Financial due diligence is one of the most requested types of projects on the DueDilio platform. In this article, we will highlight some of the ways that business sellers often inflate the value of their business – knowingly or unknowingly.
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When you’re buying a business, it’s easy to get excited about the potential you see to create a great income. Try to keep a cool head, though–because the seller’s splashy pitch deck may be covering up some serious financial statement manipulation. It’s vital to perform careful due diligence, to detect any misrepresentation in the seller’s financials.
Sadly, not every seller is completely honest about the state of their business. They may be giving you an upbeat story, but could secretly be trying to unload a floundering business. Sometimes it’s cunning, but other times the misstatements may be unwitting–they’ve been doing business their way for so long, they don’t realize and properly account for all the challenges their departure will create.
Smart buyers hire a team of due-diligence professionals to examine the seller’s disclosures in detail. Often, they find creative accounting, omissions, or outright lies told to inflate the business’s value.
As a buyer, you don’t want to overpay. What should you watch out for, in a seller’s financials? We asked six financial due diligence experts to reveal the most common types of financial statement fraud they’ve seen in their work. Here are the top ten problems they’ve repeatedly found in seller’s financials:
1. Concealed Labor Costs
In many businesses, labor is the biggest cost–which is why many sellers underreport labor expenses. How? Paying employees off the books is a popular method, says Matt Remuzzi, founder of the financial-services firm CapForge in Carlsbad, Calif. “That understates not only payroll, but also payroll taxes and worker’s comp insurance costs,” he notes.
How much labor cost can you hide? A lot! One financial statement manipulation case Remuzzi uncovered for a buyer: “We discovered off-book employees at a moving company. Nearly 50 percent of the true labor cost was hidden via cash payments off the books.
“We found it by comparing the posted work schedule and customer counts with the official payroll, noticing a big discrepancy between the amount of work done and the payroll being paid out. It was a six-figure difference!”
That’s not the only way sellers may hide labor expenses. Della Kirkman of Kirkman CPA in Auburn, Ind., offers three more strategies that make payroll appear smaller: Reducing the owner’s own stated salary, leaving unfilled positions when employees leave, and cutting back on employee benefits.
One new cost buyers often have is hiring people to do the owner’s tasks, says Geoff Warrell, president and CEO at business brokerage LinkBusiness in Fort Worth, Texas.
“Many times, an owner will claim they’re not involved in day-to-day operations,” he says. “They’ll say ‘The business runs itself!’ The owner will push for a complete addback of their wages. But if the owner is also the bookkeeper and the buyer isn’t experienced at bookkeeping, they’ll need to hire someone, which will lower their profit.”
2. Income Manipulation
Company revenue is probably the single most important factor in a business sale. That’s why this is a top area for creative accounting. How do sellers inflate revenue?
Here’s one popular strategy: Sellers take revenue that actually came in the following year and push it back into the current year (while keeping related expenses in the following year), says Mike Jerman, a former CFO for several companies who’s now head of accounting firm Honeywell Partners in Tampa, Fla. “It’s an easy catch when we do our revenue sample,” he says.
3. Fake Revenue
Sometimes, a company can appear to have ample revenue–but it’s all smoke and mirrors. One approach: Sellers simply transfer cash from owners or other family members into the company bank account, Jerman says. Then, they edit the bank statement PDFs to make the deposit appear to be a client payment.
“We often catch these when we recognize the text is different in the edited PDFs,” he says. “When we suspect something, we have the owner or accountant pull the statements from the bank via screen share, or in person. At that point, they generally ‘fess up.”
4. False Growth Figures or Projections
If a seller is inflating revenue, it’s a short step from there to forecasting overly optimistic revenue growth. Since most buyers are essentially buying based on expected future revenue, this is a vital area for close review.
Beware of growth forecasts based on year-to-year customer cohorts that aren’t true apples-to-apples comparisons. Pierre Heurtebize, a France-based investment and M&A director for Horizen Capital, saw one seller who showed strong retention metrics. But on closer scrutiny, the growth was revealed as an illusion.
The seller compared last year’s clients–some of which had only signed up in December–to the following year in which they paid in all twelve months. This made it appear growth was accelerating.
“The reality was that this business actually had a massive amount of churn, and was losing over 50 percent of their newly onboarded customers within the first 6 months,”he says.
5. Expense Manipulation
Just as sellers may find ways to inflate income, they also seek to minimize their business’s expenses. As Jerman noted above, this year’s expenses might be postponed to next year to make net profit appear larger while a sale is underway.
Three other strategies sellers use to present buyers with an artificially lowered expense sheet, from CPA Kirkman: Postponing recurring payments such as software renewals, putting off needed major-equipment purchases to make pretax earnings appear rosier, and skipping routine equipment maintenance. The latter risks potential equipment breakdowns and pushes a hidden cost onto the buyer.
6. Ongoing Costs Portrayed as One-Time R&D
Buyers have a keen eye for a business’s regular, recurring costs. One way sellers cope is by casting regular costs as unusual costs that won’t reoccur.
“I’ve seen sellers commonly add back true business expenses, like marketing spend on testing online ad keywords, and call it ‘one-time R&D,’” says Rajiv Tarigopula, business-sale advisor and founder at Snowy Owl Capital in San Diego.
7. Cash vs Accrual Accounting Problems
Many people think there are two types of accounting: cash (reporting dollars the day you get them) and accrual (reporting the dollars when the work or transaction occurs, whether or not the payment happens then). In fact, many businesses employ a hybrid of the two–and this modified accrual approach can create problems.
“EBITDA (earnings before income taxes, depreciation and amortization) may appear stronger due to inconsistent accounting practices,” says Chris Williamson, managing director at the M&A-focused financial-services firm Cayne Crossing in Atlanta. “It’s key to understand both the income statement and the balance sheet in order to uncover where inconsistencies may exist.”
8. Inflated Valuation
Valuation is the key metric in a business sale, determining what the buyer will pay.
How can sellers make their business appear more valuable? Primarily, by inflating revenue and creating the appearance of higher growth potential than is realistic.
For instance, some businesses were particularly well-suited to thrive during the pandemic, and saw an unusual sales spike, says Heurtebize of Horizen Capital. Pretending that isn’t a one-time event but instead the start of a continued growth trend creates an unrealistic picture.
In this type of scenario, watch out for inappropriate ‘weighting’ between the past three years of revenue that gives the best year more value in their growth model. Heurtebize notes that can downplay the reality that the business also has less-successful years and fluctuating income, he notes. It’s not a straight-line, predictable path to higher future income.
9. Creative Accounting for Equipment and Inventory
If a business uses machinery or sells physical goods, these are ripe areas for accounting tricks, says CPA Kirkman. Gather detailed information on the age of any inventory or equipment at a prospective acquisition.
Why? There are two ways sellers can easily make their balance sheet look better here. First off, they may be valuing equipment at the item’s purchase price, instead of stating its current fair-market value. Financial pros call this ‘inflated appraisal.’
The other approach sellers sometimes take is to attribute value to obsolete inventory or equipment that’s gathering dust in a back room. The inventory could be clothing that’s gone out of style and will need to be donated or trashed, for instance. In either case, the items should have been written off as a loss, Kirkman says. Leaving them on the books makes it appear the company has more valuable physical assets than it really does.
10. Related-Party Agreements
Successful businesses often rely on the owner’s relationships with key people at their vendors or partners. The seller might have once worked for their company, played in an adult soccer league with their CEO, or been a former college classmate, to name just a few possible scenarios.
Large customer contracts could be secured through the seller’s personal relationship to the owner. That means when the seller departs, those relationships will all be at risk–but these connections may not be disclosed in the sale documents.
The seller may have negotiated more favorable rates with vendors, or perhaps receive more prominent mention in partners’ marketing efforts, based on the owner’s relationship-building. Some customers might drift away to a competitor once this seller leaves.
The worst-case scenario? ”Vendor relationships with entities that are owned by a company shareholder, with agreement terms well below market rates,” says Williamson of Cayne Crossing. “Once the business sale closes, the shareholder is no longer a shareholder of that business. Now, the vendor demands market-rate terms going forward.”
Do Your Due Diligence When Buying a Business
As you can see, there are many ways a buyer could end up over-valuing a business. Financial due diligence is critical to flush out these most common types of financial statement frauds. And remember, these are just the tip of the iceberg, in terms of the irregularities you might find in a seller’s financial disclosures.
Many of the reporting problems described in this article are things only an accounting pro with due diligence experience has the expertise to detect. Make sure you have a strong due diligence team in your corner, before you sign on the dotted line to buy a business.