Clean Up Hidden Liabilities Before Selling Your Business

January 20, 2012

You are ready to put out feelers for selling your company. Perhaps you have contacted your CPA to have some preliminary due diligence begun. As you prepare to finalize your asking price, issues arise that you hadn’t planned on. Hidden liabilities – those unplanned-for nuisances that can depress the value of your company – can put a real damper on your plans.

What are hidden liabilities? Items that you are peripherally aware of, that you cannot feel or touch, but that have an impact on a potential buyer’s perception of your company’s value. Here are some types of hidden liabilities.

Below-market rate loans. If you have debt on you balance sheet that is not assignable to incoming purchasers, you may have a hidden liability. In other words, a buyer will have to spend more of the company’s resources to fund the debt service than you do now. If a buyer wants to maintain the same or similar capital structure, assignable loans with below-market rates of interest are a detriment to value.

Unremedied environmental problems. While these types of situations were more prevalent some years ago, any potential environmental contamination, whether caused by your company or its predecessors, will result in additional risk to the buyer. Because of the overriding scope of federal and state environmental cleanup laws, potential buyers will take a hard line on setoffs or reserves considered necessary to compensate for the risk of being subjected to a cleanup proceeding.

Unresolved tax issues. In many companies, liabilities for taxes that were not paid or were paid under aggressive strategies will cause buyers to be skeptical of the potential impact on future operations. In some states, a pre-deal audit can be arranged to force the taxing authority to sign off on the lack of liability or quantify the amount of a tax liability before the deal closes. However, you should presume that the buyer will conduct a sufficient review of your finances to uncover any open tax issues. Closing the gap on this type of liability is easy to do in planning to prepare for a sale of the company – and much harder to do after negotiations for sale have begun.

Warranty and other reserves. While a properly prepared GAAP-basis balance sheet will contain an accrual for unpaid warranty reserves, the potential effect of these reserves on a sale cannot be underestimated. The buyer will want to be sure that any liability arising during the period before the sale will be properly paid for prior to sale or reserved against the seller. The computations used in estimating potential warranty costs are subject to intense scrutiny in the due diligence process.

Litigation. The reporting requirements of the Financial Accounting Standards Board FAS 5 – Accounting for Contingencies – provide that losses to be suffered in an adverse litigation claim should be recorded if both of the following conditions are met:

• Information available … indicates that it is probable that an asset had been impaired or a liability had been incurred. …
• The amount of the loss can be reasonably estimated.

In this definition, it is implicit that one or more future events will occur confirming the fact of the loss. As such, if future events cannot be foreseen with probability, a loss contingency is not recorded. This is fine for financial reporting purposes, but if a buyer plans to purchase a company, he or she will not be constrained by accounting pronouncements in getting to the bottom of litigation liabilities.

Many of these issues can be addressed with proper structuring of a sales transaction. A seller would not want to be saddled with hidden liabilities any more than a buyer would. The best approach is to clean up any hidden liabilities long before you enter into sales negotiations.