So you have a “cash business” and don’t have accurate financial statements. How do you demonstrate to the buyer that the business is profitable without them relying on your financials? What is an observation period?

In an observation period, a buyer observes your business or works with you in the business keeping track of the sales and estimating the income. Observation periods are used for businesses that keep poor financial records.

What types of businesses are observation periods good for?

Observation periods are good for businesses that have stable cash flow from month to month, such as liquor stores, restaurants and most other retail type businesses. Observation periods are not good for service type businesses where sales can easily be ramped up for short periods of time with additional marketing and advertising.

What precautions should I take before allowing a buyer an observation period?

Be sure to get the buyer’s information, such as a copy of their Driver’s License (if you can do this in your state). I have heard of scenarios where the buyer stole money from the cash register and disappeared, leaving the seller with nothing more than a first name.

You should also have an accepted offer to purchase at a specific price, and also an earnest money deposit. Do not let the buyer observe the business without first agreeing on an offer. An alternative might be to let the buyer sit in the parking lot and watch the traffic flow for a short period of time. Many buyers do this before making an offer. The downside to this, of course, is that you could happen to have a slow day and the buyer may base his decision on this.

Any other words of advice for us?

Yes. If you cannot substantiate what you are telling the buyer with backup documentation, then do not put it in writing. I see sellers emailing documents all the time with line items called “unreported income.” This is just asking for trouble.

Now, this comes with a huge legal disclaimer and explanation: It is a known fact that small business owners do not always accurately report their earnings. I am not commenting on whether this is right or wrong. I am not going into a long diatribe about the problems with our government. I am not assisting you in evading taxes. I am only accepting the situation as it is and telling business owners that they should only put in writing what can actually be documented. That’s it; nothing more, nothing less.

With that being said, let me tell you how to legally avoid paying income taxes for the rest of your life. Just kidding! Let’s stay focused one topic at a time, the issue of legally avoiding income taxes is covered in another article. Ok...I am really kidding. The point is clear, only put in writing what you can document. For everything else, use an observation period.