This post was inspired by a conversation I had with Eric Pacifici and Kevin Henderson on the Mundane Millionaires podcast. Check that out here.
Last year, in about 20% of my clients’ deals, the EBITDA ended up being off by more than 20%. When this happens, buyers try to renegotiate the deal, but oftentimes it's not enough EBITDA to renegotiate a deal the seller will accept. Most of these deals don’t close.
This year, double that number. More than 40% have been off by more than 20%, and a lot of that has been due to fraud.
During my recent appearance on the Mundane Millionaires podcast I spoke about this fraud. The hosts Eric Pacifici and Kevin Henderson reacted strongly to me using that word. They pushed me on whether these shady practices by sellers could actually be considered fraud. This conversation inspired me to talk about fraud and how common it is in this industry.
When sellers are willing to lie about their companies, they can get away with defrauding you out of millions of your investment. Unfortunately, plenty of due diligence providers in the market aren’t doing a good enough job on diligence and don’t spot fraud. Bad due diligence can truly risk your entire investment.
- Fraud can be hidden in missing invoices, improper add backs, misrepresentations of operations, and many other areas. You need to look deep to find it.
- Good diligence evaluates much more than financials, evaluating the industry, how the business runs, and much more.
- You can help protect yourself against fraud by including certain clauses in your purchase agreement.
The Risk of Incomplete Due Diligence
Recently, I worked on a few deals that turned out to be fraudulent. If I hadn’t looked deeper than the average QoE provider, my clients would have completely lost their investments.
Revenue with No Invoices
In a deal for a professional services company, the owner deposited a million dollars into his bank account and tried to pass it off as revenue. We pressed him for three weeks for the invoices. He said they were on paper in his office, but he couldn't get them, couldn't send them. We came to the conclusion that he was trying to sell a business with a million dollars of EBITDA when all of that EBITDA was a deposit that he put in his bank account that had no invoices. It was fake work.
If the QoE provider had just done the bare minimum—taking a look at QuickBooks and bank statements, but not checking out invoices—they would not have picked up on this. That would have been a $3 million crater that a normal human would have walked into.
Fake Add Backs
In another situation, a business sent a Confidential Information Memorandum (CIM) out on an asset-heavy business claiming $2.7 million of SDE. Well, SDE is a terrible metric for heavy asset companies because they have CapEx. On $2.7 million, you may need $600,000 of CapEx. That's really $2.1 million of the EBITDA you should look at. In this case, the $2.7 million was two times what the actual EBITDA was.
What’s fraudulent here? Well, the accountant for the sellers had added back depreciation twice, but did it in a slick and complicated way that took us three weeks to unwind. That was part of it. The day after we found that issue, they came back with $500,000 of prepaids that they supposedly forgot to tell us about—which conveniently made up for the depreciation.
Both points were hogwash. On a reportedly $2.7 million EBITDA business, the true EBITDA was about $1.3 million. Had my client bought this business, they'd be bankrupt in six months.
Misrepresenting How the Business Really Makes Money
A friend of mine was looking at a digital marketing agency that claimed it was doing monthly recurring revenue. When we looked at the business, it was really a project-based business that retained only 30% of its customers for over three years. The rest of their customers had projects that were three to six months long and were not recurring.
The business had to replace 70% of its customers each year. That's not MRR! We went so far as to look at the proposals that the company sent to their clients, and once we did that, it was clear they were a project-based business. All of the higher multiples that they were requesting based on MRR were nonsense.
Really, this company had huge sales and marketing costs because they weren't able to keep customers—which implies their product wasn't all that great. Many buyers would never even look at that. They would have seen the financials, not questioned the MRR, and would have paid six times for a business that they should have paid three times for. Then, when they got in there and realized they weren't the greatest salesperson the world's ever seen, they were going to be screwed.
The Seller’s Motivation
When a seller knows they're getting three to five times the value of whatever EBITDA they include on that CIM, when most buyers don't do their due diligence, that's a huge motivation to lie. Sellers are out here lying and brokers don't have the skills sometimes to recognize it. And honestly, it's not the broker’s job to call all this out and not take on a client. It's your job as the buyer to do the diligence.
How to Mitigate Risk with Diligence
Does fraud mean I shouldn't buy a business?
Heck no. I still think buying a business is the best way to accumulate wealth and right now is the best time to do it. Although interest rates are higher, if your alternative is staying at a job or staying in a company that you don't like, it's worth the effort to try to get a piece of the American Pie and buy into an industry and company you do like.
What does a terrible QoE look like? How do I tell the difference?
Some QoE providers in the market are not doing the work. They're not doing a Proof of Cash, which is recreating the financial statements out of the bank statements. The seller will lie, but banks don’t lie. When you use a data source like bank statements that are rigid and conservative, you know that the numbers presented are correct. A lot of these QoE providers don’t go that far. They are just restating the financials and putting them into more appropriate GAAP accounting standards with a few pages of commentary.
Many terrible QoEs out there don’t look at the base system of the business.
For example, for an online e-commerce business, you can't just look at financials, taxes, and bank statements. You need to look at whatever their online system is— Amazon, Stripe, their inventory system. You need to look at those things to verify business success.
If you’re looking at an asset-heavy trucking company, you need to do the typical analysis, but you also need to know the true CapEx of the business. You need to know the condition of the trucks and whether you will have to replace all of them in two months. You need to know if the sellers did some advanced depreciation where you won't be able to file depreciation for the next three or four years because they took it all in the current year.
If you're looking at a marketing agency, a business that charges monthly, you need to look at the true churn of their customers, the consistency of their customers, and whether their customers have increased their pay with this company over time. You need to look at their marketing funnel and how they market to customers.
If you’re not looking in these areas, you’re really leaving risks on the table that could be disastrous after the sale.
How do you spot fraud pre-LOI?
You can't. That's the problem. You don't have enough data pre-LOI to definitively determine whether a seller is trying to defraud you.
This is what I mean by defrauding you: The seller is trying to lie about their EBITDA hoping you don’t do enough diligence to realize their business is worth much less. By convincing you of $500,000 of fake EBITDA, you end up paying a 4x multiple, and they have defrauded you out of $2 million. Investments are buyer-beware oriented, so even if you take them to court, you’re unlikely to recover any of that $2 million.
Your only chance to prevent this from happening is before you close the deal.
What terms or provisions can act as a safety mechanism against fraud post-close?
Having a seller’s note helps, but make sure that the seller’s note is subject to set off. I learned this from an MBA, JD who made me get smart on the legal side of this. Set off means that if any of the reps and warranties are proven to be inaccurate, youI can set off against the note. You can individually, without having to go ask anybody, say you were encumbered a certain amount of money and take that off the note immediately. This might sound crazy to those new to acquisitions, but this is a normal business practice.
Another way to protect yourself is to identify your deal breakers and know the difference between deal breakers and unsavory facts. For example, if I'm buying a $1 million EBITDA business, a $100,000 decrease in EBITDA during diligence is unsavory. I may renegotiate. It's not a deal breaker. Here’s another example: if the seller can stick around for a year to help train you on a business that you’re not fully confident you can run, but you get the sense they’re headed to the Bahamas, that might be a deal breaker. Once you know your actual deal breakers, make sure to protect them in your purchase agreement.
Are earnouts a solution to deal with risk?
Earnouts are an interesting solution. Although they are more likely to make you go sideways with the seller and make the legal process harder.
Another elegant way to get around risk, but sort of get it out of the purchase agreement is to add the “earnout” into the employment agreement and keep it out of the purchase agreement. That gets it out of the scrutiny of the lawyers and can be a smoother strategy. It would remove it from your recourse situation with the bank.
Even better, though, is showing that the false narratives that are being told in CIMs are ridiculous. You just need to show that what the seller is claiming is ridiculous and reduce the price.
How do you deal with the risk of cash payments?
I have successfully diligenced businesses that have cash payments. During the diligence process, you need to track what cash payments are coming in and out of the business and for what. You won’t know historically what cash payments have been made, but you will at least get a chance for the 90 days you’re in diligence to track cash payments in or out. And then you can at least determine if they were real.
Some buyers find cash payments reason enough to walk away. Others accept the reasoning behind the cash payments, accept they are real, and move forward anyway.
As deals get larger—north of $2 or $3 million in EBITDA–do financials get cleaner? Does fraud happen across the board at any deal size?
Bigger deals tend to have cleaner financials, but clean financials put diligence teams to sleep. We don’t have a B or C team at Guardian, but some firms will put their B and C teams on these deals. What ends up happening is that when everyone expects the financials to be clean, the fraud becomes harder to spot.
I was an expert witness in a court case for a $3 million EBITDA business that was sold. The owners realized that the seller was channel stuffing. They were overselling clients, making it look like there was growth when there wasn’t. It was one of those deals where all the numbers looked clean. Because of that, the growth wasn’t questioned. And the new owners lost out.
Even with bigger deals, you need to stay on your toes.
Don’t Go Into a Deal Naked
The Acquiring Minds podcast recently featured a business that failed. The owner, who is anonymous on the podcast, is looking for a job less than a year after acquiring a business. This person is very brave for sharing her story, and we can learn from it. If you listen to that podcast, you'll hear somewhere between 15 and 20 mistakes that a first-time buyer wouldn't know to look for and wouldn't know the appropriate way to handle even if it came up.
Like this buyer, you might get into a deal because you didn't do diligence and quit a good job. You think you've achieved your goal of being a CEO, an owner of a million-dollar opportunity. Then, you realize you bought a business that's got no cash flow and you have to grind, sweat, cry, just to end up closing the thing down in a year.
Don't go into these deals naked! Recognize that as much as you have on your whiteboard, planning how to grow this thing, how to modernize it, how to update the website, how to make it more digital, there's a seller out there somewhere with a whiteboard trying to figure out how to defraud you and a broker who won’t be able to spot fraud—nor is it their responsibility to.
Count on some info in the CIMs that you read to be false. And if you buy the sellers’ stories, you will be going to the poor house. You'll be regretting that $20 or $30k investment in a QoE that you passed up in favor of a million-dollar mistake. That will sit with you for the rest of your life.
Trust Me, Do Your Diligence
I want to get this message out there to help protect newer buyers. I’m not even trying to persuade you to work with me. I’m just trying to persuade you to find a due diligence provider who is going to do the work to save you from making a mistake that changes your life forever.
80% of my clients are first-time buyers. They are coming out of corporate roles less than 12 months ago, and this is their first time negotiating with their own money. And most of the time it’s personally guaranteed. They’re investing three or four years of their time in this deal.
When a 60-year-old broker or a 60-year-old seller tells them something that sounds reasonable, but they don’t find out through the data that it's not, many of my clients have a hard time putting their foot down. Most of my first-time clients are terrible at saying “This isn't accurate” or “We have to adjust the price.”
Most times, the broker says that the seller won’t budge. Unfortunately, 20% of my clients just do the deal. They take the false stories in the CIM for fact and end up making a bad deal that will cost them down the road.
When you do diligence correctly, you have all the tools and evidence you need to either make a fair deal or walk away from a terrible one.
I have many resources to help you do diligence successfully and close a great deal. Check them out here.