Some valuations include contingent liabilities, which can have a significant impact on value.

Defining Contingency

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% 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 experts often have to dig to find them. For obvious reasons, owners don’t always disclose these potential deal killers, so these experts must sometimes assume that they exist based on the company’s industry, type of business, meeting minutes or shareholder or spousal declarations.

Once valuation experts 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?

Expertise Required

To understand these numbers, the experts often turn to subject matter experts. For example, in the case of a lawsuit or a contract question, they will consult with the company’s attorney to assess probability of a judgment and its dollar impact. If it’s a tax audit, they will meet with the company’s CPA to assess the tax implications. If it’s a question of an EPA or OSHA investigation, the expert will call on an attorney who specializes 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.

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