Valuation Techniques: Dealing with Contingent Liabilities
Some valuations include contingent liabilities, which can have a significant impact on value.
Contingent liabilities are potential liabilities that may or may not be realized. They include possible claims against the target company, such as:
• Lawsuits – If the company has pending lawsuits against it, the outcome of these cases and any judgments to be paid may impact value.
• Product warranties – If the company’s products fail or require repair or replacement, “make goods” could consume company resources.
• Guarantees on debts – If the corporation is a guarantor on a subsidiary’s borrowing, a loan default might impair cash flow.
• Liquidated damages – If the company is party to a contract that includes a liquidated damages clause, it may owe an assessment in case of a contractual breach.
• Government probes – If the company is subject to OSHA, IRS, or EPA audits, the business may be at risk of a hefty judgment or assessment.
Contingent liabilities involve a fair amount of uncertainty. And if they are realized, their impact can be problematic for a buyer, shareholder, or divorcing spouse, unless they are disclosed.
How to Value Them
Companies using Generally Accepted Accounting Principles should report contingent liabilities estimated at a likelihood greater than 50 percent on its financial statements. However, it’s not uncommon for contingent liabilities to be hidden away in the hopes that they won’t be discovered.
So before assessing the value of contingent liabilities, valuation analysts often have to dig to find them. For obvious reasons, owners don’t always disclose these potential deal killers, so analysts must sometimes assume that they exist based on the company’s industry, type of business, meeting minutes, or shareholder or spousal declarations.
Once analysts identify a contingent liability, they must assign a value to it based on estimates of their probability and dollar amount. In other words, how likely is it to occur, and what will the damage be to the company’s value if it occurs?
To understand these numbers, analysts often turn to subject matter experts. For example, in the case of a lawsuit or a contract question, an analyst will consult with the company’s attorney to assess probability of a judgment and its dollar impact. If it’s a tax audit, the analyst will meet with the company’s CPA to assess the tax implications. If it’s a question of an EPA or OSHA investigation, the analyst will call on an attorney expert in those areas.
What follows could be a probability flow chart or net present value calculation that accounts for the expected amount and timing of future cash payments.
With so much subjectivity involved, analysts require a significant amount of expertise to make these estimates. Incorporating these figures into a valuation gives potential buyers, shareholders, or divorcing spouses a clearer picture of the company’s value.