Contingent, unknown and unquantifiable liabilities are problematic in the post-closing purchase price adjustment process. Target companies will probably see these liabilities in the best possible light and exclude them from the estimated balance sheet. When buyers prepare the final closing balance sheet, they often will naturally quantify contingent, unknown and unquantifiable liabilities using a conservative, worst-case analysis. Regardless of which might be the better way to reflect the intentions of the merger parties, buyers typically have the protection of having the opportunity to make an indemnification claim if the contingent liability is incurred, when an unknown liability arises or when a previously unquantifiable liability is finally determined. Sellers, on the other hand, usually have no ability to receive any benefit after the working capital adjustment process is completed if the liability is lower than buyer’s estimate. A common example is accruing for sales tax liabilities where the target company historically did not believe sufficient nexus exists to collect or remit the tax.
To address this, sellers have a few options. First, contingent, unknown and/or unquantifiable liabilities can be explicitly excluded from the definition of working capital and be prosecuted by the buyer solely as an indemnification claim. Since indemnification periods are typically substantially in excess of working capital periods, this allows a much longer period for the actual amount of the applicable liability to be determined. Second, the parties might consider assigning to the sellers the right to either collect or receive any contingent, unknown and unquantifiable amounts that result in a downward purchase price adjustment but are later collected or reversed. For instance, if there is a downward working capital adjustment for payment of a tax liability that may ultimately be determined not to be owed, the parties may agree that the sellers shall be assigned any future refunds related to that liability that might be received. Similarly, if the working capital adjustment is due to a distressed receivable that the buyer is writing off, they may agree that such receivable should be assigned to the sellers to try to recover whatever they may be able to recoup.
The one exception to this strategy is that the parties may wish to estimate the tax liabilities and potential tax refunds that will be received by the Company for the stub period tax returns. Since the costs of the transaction can be used to reduce taxable income, the parties may wish to quantify tax impact of the acquisition on stub period taxes and include provisions as to who is to pay additional tax liabilities and receive tax refunds, if any.