Succeeding in Your Business: What to do when a business you're buying 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 percent of the purchase price over the next five years, which we think is also a good deal.{mprestriction ids="1,3"}

“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 businesses — 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 away, 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 is for real.

• Always base the purchase price on the seller’s public set of books.

• Make sure the government, the seller’s creditors and others can’t come after you for money the seller owes them (what lawyers call “transferee liability”).

Rule No. 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.

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 No. 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 percent you would be paying him over time.

Here’s how an equity kicker works: You would pay the seller interest on the 40 percent each month at a commercial rate (5 percent to 6 percent per annum right now). Then, on top of that, you would calculate the seller’s average monthly sales as recorded on his public books for the last three years and agree to pay him 10 percent to 20 percent of the amount by which your gross sales each month exceed 110 percent of the seller’s 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.

Rule No. 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 it will probably find out about his creative accounting and come down on him hard. If you ask for a clearance letter and the seller refuses to do the deal, or if there is no way to get a clearance letter for a particular tax, walk away.

Cliff Ennico (crennico@gmail.com) is a syndicated columnist, author and former host of the PBS television series “Money Hunt.” 

COPYRIGHT 2019 CLIFFORD R. ENNICO 
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