Why You Need Certain Information for Your Due Diligence – Part I

I decided to write this blog series mainly because of the pushback we get from sellers advisors on some of the information we ask for when representing the buyer. The first item I’ll discuss are W-2s by year along with an employee roster for that year noting positions, average hours worked per week, hourly rate and any other benefits received.

Naturally one of the first responses we get is “why do you need to see the W-2s, all that information is either on the tax return or in the practice profile under the staffing section”.

Unfortunately, while the advisors mean well, they’re incorrect. The tax returns don’t list each employee, their wages, the department they work in, the hours they work, their hourly rate or the benefits like paid vacation and sick time. The tax return does show total wages; maybe an expense category called employee benefits and/or group insurance, however, it won’t tell you how much is for the staff and how much for the owner.

The practice profile may list this info in more detail, usually ONLY for the current year though and we all know employees come and go and sometimes the practice changes on the number of staff, etc.

Another reason we want to see the details is to help the buyer assess the performance of the practice. We want to be able to tell the buyer what percentage of revenue is assistant wages, hygiene wages, front desk wages and admin wages. We also want to be able to verify any adjustments the seller’s advisors made to wages for owner family members who may get paid, but their compensation may not be market value. While we’d like to accept their adjustments as accurate, you’ll see below it’s not always the case.

So here’s a list of real life experiences we’ve encountered by having the W-2 and employee roster information:

  1. I’m in the middle of an assessment right now where the owners’ wages per the tax return were shown as $210,000 while the W-2 showed $260,000. Why the difference? The owner took a $50,000 bonus in December and when the internal p&ls were prepared they were coded to office wages (front desk/admin) and the tax preparer used the p&ls to prepare the tax returns. Needless to say, after normalization adjustments to overhead it was still overstated by $50,000.
  2. We’ve seen on numerous occasions where the seller’s advisors who prepared the work to establish an asking price made reductions to overhead for family wages based upon what the seller told them about how much their family was getting paid. Unfortunately, that information was for the current year and not necessarily the same for the prior years, and the advisor assumed the same reduction in prior years for the family wages. In one case, the reduction was $35,000 for three family members where the owner JUST put them on payroll for the first time. So the $35,000 reduction in prior years was incorrect.
  3. We had a case where the advisor reduced owners wages to normalize overhead by the tax return wages noted on line one for “officers” which most of the time is JUST the owner. They also reduced the staff wages by the spouses’ wages of $75,000. That would have been fine EXCEPT the owners wages were $75,000 lower than what was stated on the tax return because the tax preparer added the spouse wages to that line since she was listed as an officer. So they reduced overhead by the spouses’ wages TWICE.
  4. We’ve seen on numerous occasions where potential buyers will back off their pursuit of a practice because the total wages are very high as a percentage of revenue compared to the norm. However, when we break it down by department and realize the hygienist and front desk wages as a percent of revenue is fine and it’s the assistant wages that are out of whack, the potential buyer reconsiders because they know they can likely improve upon that issue fairly easily.
  5. We’ve seen advisor worksheets that reduce overhead by the amount the associate was paid in wages for all years, again, based on current year information. However, when we get the W-2s for prior years, we see that the reduction for prior years isn’t accurate. The advisor simply assumed the associate made about the same.
  6. And lastly, my personal favorite…..we’re assessing a practice and when we ask for the W-2s we get a LOT of pushback….the seller and their advisors kept insisting we didn’t need them, the wages on the tax return were accurate and they could give us the breakdown by department. We insisted and the buyer was willing to walk away if we didn’t get this info. When they finally decide to give us the info they then proceed to tell us the W-2 totals will be greater than the tax returns because the doctor also works as an IC about 30 minutes away and receives 1099 income personally and they allocate the wages between the practice tax return and his IC income. Hmmm, ok, well let’s see the sellers’ personal return where this activity is being reported so we can review that and verify the allocation seems reasonable. Well, they resisted that of course & finally told the buyer they were no longer interested in selling the practice. Here’s the kicker, just about every overhead expense was on the low end of the normal range if not below the normal range and we suspect they were paying quite a bit of the practice overhead FROM the IC bank account (the personal bank account) and, therefore, making the profit look much more profitable then it appeared.

The fact is in the vast majority of the assessments we do the wages reconcile with the tax return and the adjustments made by the sellers advisors are accurate. Still, by having this info we’re able to provide so much more info to the prospective buyer about the wages statistics on the practice that goes beyond the price.

Written by Tim Lott, CPA, CVA. Send your questions to tlott@dentalcpas.com.

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