This is a true story. Names of people and places have been changed to protect the guilty. To understand this story, you need to know that I was born in India.
I will start by saying that fraud is pervasive. An average US Corporation loses 5% of gross revenue due to fraud. Then It should not be surprising that fraud occurs in M&A transactions.
How it Started
Mike had been buying and selling businesses for over 3 decades. I was 28 maybe 27. Mike calls me, “Gaurav let’s go do some diligence”. Mike had found a company with gross margins of 65%.
I had met Mike few years back while auditing one of the companies he owned. He had taken a liking to me, after that I worked on every company he bought.
The target was a company operated by an Indian scientist. Let’s call him Dr. Sanjay. He had created formulas for ingredients which would get added to food products.
Dr. Sanjay insisted that the business was easy. The customers call the office, his assistant takes the orders, then the assistant places the production order with an outsourced manufacturing facility. In due time the manufacturer drop ships the product to the customer. Making money was easy. I figured this was the power of scientific intellectual property.
Naturally this made me curious. I would ask Sanjay, “Why would you sell the business when you can make money in your sleep?” He would usually respond by launching into his memories of the soft monsoon rains and the mangoes of summer. While I shared his nostalgia, I couldn’t get over the feeling that he was trying to pull a fast one. Sometimes he would tell me that “there is a book in me which wants to express itself’.
The Diligence Process
We show up to work and I request the usual information and I start hitting hurdles right out of the gate. There was a Profit & Loss statement produced out of QuickBooks, no balance sheets. I requested copies of bank statements and tax returns. My request was rejected. Why? Apparently, the good doctor had another business and he had commingled the banking and taxes. This would be an unorthodox process.
Like a good accountant I set on testing the 65% margin. I requested copies of customer contracts, invoices, vendor contracts, vendor invoices, copies of checks and so forth. I was only provided with customer invoices produced out of QuickBooks and bank deposit slips which agreed to the invoice balances. No customer contracts. They also provided the bills from an individual who was apparently the owner of the outsourced manufacturing company. I recalculated the margin and magically it was 65% every single time. Those of us who do this for a living are suspicious of consistencies such as these.
So far, I had tested a lot but I had no hard evidence of anything. I was nervous, Mike was excited. He was already counting the money.
The PE Guys
Mike was feeling good, now it was time to line up the money. Mike had gotten a Private Equity firm interested in the transaction. The PE Guys flew in for a meeting with the doctor. After spending half a day with him they got suspicious and called me.
They wanted to know what would make me feel comfortable with the revenue. I told them that we needed to confirm the revenue directly with the customers. Sanjay reluctantly agreed.
We selected the customers to test, and prepared the letters to confirm the revenue. All we needed was the doctors signature. It was Friday, we went to pick up the letters from the Company only to be told that they had already been overnighted to the customers. This was a problem. We control the mailing to ensure that the confirmations are sent to the proper recipient.
Come Monday morning we started getting the confirmations back. They were all from an unknown fax number and none of them came back with any exceptions. All very unusual. There is no AP clerk who rushes to respond to a confirmation first thing on Monday. Moreover, it is a rare event when confirmations are returned without exceptions. My antennas were up.
I called the PE Guys and Mike, I told them that I suspected Sanjay was faxing us the confirmations. Since I had the signed confirmations, it gave me authorization to call the customers to verbally confirm the revenue. We all agreed to do this.
I called the AP clerks who had supposedly signed these confirms. Guess what I found. These people did not exist. I spoke to the real AP clerks to find out that their companies had not done business with our doctor for years.
Dr. Sanjay had made up the whole thing. He was trying to sell a business that did not exist. The PE Guys were relieved. Mike was in disbelief. The banker accused me of being from UCLA, a school without an accounting program. The deal was dead.
At 28 I had learned to trust my gut. Since then Mike and I have gone on to work on many more transactions, and we still get a good laugh when we talk about the mangoes and the monsoons. Wonder who the doctor is scamming now?
If it is too good to be true, it usually is.
Ask good questions. If you don’t get a good answer, keep at it.
Stick to the process. Audit procedures have been designed for a reason. Controlling confirmations might seem like a small thing but it is very important.
Extra Credit for Nerds:
In the graphic for this post we have combined images of my childhood hero Sherlock Holmes and my favorite fruit.