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Hiding the Money

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Hiding the Money

I attended a meeting where a business broker spoke about a visit he had with the owner of a company. The owner had contacted him and asked to meet with him to discuss the possibility of selling his business. The owner provided the broker with a review of the financials and a tour of the factory.

While walking through the factory, the broker noticed that the warehouse was reasonably filled with inventory and the machinery was significant and up-to-date.

When they returned to the owner’s office the broker pointed out that there appeared to be a significant difference between the amount of inventory on the books vs. what was in the warehouse. The owner quickly agreed, stating that if he reported it, he would just have to pay taxes. In addition, his sales would be lower because he would not have as much inventory. Therefore, he would not make as much money.

The subject changed to the equipment, which was on the books for much less than it was obviously worth.The owner agreed and indicated that all parts for the equipment are charged to cost of goods. He then would have his employees assemble the parts for the new machinery.

The broker polled the group for their thoughts. The group, to a person, felt the business was not saleable and did not want to be associated with this type of a transaction. The owner had a serious income-tax evasion issue and the potential liability for the buyer could be significant.

The owner needed to go to a tax specialist NOW. He was probably going to need five years or more to clean up his books before he could put it up for sale.

- Steve Sink

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Comments

It is true that the owner has an exposure for past income taxes owing, but it is not true that the business isn't saleable even if a broker would rather not get involved.

The income tax exposure eliminates the likelihood of a stock sale. However, an asset sale is still feasible. An asset buyer could pay fair value for the assets, including goodwill, if any. The seller would then have to contend with the question whether the net price received represents capital gain or ordinary income, and if the latter, when the ordinary income should have been recognized.

While a business run in this manner can make valuation problematical, it doesn't make it impossible. A broker may not want to take on the client because of the broker's unwillingness to make certain representations about value or because of potential liability to a buyer. A company in this condition is not easy to sell and would require a lot of extra work for the broker and the buyer. And it may be difficult to convince a buyer's lender about the true value of the company -- which is usually the case in a leveraged acquisition -- but the business is not unsaleable. Indeed, the seller's tax issues, coupled with certain other motivations for selling, may put a buyer in a strong bargaining position.

A company's balance sheet is only one factor in determining value. A buyer who doesn't look beyond the balance sheet isn't doing a proper due diligence. A buyer makes his or her money going into a deal, not exiting the deal. It is distress situations like these that can lead to a good bargain for a buyer who goes in with his eyes open.

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