Considering Liabilities
When negotiating a purchase price for a corporation, everything from employee morale to reputation to future growth potential is examined and quantified. Liabilities, both known and unknown, are a similar, though potentially more nebulous, consideration.

Liabilities can be categorized into two groups: known liabilities and unknown liabilities. Known liabilities might include a bank debt, accrued and unpaid commissions or bonuses, a lawsuit that is pending against the company, or an unprofitable contract. Unknown liabilities generally refers to future lawsuits or other damage that could result from the company's past activity (which are difficult to anticipate and quantify) but may also include debts (which are matured and quantifiable) that have been forgotten or otherwise went undiscovered during due diligence. For example, the buyer might discover that he or she is responsible for settling the claims of workers that were underpaid for overtime hours or that an order filled several months ago was actually short some merchandise.

If the deal is structured as a sale of stock (perhaps because the seller wanted to avoid the "double tax"), all liabilities, known and unknown, are effectively assumed by the buyer, since the buyer will own the selling entity. Thus, the risk of unknown liabilities must be considered when determining a purchase price.

In an asset deal, liability is less of an issue from the buyer's perspective, but is still an issue.

First, the buyer will likely assume some liabilities, and the value of these liabilities will be counted in the price. This assumption will either be because the seller insists that it wants to be free of certain items, such as bank debt, or because the buyer wants to assure that certain creditors are paid without problem, such as vendors whose goodwill is important to the buyer.

Exceptions to the Rule
While it is generally the case that any unassumed liabilities remain with the seller, and are not the responsibility of the buyer, as with most legal issues, there are important exceptions. One major exception is that most states have a "bulk sales" law that requires, in covered transactions, that notice be given to the seller's creditors that the seller is transferring substantially all of its assets to the buyer. If this notice is not given, an unpaid creditor can collect from the buyer up to the amount of the purchase price paid to the seller for the assets.

Another exception is based upon the concept of "fraudulent conveyance." This refers to a transaction in which the buyer does not pay full value for the assets purchased with the intent of assisting the seller in avoiding certain debts. This should not usually be an issue in a true arms length purchase negotiation between unrelated parties.

There is also a concept in the law of "successor liability" that can be used to hold a buyer liable for certain of the seller's liabilities. This happens when the buyer is found to be inseparable by the public from the seller, such as in a case where the buyer continues the seller's business from the same location using most of the same employees and the same name.

Environmental issues are a liability that may in practice have no statute of limitations. Any real estate, airspace or below-ground environment anywhere near where the entity has ever been located or where its products have been used could be subject to liability.

Buyers sometimes worry that liability is motivating the seller to sell. For instance, what if, soon after the papers signed, the company suddenly discovers that it is responsible for an environmental cleanup of a long-forgotten factory site?

The usual protection against such a situation is that the sales agreement will contain representations from the seller, and a typical representation is that there are no liabilities besides those that have been disclosed. Armed with this representation, the buyer has a viable claim against the seller if the buyer is ever held liable for an undisclosed liability.

However, there are limits to the comfort that a buyer can take from reliance on seller's representations. First, most contractual representations survive for only a fixed period of time after the closing of the sale. Claims cannot be brought for breaches discovered after this period lapses. Second, the agreement may contain limitations such that the buyer cannot bring an action against the seller unless and until all claims exceed a given dollar amount (say $50,000), usually called a "basket," or for an amount in excess of a given dollar amount (say $1,000,000), usually called a "cap."

Third, a claim against the seller, which arises after the buyer has had to pay an undisclosed creditor is only as helpful as the seller's actual financial ability to make good. Often the buyer will try to protect himself on this last point by arranging a hold back or escrow of part of the purchase price. Then, if the buyer should become aware of a claim against the seller, he can pay himself for that claim by keeping part of the purchase price.

While unknown liabilities can be addressed as contingencies, their real impact is after the closing. On the other hand, how the parties treat known liabilities is part of the pre-closing bargaining process. If the company being sold is under investigation, or being sued, the buyer may be able to use that information to get a more attractive price.

In certain situations, a company may have exposed itself to so much liability, known and unknown, that a stock deal is an impossibility. For instance, in today's marketplace a buyer would be very hesitant to take over a tobacco manufacturer, as its potential product liability would be enormous but cannot be easily estimated. If the company being bought is in a similar position, it may be necessary to structure the deal as a sale of assets.

Future liability can cause major headaches for buyers of corporations. Before beginning negotiations, the prudent advisor must review the present and past activities of a company. From products to contracts to real estate to employees, any and all potential liability risks must be thoroughly assessed.