Ira Silver CPA, CGMA, Principal, MBAF LLC
“Due Diligence.” Two words you are sure to be familiar with if you are considering a business decision as major as acquiring another dealership.
In an M&A transaction, the concept of “due diligence” is simple enough. The buyer is employing someone, usually a third party, to minimize his or her exposure to the various landmines and pitfalls that could occur in making the acquisition.
However, with the auto dealership “Buy-Sell” market so hot right now, there are many more buyers than sellers. This has created a marketplace where, among other reasons, blue sky valuations are very high. Due diligence is more important now than ever to determine the accuracy of the seller’s financials before you sign any Asset Purchase Agreements.
Any due diligence process is designed to provide the potential buyer with an all-inclusive and accurate valuation of the dealership to be acquired, including all assets, liabilities, and future earnings potential.
Unfortunately, the typical due diligence processes used may not go “deep enough” to detect fraud in the numbers that can impact the income multipliers. Black’s Law Dictionary defines fraud as – “A knowing misrepresentation of the truth or concealment of a material fact to induce another to act to his or her detriment.”
In general, the procedures performed during a typical due diligence evaluation are not designed to identify misconduct or misrepresentations, – either intentional, or not. This can lead to two major problems. One, you may be paying more than you should for an over-valued dealership, and two, you may end up adopting a fraud, and being held liable for it with the acquisition.
Evaluating Financial Statements for Fraud
So what do you need to look for?
- Are Assets and Revenues overstated, or Liabilities and Expenses understated?
- Are add-backs legitimate or actual expenses of the company?
- Is rent adjusted to FMV, or understated?
These are all questions that need to be answered prior to agreeing to the income values. Because, that will be used to determine the blue sky value and form the basis for the buyer’s gross income multiplier, which is obtained by dividing the dealership’s sale price by its gross annual income.
Here are some basic procedures to follow:
- If the dealership to be acquired is being audited, read all financial statements carefully. Do not forget to look for and read all footnotes on any unusual, or “one-time only” items.
- Look at their accountant’s year-end adjustments to see if the books are clean. In addition, look at their internal control letter and see if any deficiencies exist. Pay close attention to the sellers schedules for aging of receivables, and for new & used vehicles. Review the seller’s parts pad, for parts without sales in 12 months, or that have over a 12 month supply on hand.
- Determine if the seller has performed a fixed asset physical inventory, and make sure all equipment, special tools, computers, furniture and signs on the fixed asset register are indeed there and in working condition.
- Compare unit sales to manufacturer sales reports and DMV sales numbers. See how gross per unit compares to the industry average particularly in that market.
- Meet with employees to determine that employees who are noted in add back schedule in fact do not contribute to the operations of the entity. In addition, those that have management fees, determine what activities they provide, as in most cases, not all fees should be added back.
- In regard to real estate purchases, have your experts perform building inspections, zoning and other possible encumbrances to property, and any potential environmental issues. In addition, did seller receive program money for image upgrades or new facilities that buyer will not receive going forward that needs to be adjusted in buy-sell multiples?
As a buyer who could be paying an income multiplier as much as 5, 6, or 7 times earnings, it is easy to see why a seller may not be forthright in providing the whole story, but it’s your job during due diligence to gather the entire story before moving forward and making a costly mistake.
Ira Silver, CPA, CGMA, is a principal in the Tax and Accounting Department at MBAF and is the principal-in-charge of the firm’s Orlando office. Ira has been in the public accounting profession since 1982. He can be reached at (407) 781-0150 or firstname.lastname@example.org