Do You Know the Hidden Costs in a Business Acquisition?

During the last several months we have seen a lot of activity with companies merging and/or acquiring other entities. I’d like to share a few insights from a risk manager’s point of view on business acquisition and due diligence.

One of the goals in selling a company is to pass along as many of the problems associated with the business to the buyer as it can. One of the areas that can be significant is that of the workforce. Workers compensation costs are one of those problems that can accompany a workforce and it is important to recognize this during such transactions.

Most take a very detailed look at the books of a company they are considering purchasing. This review is known as due diligence. Not all companies include workers compensation (or other lines of insurance for that matter) in the scope of issues reviewed during the due diligence process. This is a grave mistake! The purchase price is often based on estimated profit and if a business underestimates its workers compensation costs – as they often do – it understates its operating expenses and overstates its profits. Because the value of a company is based on its profits, overstating profits overstates the company’s value.

Here’s an example: suppose a company purchases a plant and pays a price based on the assumption it turns a profit of $2,000,000 per year. This profit estimate is based in part on the assumption that annual workers compensation costs are $200,000 as indicated in the plant’s accounting records. If the true cost of workers compensation is $400,000 the plant’s annual profits are overstated by $200,000. This means the selling price may be overstated.

The problem may be worse than overstated future earnings. The plant likely understated its workers compensation costs in prior years and failed to establish adequate reserves. This means that the purchasing company will need to build up the reserves, which will further reduce the plant’s earnings.

In regards to the example used above, if the plant understated workers compensation costs by $200,000 for each of the previous 5 years, its reserves would be understated by $1,000,000. As those costs are recognized, the purchasing company would need to deduct them from its current earnings. This means the purchasing company will need to use its earnings from after the sale to finance liabilities it unknowingly acquired when it purchased the operation.

Understating workers compensation costs may not be intentional. Many companies are unsophisticated in their workers compensation accounting methods and recognize only a fraction of the true cost. Moreover, if there are problems on the horizon, or are buried in the past, companies have no incentive to investigate them and shed the light on them especially when they are about to sell the business. But a buyer of a business should investigate and determine if those issues exist.

The upshot is that underestimating workers compensation costs can inflate the present and future value of a company’s assets.

Further information on how these issues should be addressed is developed and determined by the nature of the transaction, assets-only or assets and liabilities. Assets-only transactions usually occur when a company sells only part of a legal entity. The buyer purchases only the plant and equipment while the seller retains the liabilities for accounts payable, taxes, workers compensation and all other liabilities.

Another area to be evaluated is the intent of the transaction with regard to past, present and future liabilities. This can be expressed in an indemnity contract whereby buyers and sellers clearly state their intentions with regard to the assumption of liability.

The bottom line is that whenever a transaction is being considered the insurance and risk management program should be investigated and evaluated as a part of the due diligence study. Make sure an insurance advisor is a part of the acquisition team – it can help you to assess potential shortfalls in profitability and ROI.