Increasing EBITDA – you’re doing it wrong

Part 2. Cases which may be classified as pure fraud

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So sometimes the pressure is too hard. And then – when all the grey areas of accounting had been exploited but there still is a deficit, when the seller really wants to get more, and has no clear understanding of the potential consequences – this is the time when more creative methods are applied.

To be fully open: in my career I have seen each and every one of things I describe below applied in practice. But in each case – it was the general management that made the decision to pursue it. The finance director was merely an accomplice, though indeed sometimes the idea originated in his/her head.

1.?????? Adding some extra revenues (that never happened in reality)

When you want to sell your business at a good price you might want to show decent revenues and margins. So how about this: within 3 months before the due diligence cut-off date you produce lots of sales invoices. Your sales are growing – but you explain it with your brilliant business and product development. You are smart – those invoices are raised to your regular customers, big international brands – so no-one suspects anything.

Obviously you do not send those invoices to those clients – you keep a copy and post it in the books. Your sales go up, but you have no extra costs – so your margins grow accordingly. So does your EBITDA. And if you agreed 10x EBITDA as the price for your business – every fake invoice is worth 10 times its fake value. Some may consider it worthwhile.

And when the buyer takes over the business after closing – they will find plenty of uncollected receivables. But if a locked-box arrangement was agreed as the closing mechanism – there will be very little that can be done with it… So they will dig deeper and deeper until the make a call to those clients of yours, who will be surprised to hear that any such invoices were raised, since they never got any and they certainly never procured the service.

Anything left to do for the buyer? Write off the receivables and litigate. Though most likely the previous owners would have to be fund in the Caribbean – if at all.

Is there a way to see it, when it is done? Well – that kind of scam can only be detected through typical forensic procedures. However even in a financial due diligence – any substantial increases in revenues (particularly when analysed per client or per client category) should be given a lot of scrutiny. Such things do not happen often – everyone wants to increase revenues fast but we all know how difficult it is in practice. So do not be na?ve. Do not believe in “once in a lifetime opportunities” – if it walks like a duck and talks like a duck – in 99% cases – it is a duck.

2.?????? Adding some extra revenues – level hard – reshuffling

Have you ever seen “The Accountant”, the film with Ben Affleck? Yes, it does happen in practice. It is actually quite easy to do in a service business. So – you take money out of the business (via a divi or a loan) and secretly feed it back in as if some services were bought by customers.

Because you took the actual cash and have it to put back in this business – there will be no issue of unpaid receivables (as in case (1) above). So it is a little more sophisticated (however also limited by the amount of cash you can take out of the company in the first place) and a little harder to detect.

To bring it closer to a perfect crime – it should be done slowly, gradually over time, to avoid sudden peaks in revenues just before the transaction. And it should be done in regular operational transaction values – in other words – if the average transaction value with a client is USD 500, and suddenly the same company has a client with the transaction value of USD 50.000 – things would get suspicious. So – slowly but surely – 100 transactions @ USD 500 over time please. And remember – every dollar you feed back into the business will came back to you tenfold when you sell.

If done like that – it would be very difficult to detect. Fortunately sudden grasps of greed do not let people plan for such a long term. They want to push EBITDA up just before the transaction. So with proper procedures in place a sudden peak in the number of transactions and in the amount of revenues, coupled with similar amount divis or loans should at least raise a flag.

3.?????? (Secretly) related parties

Now let’s look at the following example. You’re selling a gym or a chain of them. And they are profitable. In a gym business you have 3 major cost items: equipment leases, rent and personnel.

So to make the business even more profitable quick you have to impact one of those three elements. Personnel is hard to control, but lease and rent…

Say you own the properties where the gyms are located. You might sell them to someone close to you but not officially related. Maybe a distant family member, whom you trust but do not share a surname with.

Then your business rents those properties from that person at cheap rates. You boost the profitability of the business – you might lose on rent, but hey! If you sell the gym business @ 10x EBITDA – you will be far better off. And one more thing – remember the property rental contracts have to expire roughly six months after the transaction – so that you can charge market rent afterwards.

Weak – you say? Easy to spot a below market rate – you say? Well yes – if you’re talking about an office space. But gyms are often located in dodgy places where comparable rent analysis is very difficult. And if this element is missed within a due diligence and further on – future rents are not guaranteed in the SPA – you have a recipe for disaster.

And in fact this would be my suggestion. If based on your DD, you have doubts about whether some contracts are on market terms - to see through the bluff - have the price levels warrantied by the sellers in the SPA.

4.?????? Round-trip transactions

This is sophisticated, this requires planning and a whole set-up to make it happen. But rewards are big.

So let’s say you manufacture something. And to make it – you need some components which you transform into a finished good. You make two of your old friends set up two companies on the side, let’s call them A and B. Company A buys some components from you. Then it “sells” them to Company B.

You make a profit on selling the components to Company A.

Then, you buy back from Company B. But not the original components – that would be too trivial. Officially you buy something completely different – some other components or semi-finished goods for you to complete.

By doing this you achieve two goals:

• Company A gets monies to pay your invoice (so no uncollected receivables which would draw unnecessary attention);
• The things you bought are inventories – so they are included in the balance sheet until sold. So you made a P&L profit from selling components. But the repurchase is a balance sheet item, so even though you bought back at a higher price – it will not reduce your profits (now).

If you want more – you do it again. And again.

Any accountant would see – there is a dead end to it. Inventories become more and more costly which will ultimately drive down profitability when they are sold. But… it will be after the closing – so who cares?

How to spot it? Large volumes of transactions with unfinished goods or materials should raise the flag. Additionally – missing counterparty test should also reveal the scam – usually Companies A and B exist for one transaction only – so if you see a counterparty with large volume but a small number of transactions and only in one month – this may raise some questions.

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There are more schemes like those and at some point I might even consider writing a book on it. But I think this is enough for an article. As soon as EBITDA becomes the goal of its own – managers and owners want to twist it and inflate it to extremes.

It is a game between the buyers and sellers, where the only real weapon is the knowledge and experience. And as I always tell clients who say that our due diligence proposal is too expensive: “If I don’t meet you at the due diligence, I’ll see you during the forensic audit!”.