Litigation + Valuation Perspectives

Demystifying Valuation, Economic Damages + Forensic Accounting

Due Diligence Tips for Buying a Business – Part III

LIABILITIES

Compliance with bulk sales laws for asset purchases:
• Make sure the bulk sale notifications specified by local law are complied with.  The effect of failure to comply with the bulk sales law enables creditors to “follow the assets” and have valid claims against the new owner (the buyer).
• Provide in the asset purchase/sale agreement that the seller shall comply with applicable bulk sales law notice rules, or give the buyer the information necessary to give proper notice to creditors.

UCC filing search:
Conduct a UCC (Uniform Commercial Code) filing search under the corporate or DBA name of the business as well as the names of principal shareholders and officers of the company.  The search should reveal any bank loans secured by assets, accounts receivable factoring or pledge agreements, borrowings secured by inventory, outstanding judgment liens, and any equipment purchase contracts.

Public record search:
• Review court records to identify undisclosed liens or judgments and the existence of current or past litigation naming the business, owners, or officers as defendants.
• In cases where the nature or frequency of litigation seems to cast an unfavorable light on the character and business ethics of the seller or officers and employees of the target business, the buyer should consider the implications on the purchase.

Tax return reviews:
• If the transaction is a stock purchase; review income, payroll, sales, use, and excise tax returns for the prior five years period to identify aggressive or incorrect positions that may result in additional tax liabilities.
• If business does not use tax basis accounting for financial accounting purposes, aggressive income tax return positions can usually be identified by comparing the financial accounting income statement to the income tax return.
• When reviewing payroll tax returns, confirm employees have been accurately classified as independent contractors.  Look for red flags such as Form 1099-Misc filings which indicate that an individual was treated as a contract laborer in one year and an employee in another.
• Obtain from seller copies of all correspondence regarding ongoing tax audit activity (at the federal, state, and local taxing authority levels – including sales and use taxes) and copies of all IRS revenue agent reports for recent tax years.
• Obtain a seller representation that all current tax controversies (including sales and use tax disputes) have been fully disclosed.
• For each year federal income tax returns are reviewed, verify that there are sensible explanations behind all material differences in revenue and expense categories on internally prepared income statement versus the tax return.

Contracts review:
• Review all significant contracts for potential undisclosed liabilities and requirements to make future payments (examples include obligations under noncompete agreements, employment contracts, payments due under royalty or licensing arrangements, equipment lease and maintenance agreements, employee collective bargaining agreements, and agreements to provide ongoing services to customers).
• Obtain seller representation that all obligations under contracts have been fully disclosed.
• Determine if operations are adversely affected by contractual limitations such as employment contracts containing large termination payments or property tax abatement agreements calling for continued operation at a particular location.

Employee benefit plans review:
• Review all significant contracts for potential undisclosed liabilities and requirements to make future payments e.g.; obligations under noncompete agreements, employment contracts, payments due under royalty or licensing arrangements, equipment lease and maintenance agreements, employee collective bargaining agreements, and agreements to provide ongoing services to customers.
• Contact the health insurance carrier regarding the status of insured health plans (including possible rate increases).
• Check vacation pay accrual calculations for reasonableness.
• Determine if any planned employee benefit cutbacks are prohibited by employment contracts or collective bargaining agreements.

Miscellaneous liabilities review:
• Assess the likelihood of undisclosed miscellaneous liabilities of the following types:
o Environmental liabilities;
o Royalty and licensing agreement obligations;
o Warranty service contract liabilities;
o Contingent liabilities pursuant to loan guarantees (particularly for personal loans to the owner and his or her relatives);
o Contingent liabilities attributable to patent or trademark infringement litigation;
o Contingent liabilities as a result of employee discrimination or harassment suits;
o Contingent liabilities related to product liability suits; and,
o Contingent liabilities of any other type associated with existing, pending, or threatened litigation.
• Obtain a general representation by the seller (in the purchase/sell agreement) that there are no undisclosed liabilities (contingent or otherwise), except for those arising in the ordinary course of business after the preparation of the financial statements used as the basis for the negotiations and agreement.
• With regard to contingent liabilities, which may not be reserved for on the balance sheet, obtain a specific seller representation that all relevant details have been disclosed.

Don Bays, CPA/ABV, CVA, CFF

1 Buyer’s side Due Diligence Investigation Checklist, Appendix 3F, Vol. 1, Fifth Edition, Practitioners Publishing Company, Buying and Selling Small Businesses.