February 28, 2011When a Business Has "Two Sets of Books"
By Cliff Ennico
"My spouse and I have been looking to buy a business for some time. We've found a good local business with a great location and lots of existing customers.
The seller wants us to pay one and one-half times his gross sales last year, which our accountant says is a fair price. The seller has also agreed to let us pay him 40% of the purchase price over the next five years, which we think is also a good deal.
The problem is that the seller told us he carries two sets of books - 'one for the Government, the other for real' - and that he wants us to pay one and one-half times his gross sales as reported on his 'private' set of books, which naturally shows much higher gross sales.
Of course, we're nervous about doing business with this seller. Still, the business is an attractive one and we have no intention of playing any 'games' once we take over. Everything will be on the up and up.
Is there any way we can still do this deal and avoid being caught up in the seller's web if the Government should ever go after him?"
Many small business - too many, in my opinion - play these sorts of games. My initial reaction is to say "well, if this seller is lying to the Government and others, what are the odds he's being straight up with you about other things?"
Still, it may not always be practical to walk way, especially in a situation like this where the business may actually be doing quite well and has the potential for significant growth down the road.
When a client of mine is buying a business with less-than-reliable books, I have three rules:
- do lots of due diligence before you buy, and make sure the "private" set of books are for real;
- always base the purchase price on the seller's "public" set of books; and
- make sure the Government, the seller's creditors and others can't come after you for money the seller owed them when you bought the business (what lawyers call "transferee liability").
Rule # 1 Do Your Diligence: You need to hire a good lawyer AND a good accountant. Make sure you have both. Get the seller to give you both sets of books for the last three years, and have your professional "team" tear them apart.
Posted by Staff at 11:43 PM
Next, go to work in the business as an unpaid employee. Make sure you are the one standing behind the cash register and recording sales. See how his actual sales stack up against both sets of books. That will tell you which one is more likely to be "the truth".
Rule '# 2: Base Your Price on Public Records. Your purchase price should be based on the lower, more conservative, books he is using to pay his taxes, show to creditors, etc. If he protests (and he will), offer him an "equity kicker" on the 40% you will be paying him over time.
Here's how an "equity kicker" works: you would pay the seller interest on the 40% each month at a commercial rate (5% to 6% per annum right now). Then, on top of that, calculate the seller's average monthly sales as recorded on his "public" books for the last three years, and agree to pay him 10% to 20% of the amount by which your actual gross sales each month exceeds 110% of that average monthly sales figure. That way, if the seller has been lying about the business generating more sales than reported, he doesn't get a penny more from you than he is due. If he hasn't been lying, his payout is based on actual sales.
Rule # 3: Protect Yourself Against the Seller's Problems. You should buy the assets of this business, not stock in the seller's company. That way you assume only those of the seller's liabilities (such as his current lease) that you want to assume. He's stuck with everything else. If there is a lien (called a "UCC security interest") on any of the assets you are buying, pay that creditor off in full at the closing and get the lien released.
Next, find out from your attorney if you will be liable for any taxes the seller owes. Many states hold buyers of business assets accountable for sales, payroll and other taxes owed by a seller when the business changes hands. If this is the case, you may be able to ask the state tax authority for a "clearance letter" - basically a promise that if the state ever finds out the seller owed them money when you bought the business, they will go after the seller and not you. If the state issues the "clearance letter", then you can buy the business with a clear conscience.
The seller won't like this, as the state may use your request as an excuse to audit his books, in which case they will probably find out about his creative accounting and come down on him hard. If the seller refuses to do the deal if you ask for a "clearance letter," or if there is no way to get a "clearance letter" for a particular tax, walk away.
Cliff Ennico (firstname.lastname@example.org) is a syndicated columnist, author and former host of the PBS television series "Money Hunt." This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state. To find out more about Cliff Ennico and other Creators Syndicate writers and cartoonists, visit our Web page at www.creators.com. COPYRIGHT 2011 CLIFFORD R. ENNICO. DISTRIBUTED BY CREATORS.COM