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Wednesday, November 11, 2009

Always Keep Good Books

Peter King
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Have you ever wondered about the consequences when business owners don’t report all of the revenue that they’re creating? Business intermediaries know that buyers will only pay for what can be proven, so one ramification is the eventual selling price of the business will be lower due to the decreasing number of documented profits.  
The question is how much lower will the price be as a result? A more important question from this arises: how much can a second set of books save – disregarding the potential costs, financial and getting caught for underreporting income? It may sound like a good idea in the beginning, you may be able to get away with it for a while; but like karma, you’ll find out that it will come back to haunt you 100 fold.  
Never Dip Into the Till  
Lincoln is the owner of the “Good Books” company that has slightly over $100,000 in cash flow on slightly over $750,000 in revenues. Remember, cash flow is the owner salary plus EBITDA – earnings before interest, taxes, depreciation and amortization.  
Dipper is the owner of the mythical twin “Bad Books” company who has the exact same revenues and expenses.  
Say both businesses have been performing about the same in the four years that Lincoln and Dipper have owned them respectively.  
Let’s assume that Dipper has gotten bold gradually – taking $200 per week from the cash register in his first year; $400 a week the second year; $600 a week the third year and $1,000 a week the fourth year. Even though he’s been at this for four years, let’s assume that he didn’t get caught and incur any extra accounting or legal bills.  
So what did Dipper accomplish?  
  1. While taking some of “his” money out of the till, he also took the sales taxes that he had collected from his customers on behalf of the state;
  2. He also has held back the percentage of gross sales that his insurance company charges for worker’s compensation coverage.  
These two items would have been deductable; therefore, Dipper’s taxable profits are reduced by something less than the amount that he took from the till. Let’s also assume that Dipper pays 40% combined state and federal taxes on these profits.  
Dipper's Doing  
                               Year 1             Year 2              Year 3              Year 4
Cash from Till $10,000 $20,000 $30,000 $50,000
6% Sales Taxes Kept $600       $1,200 $1,800 $2,830
4% Insurance Unpaid $400 $800 $1,200 $1,887
40% Taxes Evaded $3,600 $7,200 $10,800 $18,113
Yearly "Take" $4,600 $9,200 $13,800 $22,830
If you combine the capital that Dipper took out of the sales tax account, the money he would have paid the insurance company and the taxes he evaded; his “take” was $50,430. At first look, Dipper is ahead of Lincoln by a little over $50,000 for the four years, primarily in taxes that he has so far been able to avoid; despite both having identical businesses.
What Dipper Loses When He Sells  
When Lincoln sells his business, he receives the price at the midpoint of the recommended pricing that’s based on generally accepted business valuation methodology. On the other end, Dipper receives approximately $67,000 less; also the midpoint of the pricing range for his business with its reduced cash flow.  
While Dipper had a chance to “pocket” some $50,000 over a four-year period with considerable risk, it resulted in him with a net loss at the time of the transaction. This is not counting his risk of an IRS audit that can come after the business sale either.  
If we examine the predicted selling price, using the same methodology for numerous businesses for which we had performed valuations in the recent past – fair market values between $125,000 and $800,000. We repeat the valuations after reducing the gross sales, but not expenses, by approximately half the pre-adjustment cash flow to simulate the “dipping in the till” for each. The results would be completely consistent with the example above.  
The point here is to never dip into the till no matter if you can get away with it because you will lose in the end when it comes time to sell. Keeping good books will keep you in the black and away from IRS scrutiny, no matter how tempting it is to take a little capital off the top.


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