M&A Fraud Case Study: How a $49k Retail Store Purchase Turned Into a $104k Loss
Background: Retail Store Purchase That Looked Like a Great Deal
It looked like a great deal – $49,000 plus inventory for the purchase of a store that had $300,000 of revenue and nearly $100,000 of profit. As an Apple reseller, we were required to have an Apple store. We had struggled to have a profitable one near our headquarters in Portland, Oregon so looked around in other cities on the West Coast.
We found several possibilities – they would have to be approved by Apple, which meant they couldn’t be too close to other Apple stores, had to look good etc. During this process, we located Metro Cellular, which was near an Apple store, but was at an upscale mall and had the above stats.
We did our due diligence, hired a CFO, traveled to the store, interviewed the store manager and broker, and obtained financial statements. We then asked for contracts, bank statements, and other information. While the bank deposits were a little lower than the Profit & Loss statement, the seller said it was due to combining his 2 businesses into 1 bank account and somewhat askew bookkeeping. It seemed reasonable, and we thought with our expertise we could possibly increase revenues. The only negative of the deal seemed to be high rent expense.
We made sure to address due diligence (including Valuation) issues and after an extensive closing process, we made a down payment and paid most of the consideration. The only item to be paid later was the inventory, in the form of a seller note. The transfer occurred and we took over in late December, 2017. It was toward the end of the holiday season, so the benefit was stifled.
We took on a store manager and tried to integrate the operations with those of our headquarters. We thought our investment would start to payoff immediately.
Troubles: When $300k Revenue Becomes $6k in January
Unfortunately, when January sales shrunk to a monthly level of $6,000, we questioned the validity of the numbers. We dug a little deeper, now that we had a direct relationship with the landlord. We asked for monthly sales figures, and were very concerned when the ones we received were about half of what had been presented to us. Likewise, we pulled data from the point of sale (POS) system before it was terminated by the seller. This too pointed to the fact that the sales had been vastly overstated, both by the seller and its agent.
After asking the seller about this, and not receiving a satisfactory answer, we realized we had been duped.
Even at our end, we used a valuation calculator to cross-verify the fair market value of the company, but we were again left unsatisfied. We talked with our lawyer, who recommended sending a letter to the seller and agent. This also had no effect, other than learning that the agent, who tried to sneak in an indemnity clause to the purchase agreement, was at least aware of, and may have propounded the fraud.
At this point we had no other alternative but to file suit against the perpetrators, since the landlord wouldn’t let us out of the lease for another 8 months. This meant instead of making $100,000 profit, we were looking at losses of $40,000 purchase price and $64,000 rent, at a minimum.
How Forensic Accounting Caught the Fraud: The 4-Way Cross Check
As a CVA and CFO Expert Witness, this is how we proved fraud – and how you can prevent it on your next deal:
1. P&L vs Bank Deposits: The seller’s P&L showed ∼$25k/month. Bank deposits showed ∼$18k/month. The seller’s excuse was “I combine 2 businesses into 1 account.” That’s the #1 red flag in retail fraud. A legitimate seller provides a separate bank account for the business being sold, or a 12-month bank reconciliation tying deposits to P&L. We accepted an explanation instead of data.
2. POS System vs P&L: We pulled data from the point of sale (POS) system before it was terminated by the seller. This is the source of truth. POS showed actual sales of ∼$12k-$15k/month, not $25k. Always get admin access to POS, read-only, and export 24 months of daily sales BEFORE close. Take a video of the export.
3. Landlord Sales Reports: In most mall leases, tenants must report monthly sales to the landlord for percentage rent calculation. When we got a direct relationship with the landlord, we asked for monthly sales figures, and were very concerned when the ones we received were about half of what had been presented to us. Landlord reports are hard to fake because landlord charges rent on them.
4. Sales Tax Returns vs P&L: We pulled CA sales tax returns after – they matched the POS and landlord reports, not the P&L given to us. Always request Form BOE-401 in California or equivalent – sellers rarely think to fake state filings.
If any one of these four doesn’t tie within 5%, walk away or demand a Quality of Earnings (QOE) from an independent CPA firm.
The Broker’s Indemnity Clause That Doesn’t Protect Fraud in California
The case is still ongoing but the broker is claiming their indemnity clause protects them. However, state statute and case law indicate otherwise. Basically one cannot have an ‘out’ from fraud in California without reaching a very high bar. Even if the contract had said ‘buyer understands there is a statute that protects them but is still willing to waive their ability to prosecute unknown frauds’ it would still be an uphill battle for the agent.
This is California Civil Code Section 1668: “All contracts which have for their object, directly or indirectly, to exempt anyone from responsibility for his own fraud… are against the policy of the law.”
In California you also have:
- Civil Code 1709 & 1710: Definition of fraud – intentional misrepresentation
- Penal Code 532: Theft by false pretenses – which makes this a wobbler (misdemeanor/felony)
A broker cannot hide behind “Seller provided the numbers, I just passed them on.” If the broker had access to POS or bank statements and failed to verify, or tried to sneak in an indemnity clause, that’s evidence of knowledge. That’s why I was brought in as a CFO Expert Witness – to show the broker had a duty to verify.
Treble Damages: Why This Is Theft, Not Just Breach of Contract
Time will tell what happens but since both the seller and agent have criminal records, and this was a significant white collar crime, we contacted the District Attorney for possible criminal investigation. We are determined to recover our losses and have hopped over to professional CPA Accounting Services.
Moreover, case law also allows us to collect treble damages due to the fraud, which is deemed to be a theft, since it was done under false pretenses.
Under California Penal Code 496(c), if you buy property obtained by theft by false pretenses, you can recover three times actual damages plus attorney fees. A civil court finding of fraud based on false P&L can trigger treble damages – turning a $104k loss ($40k purchase + $64k rent) into a $312k judgment plus fees. That’s why we made the DA referral.
CFO Due Diligence Checklist: How to Avoid Retail Store Purchase Fraud
If you’re buying a retail store, coffee shop, or any cash-heavy business for $50k-$500k, demand these 10 items BEFORE you wire money:
- 12 months bank statements – for the specific account for that store, not commingled
- POS admin export – 24 months, daily detail, exported in front of you
- Landlord sales reports – direct from landlord, not seller
- Sales tax returns – 2 years, state-stamped
- Federal tax returns – 2 years, with proof of filing
- Lease estoppel certificate – landlord confirms rent, no defaults, actual sales reported
- Inventory count – physical count at closing with you present
- Seller note for inventory only – just like we did – don’t pay inventory cash up front
- Representation & Warranty that financials are true + no 1668 waiver
- QOE or agreed-upon procedures by independent CPA if profit >$75k claimed
If seller pushes back on any of 1-5, it’s a walk-away signal. I now do this review for buyers as a fractional CFO for $2,500-$5,000 – much cheaper than $104k in losses plus 2 years of litigation.
Conclusion
What looked like a $49k plus inventory deal for a $300k revenue / $100k profit Apple-adjacent store was a classic small business M&A fraud. The POS, bank, landlord, and sales tax all told a different story than the P&L the broker gave us.
If you are buying a retail store in California and want a forensic review of the financials before close, or need a CFO Expert Witness after fraud, contact me at hpaccounting.com. I am based in Fremont and work with business attorneys throughout the Bay Area.