Bullet Proof Your Business

Buying a Business – Don’t Buy a Lemon !!

Bernie and Beris had been sheep farmers near Gore in the South Island of New Zealand. They were in their mid-50s and had four adult children. They were farmers and had worked hard on the land their entire lives. They are terrific people.

Beris had developed chest infections and associated medical problems and her health was deteriorating. Her doctor recommended that she and Bernie move to a warmer climate.

They loved Australia, and over the years holidayed on the Gold Coast. They decided to visit the coast and consider moving there. During their visit, they looked at many businesses for sale and eventually became interested in buying body corporate rights. This business consisted of the rights to manage a block of 122 low-rise holiday units. The purchase price was $1.2 million. Inclusive in the acquisition was a two-bedroom unit and car parking space. Initial representations made by the agent was that the business would return about 15%, or $180,000 per annum, if worked by them.

This rate of return was extremely high by industry standards. Most body corporate rights businesses return between 7% and 10% each year.

Bernie and Beris signed a Memorandum of Understanding (MOU) and were provided with three years of certified taxation figures, including a profit and loss statement and a balance sheet. They conducted thorough due diligence on the business, including examining source documents and bankings. This included having the certified figures examined by a reputable accountant. This accountant advised them that the figures stacked up and were consistent with bank statements and other source documents.

They checked accommodation records that revealed a high rate of occupancy. They made enquiries with body corporate groups and the tourism Industry. They made up their mind to buy the business and executed a contract for $1.175 million, conditional on the fact that they sell their farm in New Zealand in 90 days, were happy with due diligence and were able to obtain finance.

They took the contract to a reputable legal practitioner who began to conduct all of the usual searches on their behalf. Everything stacked up and the business looked clean.

They applied for finance to about 60% of the purchase price and obtained approval using their farm as security.

Then they returned to their farm, met with their children and advised them of their decision. This was supported by their children, who wanted to see their mother recover from her illness. The farm was placed on the market and sold for approximately $850,000. The contract became unconditional and they settled a short time later with about $375,000 finance.

Upon settlement, Bernie and Beris moved straight in and started running the business. During the period of the contract being conditional, they had undertaken a necessary course dealing with their duties in the role and the operation of a trust account.

The first month was slow and takings were down about 50%. They put this down to the low season and their inexperience. This situation, however, never changed and only ever grew to about 60% of what they were promised by the vendor’s agent, and represented in the vendor’s figures.

When we commenced investigations, we observed that the source of income categories differed greatly between the vendor’s books and Bernie and Beris’s books. The vendor had extra categories of income and a much higher occupancy rate.

Upon examination of the categories of income, and the monthly statements to unit owners, I soon realised that the previous vendor had been charging each owner large sums monthly for services such as window cleaning, glass-door cleaning, bedspread dry cleaning, and maintenance. The level of charges each month was nearly half what the owners monthly receipts were. In some cases, owners were being charged for glass window and door cleaning on four occasions. On many times bedspread dry cleaning was being charged up to 10 times per month.

We examined the vendor’s payments and observed that he had been paying very low amounts for these types of services. We calculated that costs in his books of account to perform these services amounted to about 5% of what he was charging. In other words, the services were not actually being undertaken. Owners, many of them from overseas, were just being billed for them.

In one month the vendor charged every unit owner the sum of $22.50 for charcoal filter replacement in the unit range hood. The problem was that only about 20 units had range hoods that had a need for charcoal filters.

When we interviewed them as to their charges to unit owners, they indicated that they charged owners for services, however only did so when they undertook these services, and that in all cases, the services were not required to the level indicated by the previous owner. An example of this was that glass and door cleaning was only required once per month.

We also learnt that the previous owner paid cash to his son to undertake some of the services. This cost was not declared.

We calculated, based upon the actual need for these services, and the previously billed amounts for such, the previous vendor was probably netting about $90,000 per year for services that he did not undertake, or were not required. Our clients were honest, and not prepared to do the same, and this was being reflected in their lower turnover.

When we examined the high occupancy rate of the previous owner’s business, we soon realised that his cleaning fees were only about the same as my clients. We also noticed that his electricity account was about the same as my clients. Sheet dry cleaning accounts were at the same level experienced by my clients. There were no telephone charges for many rooms rented and this seemed unusual. We also saw that the previous owner had banked a considerably larger amount of cash for unit rental than my clients were banking. Most persons were using credit cards with my clients. The amount of cash banked, was close to about 40% of the total unit rental amount.

Why was he renting about 40% more rooms, yet still incurring about the same costs to do so? This area of the investigation caused us considerable anxiety for some time.

We decided to undertake some due diligence on the previous vendor, and soon worked out why he was banking more cash and renting more units. He had an extensive criminal history for drug trafficking and related crimes. It was obvious that he had used this business to wash his tainted money. While doing this, he had also seriously overcharged unit owners for services he clearly did not undertake.

In not overcharging for services, and suffering a 40% reduction in occupancy rates, in effect, my clients’ return on their investment was about 4%.

Although our investigations clearly had shown why there was a difference in income, and my theory was supported by records, it was still circumstantial and difficult to prove. Unfortunately Bernie and Beris paid about $700,000 too much for their business. Even worse, Beris’s health has never improved.

Don’t get caught buying a bad business

Buying a business? Remember the old Latin adage ‘Caveat Emptor’ – Buyer Beware!

Ensuring a business ‘stacks up’, and is what you are paying for is a big job, so you must do your homework. This is your opportunity to avoid a world of problems.

We am frequently approached by new business owners who realise they have made a terrible mistake and bought the wrong business. Common complaints include:

• The business does not turn over what was represented.
• The previous owner ‘was’ the business and when he left, the business left with him.
• The previous owner has taken all of the clients and is operating in opposition.
• Key management and staff left upon settlement.
• The business entity is being sued or is exposed to some other liability or undisclosed payments.
• Title of the business did not cover certain plant and equipment or intellectual property.
• Plant and equipment does not work.
• General representations made on a variety of subjects found to be incorrect.
• Unfortunately the old adage, ‘Possession is nine tenths of the law’ is so true. Once settlement has been effected it is hard and costly to seek remedy.

Although there are many pitfalls in buying a business, there are steps you can take to minimise the risk of buying a lemon.

The background and organisation of the company. Ensure you examine in detail:

• Articles of Incorporation and any amendments.
• Certificate of Incorporation.
• Organisation minutes.
• Names under which the business is and has been conducted.
• Descriptions of all mergers, acquisitions, or other transactions in which other existing businesses were acquired.
• Descriptions of all transactions in which any subsidiaries were sold or otherwise transferred.
• All specific plans or agreements for future acquisitions or dispositions.
• The company’s business plan.
• Run some checks on the business, the seller and key personnel before buying. Obtain a resumé from the business owner. Things to look out for include:
• Is the seller an undischarged bankrupt? If so, you may be giving your money away because the seller may not have the right to sell the business.
• Does the business owner, directors, key personnel or staff have criminal history, current indictments, or a history of breaches by government agencies?
• Do press searches reveal adverse comments about the business or business owners?
• Complete business history searches of the business owner to provide you with a picture of the owner’s track record. This will also provide you with leads for potential enquiry.
• Are any of the assets of the business encumbered? If, for example, a bank has loaned money to the seller it may have taken security over some of the assets of the business. If you do not get a ‘clearance’ for this security, the bank may repossess these assets and you will be left trying to get compensation from the seller. Complete a Bill of Sale search.
• Are there any current legal proceedings against the seller? The business may be the subject of litigation or the litigant may obtain judgment against the seller and the seller may become a bankrupt; if so, the trustee in bankruptcy may come along and take the business with no compensation to you. Again, you would be left trying to get your money back from a bankrupt.
• Are all trademarks, business names etc. registered? The seller may be selling you a business or trademark he does not own.
• Has the seller complied with all government requirements?

Company operations

Ensure you examine in detail:

• A description of the nature of the company’s business.
• If the company is engaged in more than one line of business, the line or product representing 10% or more of the net sales or earnings from operations for any one of the past five years.
• Proposed changes in emphasis and direction of business.
• Major products and services.
• The geographical areas served.
• Any limitations on markets that can be reached, such as freight charges, duties, service and maintenance requirements, patent licences, tariffs and agreements.
• The states and countries in which the company conducts business or is licensed or qualified to do so.
• A list of competitors and their principal products or services and a description of the nature of the competition.
• The profit and loss statement and balance sheets of the business for at least the past three years. Ensure they have been certified as correct by the accountant for the business. Have your accountant analyse the figures and give their professional opinion as to whether the figures are workable and believable.
• Ensure the figures, although certified, are supported by the business bank statements, and that you audit the statements with the financial statements.
• Look at the business taxation returns for at least the past three years and compare them with financial statements and bank statements.
• Attach all of this financial information to the contract of sale. Make sure that a clause is inserted into the contract that the seller warrants the figures are correct. That way, if they turn out to be false, you can litigate against the seller for breach of contract. Most countries have legislation that makes it an offence to make misleading and deceptive representations, so you may have multiple actions against the seller to get your money back and obtain compensation if it turns out that the figures are false.
• Having an accountant certify that the figures are correct may mean that you can litigate against the accountant too, as a last resort.
• Complete a physical inspection of all capital items identified in the balance sheet and ensure the items are present, and commensurate with their balance sheet value.
• Consider conducting surveillance on the business to ensure it does what is represented and to the level represented.

Management and employees

Ensure you examine in detail a complete list of all directors and officers, together with the following data:

• Age and education.
• Title, function, and responsibilities, including positions held with any subsidiary.
• Length of service.
• Prior positions with the company.
• All compensation, cash or otherwise.
• Past business associations and positions held in the last five years.
• Special distinctions and education.
• Other present directorships or business affiliations.
• All bonus or incentive plans – stock, cash or otherwise.
• All severance benefits provided to directors and officers if there is a change in the control of the company.
• Copies of all employment contracts. Many businesses hire employees pursuant to employment agreements. Again, you need to be aware of what you will be bound by when employing those people so have a careful look at the terms of any agreement.
• Also, be aware of any awards that govern employment of any of the employees.
• And be aware of any entitlements to sick leave, holiday leave, superannuation and the like because you may be responsible for honouring these entitlements even though they accrued while the employee was employed by the seller. You need to negotiate with the seller as to the best way to deal with these entitlements, and you must ensure the seller fully discloses what these entitlements are, particularly where you are purchasing the corporate entity and not just its assets and name.
• Find out whether the company and any of its officers or directors is the subject of any litigation arising out of the relationship between them.

Other considerations

• Ask the seller for a period of time to work in the business. This will give you the opportunity to see how the business operates, and if it is as busy as the seller says. This is also a good way to gauge the true turnover of the business and ensure you are suited to running it.
• Incorporate a training period into the contract. This means the seller will have to train you in the operations of the business rather than dropping you in the ‘deep end’.
• Look at the premises and the lease (if there is one). Remember, in most cases the lease for the premises is to be transferred to you (otherwise you will have to find somewhere else to trade) and before the lease is assigned to you, you need to know what you are getting into. Ensure that you can continue the lease if this is your objective and it is important to the continuance of the business.
• Set a limit as to how much stock you have to take. In most cases you will have to pay for stock in addition to the purchase price of the business. Also, specify that you do not have to take any out-of-date (or nearing out-of-date) stock, and that a stock-take is to take place on the day before settlement. You can either undertake the stock-take with the seller or employ a firm that specialises in stock-taking.
• You may get a valuation of the business before committing to the purchase to ensure that you are not spending too much.
• Check the profitability of the business against industry standards.
• Many businesses have supply contracts for their goods or services. Examine these contracts carefully. The price of the business would have taken these contracts into account; however, they may only run for a short while.
• Businesses may also lease equipment like computers, cars, refrigerators etc., and if these lease agreements are being transferred, you need to know what you are getting into.
• Ensure that the business owner enters into a Non-Competition Agreement. This ensures they cannot trade in competition with you for a period of at least three years. A way of enforcing such agreement is to have the vendor agree to part payments for the acquisition of the business over this non-competition period.
• Although turnover and expenses may be certified and ‘stack up’ when audited, there is still a further risk that they are not an accurate reflection of the true business income. I have been engaged by many new purchasers to investigate businesses that do not perform in accordance with the certified and audited figures. In some cases it is a simple case that the previous owner was the business. When he or she left, the business did not have the same goodwill.
• Unfortunately, in quite a few cases, I have found that businesses are used to launder tainted money. This might include money from drugs or other illegal activity, or cash from a high profit business that is not declared and subsequently laundered through a lower profit centre for tax minimisation purposes.
• Do your homework. Always check industry standards. If a hotel alcoholic product should represent 18% of its turnover, you would question what else is being sold there if audited figures represent that same product at 13%.
• If employees represent 25% of a service industry hourly rate, this needs to be reasonably reflected in the figures.
• A frequent area of misrepresentation occurs in the sale of unit management rights. Many services are charged for – for example, washing of windows and bedspreads, replacement of exhaust fans. But are these services undertaken? Is this an execrated income stream and are you prepared to continue the same corrupt practices to ensure you maintain the represented income?

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