather than an accountant for their bookkeeping and tax filings. Owners of larger businesses, on the other hand, usually use an accountant, a condition that helps dramatically.

But when the financial records of a business are screwed up, there are generally two reasons. The first is a general adversity on the part of the owners to do the books; to keep them clean, current and accurate. The second is usually cash; when a significant portion of the “actual” revenue is in cash and much or all of that cash is not making it onto the books. There are remedies for the former. There is only one for the latter.

Let’s look at a couple of real-life examples.

Lazy Owners

We’ve found that, especially with the owners of small, Main Street businesses, owners are not so fastidious with their accounting as we would like. Quickbooks is a widely-used software program for small business accounting but because it is so easily tailored to a user’s needs, we’ve found an extraordinary range of categories and many expenses – and sometimes even revenue – mis-categorized. Confusing financial records are guaranteed to scare off all but the most risk-tolerant buyers. A sure way to reduce the number of potential buyers of your client’s business is to provide that buyer with financial documentation that does not make sense.

As an example, we have often seen a category for “Professional Fees”, which would generally refer to accounting and legal expenses, and another for “Legal Fees” suggesting that legal fees are being listed in TWO categories. This is not to say that the owner is doubling up on his expenses but only that some legal fees are shown in Professional Fees and others are shown in Legal Fees. This kind of mis-categorization – the result of simple sloppiness – causes the buyer to begin to suspect the accuracy of ALL the numbers.

In some other cases, not all revenue has been booked and bank statements have not been balanced for months, if not years. There is no telling whether all the expenses have been entered into the system but the chances are they have not been. If the financial statements presented by the seller don’t make sense – for instance, the electric bill is extraordinary high or revenues of $3.5 million show a loss of $500 – you know that some digging through the books will be required.

Not too long ago, in the same year, I was asked to value and sell two different businesses. One was a wholesaler/distributor with revenue of roughly $1.5 million. The second was a retailer that enjoyed sales of nearly $3 million. In the first case, the financials were a disaster; the balance sheet showed a negative checking account balance of more than $8 million and a line item labeled “Undeposited Funds” in the amount of $7.5 million, an amount that represented more than four year’s total sales! In the second case, we didn’t even get any financials (daily sales were recorded in a spiral binder and in pencil, no less); all we were given were tax returns for two years, the latest of which showed sales of $2.6 million and taxable income of $35,000. (Ask yourself if you and your spouse would willingly work retail hours, six days a week, plus additional time ordering replacement product, stocking that product, doing inventory, cleaning, etc., to split $35,000. When I saw this, I said to the owner that a buyer that did some basic math would not unreasonably assume that the sellers were working for less than SIX BUCKS AN HOUR. They could go to McDonald’s and make more than that without any of the headaches of ownership!)

Business Brokers’ Solutions

Let’s address the first issue – sloppy and inaccurate books – first.

If you can’t use or trust the numbers provided by the client, the first question must be, how will you be able to value the business? The second question is, how can you justify whatever the asking price is? In order to answer either question, the books have to be cleaned up. How much digging will this clean-up effort require – and who does that digging – is the question.

Our brokers generally advise clients that present funky books to contact a bookkeeper or an accountant. Granted, it’s tough to find either with much time on their hands during tax season but we advise the business owners that we can’t sell the business – and may not be able to even value the business – unless the books are accurate and reasonably organized.

Some small business owners will take on the task of cleaning up their books by themselves, a perfectly satisfactory approach. If their invoices are organized and their revenue accounted for, they should be able to do the same thing a professional will do; use their check book and “paid” invoice files to enter correct data into their accounting software (i.e., Quickbooks, Peachtree, etc.) and, after some late nights, be able to generate financial reports that are reasonably accurate and defensible.

As the broker, you could even do this yourself but I counsel against this because, unless you are trained in bookkeeping or financial accounting, your client, possibly having used your computations to file tax returns that were subsequently audited and found wanting, will consider you the cause of his NEW problems with the tax authorities and you could find your heretofore unblemished posterior in some trouble.

That said, one of the brokers in our network is a former CFO (chief financial officer) of several Middle Market businesses and he offers his services to “audit” funky financials when he receives them. This is not something he necessarily enjoys doing but it does provide another income stream for him. Personally, I find the task tedious and unpleasant in the extreme and I would advise you to develop a relationship with one or more local small accountants to whom you can steer such work. (An ancillary benefit of this is that such accountants generally perform accounting and bookkeeping duties for many other businesses and when the owners of those businesses get ready to sell, one of the people they’ll consult with is their accountant. Your relationship with their accountant is very likely to result in the accountant referring the owner to you.)

The Second Issue: Cash

Cash SalesWe have experienced the “phantom cash” issue more often than we would like to remember. Phantom cash is the revenue a business owner tells you came in the door but never made it to the books – or the bank account, for that matter. It is a phenomenon that is particularly endemic to “mom and pop” restaurants wherein a certain amount of the revenue is received as cash. But this is not limited to restaurants. Many businesses, especially those that cater to the “unbanked“, take cash as payment. It is reasonable to assume that the owners of such businesses, not unreasonably thinking that they, rather than some government knucklehead at The National Institute of Health spending $387,000 to study the effects of Swedish massages on rabbits, would find more productive and far less wasteful uses for their cash.

Fixing this issue is neither quick nor easy. We advise the seller to spend two or three years to gradually start accounting for all the cash that comes into the business. Given that any buyer with a three-digit IQ will not for a second believe that the seller put X amount of money under the mattress in the past couple of years, the only way the seller will ever be paid for this revenue is to show it. We have a podcast that specifically addresses the problems phantom cash causes for sellers and brokers alike. (You can hear it here; scroll down to Episode 3.) If you’re a broker, I suggest never taking a listing where phantom cash is considered. If the seller has taken cash out of the business, discount it immediately. Do your valuation on the financial statements, tax returns and other documents generally used to assess the value of a business and stick to your numbers – or prepare to waste months of your time because trying to sell a business offered at a price that cannot be supported by the financial documents is a fool’s errand. You’d be better off spending your time at the beach.

If you have questions or comments, put them in the Comments box, below. I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.

I’ll be back with you again next Monday.

Joe

The author holds a certification from the International Business Brokers Association (IBBA) as a Certified Business Intermediary (CBI) and can be reached at joe@WorldwideBusinessBlog.com

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