I'm about to purchase a business, but the profit on the tax return is a lot lower than the owner's internal financials. How can I make them rectify this discrepancy to my satisfaction? After all, I'm not into the whole "going bankrupt" thing.
I'm about to purchase an existing retail business from a seller who's in his 70s and recently fell into poor health, to the point that doctors are testing him to determine if he's got ALS. This was given to me as the reason he's selling, and the internally-produced financial data they've provided me seems to bear that out. The store makes a good profit, and except for a bit of a dent in FY 2008 due to the recession, gets more profitable every year. (FY 2009 numbers so far already have them on track to return to the trend of increasing profit every year, so 2008 looks to have been a fluke.)
Here's where the problem arises. In 2008, their internally produced financials showed a net profit of about $93k, while their corporate tax return (they're a C corporation, which seems a bit much for one owner) shows about $11k. I am NOT a financial-head, so I initially missed this. One of the banks I was applying for financing from brought this to my attention. An $11k net profit at the end of the year is so low that if it were correct, I wouldn't be able to service the debt on the 10% seller financing, let ALONE the bank financing. (Of course, that's points in favor of "the seller is acting in good faith" -- if the $11k number were real, he would HAVE to know he couldn't afford to finance to me, since I wouldn't be able to pay him.)
I passed this along to the seller's broker, and he initially attributed it to differences between cash- and accrual-basis accounting, and that virtually all businesses try to make their income appear less than what it is, so as to ease their tax burden. He then took about a week to comb through financial data and prepare for me a relatively detailed Excel spreadsheet following, nearly line by line, the differences (a) the accrual-basis documents as received by the seller, (b) cash-basis as received by the seller, and (c) the actual tax return. He even put in a couple of questions/answers in the document:
"Is there significant difference in profitability between the accrual vs. cash way of constructing this company's financials? No."
and
"Is there significant difference in profitability between accrual and cash vs. tax return way of constructing this company's financials? Yes, and it is [due to] how certain expenses are accounted for between accrual and cash vs. tax return."
And there's line after line of numbers, with three columns for each. Some highlights are that the tax return shows about $27k more expenses and about $29k less profit.
On their tax return, from what I can tell, they aren't reporting $12k in undeposited funds. They have $24k in A/R on their internals that they reclassify as bad debt on their tax return.
My eyes begin to glaze over all the detail, though I sorta feel like the sheer volume of all these numbers, complete with annotations, suggests that they really wanted to document the source of the discrepancy and demonstrate that they're above board. Throughout this whole process, they've always been forthcoming with documents, and have even taken the initiative to provide data on their own (e.g, as a month ends, sending along the numbers for that month so that I'm kept up to date).
And while I've not been in the retail business specifically before, I've been working for nearly a decade, as an independent consultant, in a field intimately tied to the main product line that this store sells, one which tends to center on one particular multi-national corporation which sells a lot of very cool products and services. As a real nerd when it comes to this particular company, I know that their market share has been climbing year after year, and that their own financials show them to be essentially recession-proof. So on that basis, at least, I have no reason to doubt the seller-provided numbers. I don't want to say you'd have to be a complete idiot to have a store like this and NOT make pretty respectable money, but . . . you kinda would have to be a complete idiot.
I got an OK for financing from one bank so far (would like to hear from others, but at least I have something solid); we already agreed on a selling price in the earlier, non-binding Letter of Intent phase, and according to the lawyer, the next steps now that I have a financing offer are a lien/title search, some due diligence on his part, etc. The bank did the financing only because I'm backing it with both mine and my father's stock portfolios (he's a guarantor but otherwise won't have any involvement in the business). This was the only way they could get past their reservations about the tax return, saying that while they understand most businesses play with the numbers a little, their policy is that they have to go by what's on the tax return. Thus, this transfers the risk to me.
I guess what I want to know is . . . what other documents can I request from the seller to back up his internal financials? (For instance, if I were a private citizen under-reporting my income to the IRS, and got a lot of money from an under-the-table contracting gig, but somebody wanted proof of this since it's not on my 1040, I could produced copies of the checks the contractor gave me throughout the year, or maybe have them sign a letter stating that they paid me X amount, etc.)
The seller's broker has said all along that he'd be more than happy to have a sit-down or conference call with me, the seller, and any bank(s) that would like clarification on these numbers (none have taken him up on this so far). I'm thinking I should take him up on this, but to go over it with me, specifically -- line by line, if necessary.
My gut tells me the seller's honest, not just because I've met him, but also from what I know of this market and the success of this product line. But gut isn't enough.
Other details: Located in Richmond, VA; only two competitors (it's kind of a high barrier-to-entry situation to sell this company's products), both of which are out in the 'burbs (while this place is next to downtown); store has been under this ownership since 2003, but originally founded around 1989; it's received recognition from the corporation whose products it primarily sells for being in the highest level of sales and customer satisfaction with service. Selling price is $145k (couldn't negotiate it down much from the $150k asking price), which seems kind of low given a 2008 seller-provided net profit of $93k (but insanely high if the $11k number is to be believed) . . . but I know that when using net profit to determine a valuation, the "multiplier" can be anywhere from 1-4 depending on the industry.
On the plus side, like I said, the seller and his broker have been nothing but cooperative all along, so I think that we can ask for damn near any document we desire.
Okiedoke. Thanks for reading all this. Many thanks in advance.
posted by CommonSense to work & money (9 comments total)
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Again the business in the question here may not be required to abide by these standards becaus of its small size and number of shareholders.
I would retain the services of a CPA.
posted by dfriedman at 12:58 PM on September 21