Due Diligence Case Study: Buying a Dry Cleaner

Dry Cleaning ready to pick up.

A True Story

This is a true story of one of my fact finding (due diligence) assignments regarding buying a dry cleaner in West Los Angeles.

George made an offer with the help of the listing broker on this West Los Angeles dry cleaner. The offer was made and accepted before I was brought into the picture. The listing agent explained that after escrow was opened, the due diligence period begins.  This is when a CPA would start the due diligence.

In addition, the offer had a due diligence period that started after the offer was signed by the seller. It also had a $30,000 deposit with a liquidated damage clause. Liquidated damages actually means the seller and broker can keep the deposit if the buyer backs out of the deal. Due diligence typically finds situations that the buyer wants corrected before he buys the business. These are the “contingencies”.  The liquidated damage clause is supposed to kick in after the contingencies have been removed, which would be after the due diligence period has ended.

To repeat myself, the buyer was told by the broker that normally due diligence is done after the opening of escrow. This on the surface makes sense. I was hired after the opening of escrow. I never saw the purchase agreement or escrow instructions until weeks later when the problems started.

What the Due Diligence Uncovered.

My due diligence showed that all of the employees were being paid as independent contractors on 1099 forms and not as W-2 employees. The IRS would never go along with the staff not being employees. If—or should I say when—they audit this company, they would charge the business owner with the unpaid payroll taxes of the employer’s portion and the employee’s portions, as well as penalties and interest on the unpaid taxes going back three years. State Workers Compensation Fund would also be looking for their money.

Trying to classify employees as Independent Contractors can save the employees 15% deductions off their paychecks and the employers 20% in payroll taxes, including workers compensation insurance. This is an illegal act, and its liabilities reduce the claimed profit substantially when the payroll is $150,000. It also greatly reduces the price when buying any business.

The other things discovered were:

  • Rent on the tax return was way off from the reported rent numbers by the seller. We are talking $100,000 difference on the rent.
  • The tax return showed $300,000 more gross income than the broker reported to the buyer on the business summary. Who reports more income to the IRS than they took in?
  • The other important fact, not presented in the business summary report, was that the second location was an agency, not a full dry cleaning plant. An agency is just a store front for collecting and delivering finished work. No other activity takes place at an agency. This substantially changes the profit and value of the business.

As a result of my discoveries, the buyer told escrow to cancel the contract and return his security deposit. Escrow then cancelled escrow and gave the full $30,000 deposit to the seller and broker. That was a shock to both the buyer and myself. This of course raised a lot of questions by me. I then asked for and received the purchase contract and escrow instructions from the buyer.

The Dirty Trick the Broker Played

What I found was that the broker, immediately after having the purchase contract signed by both parties, opened escrow. The broker should have given escrow the purchase contract, which has a due diligence period. Instead the broker gave the escrow different instructions, not related to the contract. The escrow instructions said. “Due diligence has been completed.” That translates into, if the buyer didn’t go through with the purchase, for any reason, the deposit was forfeit and given to the seller and broker.

The buyer assumed, as anyone would, that the contract and escrow instructions were identical. English is the buyer’s second language so he did not understand what he was reading.  Consequently the buyer listened to and relied on what the broker told him. This is one good reason you need an advisor when buying a dry cleaner or any business. You want an advisor that knows what wording should and should not be in the documents you sign.

Lessons to be learned:

  • Read everything you sign. If you do not understand what you are reading, do not sign it until you do.
  • Get advice from an experienced CPA in these matters or from an attorney. Do not trust the listing business broker or business owner.
  • Assume nothing, and remember, “If it is not written it is not true.”  In other words, when buying a dry cleaner or any business, don’t believe any verbal promises. Only believe what is in the documents you sign that are easily enforceable in a court of law. Whatever the business is, click here to be sure it is the right business for you.

Willard Michlin is a CPA, CFE (Certified Fraud Examiner) and Business Broker. He offers assistance, anywhere in the USA, in the key areas involved in the buying of a business: Due Diligence and Business valuation. As he has assisted in the sale of hundreds of businesses, he is an experienced, honest and trustworthy consultant. He has published many articles and is in demand as a public speaker in and for the business community. You can write to Willard at Willard@EvaluateABusiness.com and he will always answer your questions. He can also be contacted at his Seal Beach, California office by calling 805-428-2063 Creative Commons Attribution: Permission is granted to repost this article in its entirety with credit to Business Buying Services and a clickable link back to this page.