Something Stinks, aka The Seller is a Liar, aka Buying a Small Business
It was time to be a small business owner again.
A couple of years had passed since the sale of my first business, and I was in the market for another. I didn’t want to buy anything that would be terribly complicated to manage. Something simple. Where I could increase the value and get out.
Turns out that a search for something simple can be a convoluted, trust trashing journey . . .
After reviewing hundreds of listings online and seeing dozens in-person, I found a business I thought might fit.
It was a car wash/laundromat service center located about 45 minutes from my home. The owner was asking $950,000 for it, with cash-flow of $150,000. That pegged the multiple at 6.3, which I thought was high, but not nose-bleed high (most range from 3x-5x). Given how little I was seeing in the market that interested me, this one was close enough to engage, so I did.
First Offer or Offer First?
After a couple meetings onsite with the broker, the analytical part of my brain was screaming to see some more numbers. To this point, I’d only been allowed to see the front page of the tax returns, but no detailed financials. The broker said the owner was emphatic that he wasn’t going to share financial details until someone “was ready to commit”.
So, I wrote an offer of $629,000.
Blind Offers are Crazy, Right?
Why would you ever make an offer without seeing the financials?
Four years before making this offer, right after selling my own business, I’d spent an “unsuccessful” year as a business broker. My failure as a broker came from many factors, including the burning down of one of my early listings (it actually started on fire and burnt to the ground).
Despite my meager earnings from that year, it turns out I had learned a lot. I’d learned:
- Brokers like to move deals forward.
- Buyer’s are very reluctant to commit.
- An offer is a BIG STEP, but an easily reversible step, especially in a situation like this where so much information is being withheld.
The exposure to buy/sell process I’d had as a broker made me comfortable making an offer. I wrote a contingency into my offer that essentially said “You’ve refused to show me any numbers. Once you show me, if they are different from what you’ve told me, I can walk away from this deal.”
I was willing to buy the business, at the price I’d offered. That is, if the business actually was what they had said it was. Due diligence would show.
The Sour Taste of Root Beer
My offer was accepted, and we scheduled a time to start the due diligence process.
The owner asked to meet me at a nearby restaurant famous for their homemade root beer.
After making small talk, the seller and I got down to business. We started exploring some of the financial records. Quickly, I realized things weren’t going to line up. Every time I probed for more information about something (like a piece of paper that would document a number) the seller distracted and deferred. Everything was foggy, until the truth finally broke through.
I don’t have perfect recall of the whole meeting, but the next part stands out vividly. After dancing for a while, I handed the buyer a form I’d received from my banker.
“What’s this?” he asked.
“This is a form that authorizes my bank to request an official copy of your tax returns, directly from the IRS,” I responded.
“Why do they need this?” he asked.
“Just part of their process,” I answered. “It ensures that the information you’ve provided us is the same you provided to the IRS.”
He paused for a long-time and finally said, “that’s going to be a problem.”
“Why?” I asked.
“Because the tax returns you’ve seen aren’t the returns that got filed with the IRS,” he said, shamelessly looking me in the eyes.
I looked at him for a few seconds and then slowly bent forward until my forehead rested on the table in front of me.
“You’ve got to be kidding,” I said with my face pressed against the table.
I left the restaurant.
I rescinded the offer.
I chewed out the broker.
Three months went by.
I was still looking for a business to buy, and was finding nothing. I grudgingly reached back out to the broker. I told him I was reluctantly still interested in the business but would have no further dealing with the owner.
The only path forward, I said, was to authorize me to access documents directly from the owner’s bank. I thought with direct access I could try to figure out the financial realities of the business outside of the owner’s toxic dishonesty. The broker talked with the owner and agreed to the conditions . . . if I made another offer.
So, I made a new offer on the business. It was 30% lower than my previous offer, and allowed me to walk away for really any reason, or no reason at all.
They agreed, accepted the offer, and gave me the authorizations I required.
“That will give him an honest look at the business”, the owner said through the broker.
Even Stranger Than I Expected.
I dove in and started re-creating the business financials from the bank documentation. As you might guess, the bank reality was far worse than the mythical picture the owner had previously painted:
- He’d been losing money from the moment he built the place.
- His financing costs were killing him.
- Revenue was 60% lower than he’d said . . . or maybe not. . .Because the active manager at the business made most of the cash deposits, I was authorized to interview him as well. He was tired of the current owner’s shenanigans, and was hopeful for a sale, so he told me many, many things. Like how the current owner had a habit of stopping by arbitrarily and pulling cash from change machines. Clearly a concerning habit, but curiously one where the revenue might actually be higher than what was deposited in the bank.
I just didn’t know how much higher, and I still didn’t know what the deposits would show. . . so I started to study the bank deposit records closer.
Numbers are Weird
Anyone who has spent any time doing accounting work knows there are strange coincidences that occur with numbers. Repeated figures, mirror images, or any of a number of goofy quirks can occur. I knew these can be happenstance, but sometimes they indicate something more sinister. As I did my initial inspection, I found one of those oddities.
I discovered there were several deposit amounts that were identical. Deposits of exactly $1,778.25 had re-occurred 3-4 times in separate months of the first year I analyzed.
That’s weird in a cash-based business, right?
What are the odds that the random flow from a cash-based business would result in this identical deposit amount on more than 3 occasions? I asked the bank to send me the detail on these, and a number of other strange deposits. I wanted to see the actual scans of the items provided when the deposit was made.
That’s how I found out the owner had:
- Periodically deposited his pension check into the business account.
- Deposited his personal state tax refund check (over $4,000) into the account.
- Deposited a check written with a notation for “pontoon storage” into the business account.
Clearly, the owner was dealing with a cash-flow crunch. He’d deposited these, and other personal funds into the business account to be able to meet business obligations.
The “honest look” I’d been promised again fell prey to the owner’s dishonesty. The bank deposits weren’t reflective of business revenue. I’d spent hours recreating the last several years of financials only to find out that even the original documentation was soiled.
- I had wasted my time.
- I could trust nothing.
- I rescinded the offer.
Note Sent to Broker:
I am cancelling the offer based on the fact that I received additional documentation that is significantly inconsistent with prior representations.
Note received from Broker:
While I am clearly frustrated with my client, I am thankful that you have done your due diligence vs both of us finding out later.
But before you feel sorry for the broker, you should know he took me to lunch and asked for the financial analysis I had done on the business. You know, in case there was another potential buyer who wanted to know how the business did financially. Yeah, the broker renewed the listing despite what he’d learned about the owner’s dishonesty.
I could stretch out this next part out, but why bother.
- More time went by.
- The owner finally lost the business.
- There was a sheriff’s auction.
- The bank that owned the debt took possession of the property.
- Three months went by.
- The bank fixed a bunch of broken stuff at the business and cleared up the past due taxes.
- I bought the property from the bank for 30% of my first offer for the business.
- I sold the business 4 years later for 250% of what I paid for it.
The Moral of the Story
Honestly, I’m not sure, but here’s some of what I took away from the experience:
Trust during a transaction is binary:
Discovered dishonesty should be treated like an all-consuming cancer. It’s not incremental. If a seller will lie to you about one thing, assume they are lying about everything. EVERYTHING.
Even so, tenacity can win-out:
The straightforward offer/acceptance is the preferred process. However, there are other paths forward, but they are crooked, long and unlikely to succeed – that doesn’t mean you should never take them.
The tangible benefits of education can be delayed:
For a while I thought my year as a business broker was an uncompensated failure. This transaction (and others after it) showed me that what I had learned was going to have substantial value. Don’t underestimate the financial value of an unpaid education.
Finally, fall in love with the search:
When I coach or talk with potential business buyers, I tell them the most important element of finding a good deal is falling in love with searching for the right business to buy.
If you enjoy the process of looking, if you allow yourself to be rewarded by the investigations, it can create the patience you need to find the needle in the haystack.
Even if the needle is a little stinky when you first find it.