Investing in Car Dealerships: Doing Your Homework

Car Dealerships are not passive investments. An investor and his advisors have to do more than look at financial statements, inspect facilities for potential liabilities, and like the brand name being sold.

This article attempts to help give the investor and his/her advisors a broader basis upon which to decide whether the dealership merits their time, money and attention.

Interviewing Factories and Financial Institutions

Lenders have an affirmative duty not to promiscuously disclose the financial condition of their debtors. In addition, most Manufacturer/Distributor Sales and Service Agreements contain confidentiality agreements, with respect to the unauthorized disclosure of a dealer's business to any third party.

Consequently, it is advisable to limit questions directed to factories and finance companies to pertinent, non-confidential questions, such as planning potential, capitalization requirements, required location and number of other dealerships in the area.

The Buyer’s Responsibilities

In 230 Kan. 684, 640 P2d 1235, the court held that not only was a bank under no duty to disclose information to a borrower intending to purchase a dealership, but that because the buyer held himself out as a knowledgeable business man who had expertise in the retail automotive business, he could not avoid the responsibility of exercising reasonable diligence for his own protection. See too: 387 NW2d 373 (Iowa) and 773 F2d 771 (7th Cir.)

A buyer may not abandon all caution and responsibility for his own protection and unilaterally impose a fiduciary relationship on another without a conscious assumption of such duties by the one sought to be held liable as a fiduciary. An investor has an affirmative duty to investigate and if there are facts which the investor could or should have discovered by other means, the investor has no case against another party for withholding the information. 724 SW2d 343

Courts have even held that a seller's accountants upon discovery its client's financial statements were misleading at the time they were given out, had no duty to correct them, even though they were included in a prospectus. See: 513 FSupp 608 N.D. Ga.

The Physical Inspection of the Dealership

Due diligence requires more from a physical inspection of the dealership then searching for defects in the facility, or potential EPA or OSHA problems.

A skilled purchaser, or consultant, can surmise how well a potential seller is operating by a visit to the facility. Such things as whether the sales people are energetic, or lethargic; the amount of time it takes sales personnel to greet customers; whether the store is clean and well maintained; whether awards plaques are kept up to date, all indicate to a prospective purchaser, the financial condition of the dealership.

UCC-1, Mechanic’s Lien, and Title Searches

Data can be obtained from public information to determine not only the financial strength of the dealership, but also how to structure an offer to make it more attractive to the seller. Sometimes the seller will accept a lesser dollar offer because of the manner in which it was structured. Determine what a seller needs and then find a way to enable him/her to get it.

Knowing prior to negotiations whether contractors put liens on assets, whether the facility has a substantial mortgage, and whether the equipment is mortgaged or leased provides a distinct advantage when structuring an offer.

UCC-1, title and mechanic's lien searches supply information without having to seek permission to obtain credit reports and without violating contractual relationships with lenders. Recent lien filings by flooring institutions may be indicative of a lender securing an out of trust position, or attempting to protect its position.

The Fallibility of Dealership Financial Statements

Car dealers are required to close their books and file financial statements by the tenth day of each month. Most Sales and Service Agreements require a uniform accounting system in accordance with the accounting manual provided by the factory/distributor. These statements, however, should not be materially relied upon in making projections.

Some dealers reflect profit from items such as service contracts, finance, insurance, after-market products, advertising, factory rebates and spiffs, in the "Other Income" section of the dealership statement, some allocate them to specific departments, and yet others take one or more of the items completely off the financial statement. A profitable parts department and a losing service department may mean the service department is doing poorly, or that a strong parts manager is intimidating the service manager into paying too much for the part. In one instance, we found the parts manager selling truck bed-liners to the service department for pre-installation into vehicles and, if the customer did not purchase the bed-liner, the loss was charged back to the service department. As a consequence, the financial statement projected a wrong impression of both departments.

A purchaser can proceed with the negotiations understanding that a dealership financial statement should be used as a checklist to ask questions. If portions of the statement which are generally accurate, such as the operational pages, as opposed to the balance sheet, show unusually high or low income or expense percentages, the burden of due diligence would require a purchaser to ask questions regarding the abnormal figures and, if necessary, have a Seller warranty the answers.

Industry Guides are available for each area of a dealership's operations. Guides, however, are good servants but bad masters. They are prepared by many different groups, using a variety of sources. A prospective purchaser should:

(1) Compare the selling dealer's actual performance figures, to the guides and obtain explanations for any variances; and

(2) Prepare a pro forma statement, based upon expected sales and forecast gross profits and expenses, based upon personal experience, rather than the selling dealer's experience.

(3) Recognize inconsistencies and irregularities in the statements, and pursue a more thorough investigation of those items.

Financial statements do not provide answers about a dealership; they present a method to formulate intelligent questions in order to pursue answers.

Keys to Analyzing Dealership Financial Statements

Analyzing financial statements plays a more significant role when one is purchasing the stock of a corporation. With respect to a stock purchase, in addition to the purchaser insisting upon certain warranties from the seller regarding accuracy, answers to questions about material portions of the statements should also be warranted.

Basic “flags” when analyzing dealership financial statements:

a. expenses which have recently declined, therefore making the statement look better;

b. significant changes in the percentage of receivables versus service and parts sales;

c. any changes in inventory methods;

d. changes in the method of preparing the financial statement (cash vs. accrual);

e. any substantial difference between items of income, expense, receivables and inventory, within one year of the potential sale;

f. inter-company, shareholder, director, or officer transactions with the store;

g. state tax losses which are not available for federal tax purposes, either because of consolidated returns, or for some other reason;

h. any factory, finance or tax obligations omitted from the statement;

i. items such as the sales commissions being under or over stated;

j. the items are included in the "other income" and "other deductions" category;

k. items such as finance, insurance, or service contracts being carried off the statement;

l. whether the repo reserve accurately reflects the dealerships history;

m. a significant increase in leasehold improvements, which may mean the dealership allocated repairs to improvements in order to inflate net worth and profits;

n. whether the corporation has been using LIFO and the effect it may have on profits;

o. compare cash flow vs. stated profits and whether the new dealer should expect a different ratio;

Consistency should exist from month to month in each individual account. Unexplained increases or decreases, such as parts or used car inventories, should be explained. All expense accounts should be compared. Note and receive an explanation with respect to major fluctuations.

Buying Without Relying

Buy a dealership without relying solely upon a seller's financial statements in the same way factories open new points. Major differences in these approaches are generally to the buyer's benefit. For example, when opening a new point there will be no wholesale parts business, no retail sales base; no telephone number in the book; and no vehicles lined up for service the day after the escrow closes. Buying an existing business gives you all that, plus “historical” versus “projected” income to use with your forecast.

In addition to reviewing financial statement, three additional questions should be answered before making projections for a new dealership:

(a) the current retail sales volume;

(b) the planning potential, at closing; and

(c) the new rent factor.

Given those three figures, one may guesstimate the dealership’s earnings under proper management. The answers to all three questions may be obtained without a financial statement. The factory has the planning potential and past sales records, and a lease is required to accurately determine the rent.

Generally, the more experienced the purchaser, the less weight he/she gives the seller's financial statements. While financial statements provide a starting point for asking questions; they do not provide all the answers.

In one instance we know about, an inexperienced investor ended-up being held liable for approximately $2.5 million. He sued alleging a variety of defendants conspired to defraud him by misrepresenting the value of the dealership, enticing him to buy it and then causing it to fail so that it could be reacquired free of debt. The Seller countersued to force buyer to live up to the purchase contract.

The judge released the banks and financial institutions, which the buyer was suing for fraud and conspiracy and, after making several adjustments to the accountant's version of the net worth of the dealership, concluded the store had a negative net worth when the buyer agreed to purchase it. The buyer was then held liable for damages incurred by the dealership, its dealer, for the remaining debt to the Bank, -- plus the dealer’s and bank's attorneys fees and court costs for all defendants, including the accounting firm and his own attorneys. See the Modesto Bee, June 10, 1988.

The real irony is that not only did the buyer end-up with no dealership and a huge liability, but he was the one who initiated the legal action.

Officer, Director and Shareholder Approval

Many times neither the general manager, nor the dealer-operator has much input with respect to whether the dealership will be sold, to whom, or under what terms and conditions. Most dealerships are incorporated, however, and a check with the Secretary of State or Corporations Commissioner of a given state will reveal the shareholders, directors and officers of the corporation, LLC, or limited partnership. A check of the County records will generally reveal a d.b.a., limited or general partnership, whether or not a partnership agreement or stock has been pledged or encumbered and, if so, to whom.

Information, regarding shareholders and officers should be acquired from sources in addition to the factory, as the factory may not have all the information needed to assure the buyer he or she is actually negotiating with the person who possesses the authority to make a contract. In addition, dealers on occasion have silent partners, or have sold an interest in the business without informing the factory. In either instance, a potential purchaser could be misled into negotiating with the wrong party.

In 796 F2d 345 (10th Cir), Michael Gage, president of Michael Gage Chevrolet, signed a "Memorandum of Agreement" to sell his store. Gage had no approval from either the Board of Directors, or the shareholders of the corporation. Subsequent thereto, the Board and the shareholders rejected Gage's buyer and entered into and approved a Buy-Sell Agreement, with another party that was consummated.

Gage sued alleging (1) the Board of Directors and the shareholders breached a fiduciary duty by not approving the first agreement and (2) that the board and shareholders interfered with Gage's contractual business relations. The state court dismissed and Gage re-filed in federal court, alleging the same two causes of action, plus violations of both the state and federal Dealer Day in Court Acts. He lost. The court held that when the dealer signed a "Memorandum of Agreement" to sell, he had no approval from either the Board of Directors, or the shareholders and "without such authority Gage could not validly contract to sell the corporation's assets."

Also be aware that states vary with respect to the number of shareholder votes required. Some require consent from all shareholders, some a two-thirds vote and some only a majority.

Attorneys, Accountants, Brokers and other Automotive Advisors

Attempt to determine the other party's advisors and whether they possess talent; are knowledgeable with respect to the automobile business; and their reputations for veracity and keeping their word.

Preparation is ninety-nine percent of the game. After an investigation of the other party and its advisors is completed, a decision should be made whether or not to proceed. Some purchases are better avoided, regardless of the attraction.

Questions to Ask about the Business

Why did it Fail or Succeed?

As in "Valuation of Dealerships" (a topic for another article), the critical question is not whether a selling dealership's financial statements reflect a profit or a loss, but rather why?

The fact a dealership shows a large net operating profit and a large number of vehicles sold is not enough answer to answer why. Were they sold within the dealer's Sales and Service Area? Were they retail or fleet? Were the sales due to the operation of the dealership, the personal contacts of the dealer or shareholders, or because of the area, the sales personnel, or some other reason? Are the sales above or below planning potential? Will the new owner continue the same type of sales system as the selling dealer? What does the buyer anticipate in retail sales the first full year after close of escrow?

The above questions must be answered before projecting whether new management will make a profit and before deciding upon a reasonable offer for the dealership. How many new units are other dealers on the street selling? How is this dealer's nameplate selling in the over-all area? Answers may be found by carefully questioning the dealer, his accountant, attorney and anyone else in the dealership, with whom the dealer permits discussion. They may be found by talking to the factory, finance companies, banks and other dealers. Advice from factories and financial institutions, however, must be weighed against the institution's potential exposure to the selling dealer for breach of confidence.

Inform the selling dealer's advisors at the outset of performing your due diligence that warranties regarding the accuracy of the selling dealer's representations regarding retail sales and other material information, will be required when the final Buy-Sell Agreement is written. Keep in mind, however, a flat refusal to give the warranties does not mean a sale will not be worth completing. Many dealers believe they are not selling "financial statements"; they are selling hard assets and a business opportunity.

In determining the cause for a dealership’s failure, remember it is generally better to purchase a dealership that failed because of correctible mistakes, such as a selling dealer’s lack of business acumen or personal problems, than to purchase a store that had the best operator in the world and still failed, or one that succeeded only because it had the best operator in the world.

Actual Sales vs. Planning Potential

Planning potential is important for several reasons, such as vehicle allotment, build-out allotments, capitalization requirements and reasonable expectations. A low planning potential and high volume sales may mean the working capital requirements are unrealistic. It is almost impossible to retail 2,000 new vehicles, if the dealership is capitalized to sell 500. There would not be enough working capital to adequately advertise, purchase trades, or to complete the other requirements necessary to maintain a high volume store.

When questioning the factory about planning potential, not only inquire as to the number, but also as to the manner in which the planning was derived, the date it was determined, when it is expected to be updated, whether it reflects actual sales in the market area and if not, why not.

Area of Sales and Service Responsibility

The dealership's area of geographic sales and service responsibility is important both with respect to surrounding dealers, and with respect to whether or not the factory intends to close an open store, or open a new store. Past service and sales numbers will be of less value to future projections if the factory intends to add or delete points.

Inquire of the factory, as to what the planning potential requirements would be, taking into consideration the newly closed or opened point.

Significant Document Checklist

Although some of the following items are more important when dealing with a stock sale, versus an assets sale, the prospective purchaser should have his or her advisors collect:

(a) leases and contracts, including employment contracts, and all modifications;

(b) copies of all employee benefit plans;

(c) signed income tax returns (5 years);

(d) dealership financial statements (5 years);

(e) the selling dealer's Direct Dealer Sales and Service Agreement;

(f) copies of by-laws and articles of incorporation;

(g) copies of insurance policies, to include: premiums; expiration dates; beneficiaries; and cash surrender values;

(h) verification for all off-statement income claimed, such as service contracts and insurance, as some of this income may appear on the dealer's personal tax return, or the tax return of another company;

(i) verification of any claimed management, or inter-related company fees.

In addition, the advisors should be certain to verify addresses on insurance policies, as we have encountered instances where the address being insured was not the address where the dealership was located.

Finally, the appropriate advisors should have an understanding of past, pending and potential litigation, DMV, factory and finance company problems, along with any settlements, payment of sales taxes and whether or not favorable state unemployment insurance rates may be transferred.

John J. Pico holds a Doctorate of Jurisprudence degree, is a vice president of Automotive Advisors of America, Inc. and in the last 33 years has completed over 1,000 dealership transactions. In addition to lecturing about buying and selling automobile dealerships, Mr. Pico has published two books and numerous articles on the subject. For more tips, sources and a list of references and experience, go to http://www.automotiveadvisors.com

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The one place to go for advice when investing in an automobile dealership is Automotive Advisors of America, Inc.