Off Balance Sheet Liabilities
In the past couple weeks we’ve talked about some costs that don’t always appear on the income statement; opportunity costs and sunk costs. Today, I’d like to talk about some liabilities that don’t appear on the balance sheet. The technical term for them is “off balance sheet liabilities” and they are something to be very wary of as an investor.
When you think about investing in a business, whether it is a public stock you can buy via Schwab, or a mature business you are acquiring with debt financing in a leveraged purchase transaction, or a growth company you are investing in, or even a young startup, you should take a close look at the balance sheet. You should see what obligations that company has built up over the years and how they compare to the company’s assets. When the liabilities are large and the assets are not and if the cash flow is weak or non-existent, then you should be extremely cautious because those liabilities can sink the company. We talked a bit about this in the post I did on financial statement analysis and the balance sheet.
But sometimes companies don’t put all of their obligations on the balance sheet. There are at times valid reasons for this, but there are times when the company is just trying to pull a fast one on the investor community. Enron is a classic business case story about this. What Enron did was create investment partnerships where they transferred assets and liabilities. But those partnerships had close ties back to Enron and at the end of the day, they did not eliminate the liabilities, they just took them off their reported balance sheet. When those partnerships blew up, Enron came crashing down. Billions were lost and executives went to jail.
Even if the company you are looking to invest in is totally clean and honest, there will be likely be liabilities that are not on the balance sheet. Let’s say you are looking at investing in a company that does mobile software development for big media companies. Let’s say they have just signed a three-year contract to develop mobile apps for one of the largest media companies in the world. Let’s say they got paid upfront $1mm to do this work. That $1mm will appear on the balance sheet as deferred revenue and that is a liability. But what if the company misjudged the amount of work it will take and they will ultimately lose money on the deal? What if it will actually take them $1.5mm in costs to do this work? The $500k of losses is an additional liability but it doesn’t appear on the balance sheet anywhere. But those losses could sink the company if it is thinly capitalized.
Real estate liabilities are a particularly thorny issue. Back in the early part of the last decade, right after the Internet bubble burst, I spent almost all of 2001 trying to negotiate a bunch of companies out of real estate liabilities. These companies were all growing like crazy in 1999 and 2000 and they signed five and ten year leases on big spaces (like 10,000 square feet or more) with big landlords. Many of these leases had rent concessions in the first year or 18 months and when those concessions came off, the companies instantly faced the dual reality that they could not afford the leases and that they were not going to raise more money with these huge lease obligations in place. But those lease obligations were not on the balance sheets. The annual rent expenses were on the income statement, but the future lease obligations that ultimately sunk a few of these companies were only disclosed in the back of the footnotes.
The footnotes are where you have to go to see these off balance sheet liabilities. If the Company is audited, then their annual financial statements will have footnotes and this kind of stuff is likely to be in there. If the company is publicly traded, it will be audited, and the footnotes will be in the 10Ks and 10Qs that the company files with the SEC. But many privately held companies, particularly early stage privately held companies, are not audited. So if you are going to invest in a company that is not audited, you need to diligence these unreported liabilities yourself. You should ask about lease obligations and any other contractual obligations the company has. Read the leases and the contracts. Understand what the company is obligated to do and how much money it will cost. Make sure those funds are in the projected cash flows.
Balance sheets and income statements are important to understanding a company. But they do not tell the entire picture. They don’t tell you if the team is solid. They don’t tell you if the product is any good. They don’t tell you if the market is big. And they don’t even tell you about all the costs and they don’t tell you about all the liabilities. So you have to dig deeper and understand what is really going on before putting your capital at risk. That is called due diligence and it is critical to investing. And looking out for liabilities that aren’t reported on the financial statements is an important part of that.
Comments (Archived):
Operating leases (computer hardware) are a common way of keeping assets off the balance sheet. I have had many conversations with auditors about what constitutes a finance lease or an operating lease.Also for Biotech companies joint ventures and R&D partnerships can also be tricky.
all good examples. joint ventures and any kind of partnership are things to be careful about. that said, for biotech companies, this is a very common and important kind of financing
Fred, what is your opinion about startups where founders are “split” between countries – say one lives in US and the other lives overseas.
It can work. But they have to have a long and deep history of working together and unwavering trust in each other
Don’t forget that not a single airline company in this country has an airplane as an asset on their balance sheet.
fantastic….I can keep the company jet that I’m going to buy with VC money off the balance sheet.
if it flies, floats or fornicates…………………………………………………..rent it.
LOL
JLM you have violated two of those and we know it. I at one time violated all three until my wife forced me to sell the plane because of two accidents by CEO friends in less than a year.
I guess technically I am in violation of all three. I fly a Bonanza and am headed to the E Coast Wednesday morning — wheels up to touchdown, Austin to Columbia SC in 4:45 non-stop. Tip tanks and a tailwind (I hope).On one occasion I made it Austin to Myrtle Beach in less than 4:00 w/ a hell of a tailwind. GS in excess of 250 knots.I really want a Pilatus.
A Pilatus would be awesome. Swiss engineering and stone reliable PT6 turboprop….never been in one.I did “fly” a T-6 “Naughty Nurse Nancy” with a Korean War Vet last week. He asked when the last time I flew a tailwheel, and I said never….he said we’re not learning on this one…you get it 300ft off the deck and give it back when you line up 300ft from the deck.Boy he could fly and they must have made rudders a bunch bigger 50 years ago. My first couple of Chandelles were interesting…..I give him credit he was completely non-plussed….just laughed and made a comment about “modern airplanes” which I couldn’t decipher in the open air.
And try figuring out what their liabilities are for those planes
Other side of the coin.Due diligence is a must for investment but a real pain-in-ass for the entrepreneur… because the initial finance you get from are friends, family and may be friends-friend and sometimes on interest-based-loan, word-of-mouth loan. Getting that sorted with the auditor is a real pain … if you are into manufacturing it burns like a hot chili up your nose … by that time you could build your next product!!. All said and done… if you need money you gotta byte the chili… through whatever opening the auditor and investor likes.
An accountants review is often a solid middle ground between pure internals and a full-on audit as the notes disclose all of these off BS issues. It’s significantly cheaper and less stressful on the entrepreneur, but can often – nearly always in my experience – satisfy the concerns of not only early stage equity investors but later stage investors and even non-PGd’ debt with real collateral from a “name brand” lender. Although we have the most “audit-able” of businesses out there with lots of real assets on the BS (where we can borrow up tp 50% of our inventory let alone most of our receivables), our financial partners have always been satisfied with an accountants review and their own twice yearly “bank audits” (which are nothing like an accountants audit and not even a review)
Many of the liabilities of companies are “contingent.” The disclosure of these liabilities is governed by financial accounting statement 5 of the Financial Accounting Standards Board. On July 20 the board proposed important revisions to this standard. Watch my website at http://corporatedisclosurea… for more information on this proposal.
One of my biggest pieces of advice (learned the hard, way) for companies I am involved in is to start out with temporary space or very short term leases. Always better being a little uncomfortable and too crowded in lease before you upgrade; and always better signing short (less than 12 months if possible for seed stage) leases and/or temporary space. Flexibility is gold.Eventually, you get to a point where you’ll need to sign leases — but even then you want to only make hard commitments against some specific scenarios (ie can you afford it). This is an area where VCs and experienced angels can really help also – I have personally seen significant games played with Taxes and Operating Costs vs. baselines that because they (naturally) don’t get the energy of a product type entrepreneur and can be filled with potholes and traps.Give yourself plenty of optionality around your real estate. Discomfort and crowdedness is a small price to pay for a great set of options going forward.
So true Al. That is one of the many important lessons I learned post bubble. Long term leases are not good for startups
Agree totally. From a company morale point of view there is something much worse than being overcrowded….and that is sitting in a deserted office. When you go into a space like that you can just feel the depression.I’ve been visiting some datacenters lately and when you go to one that you can see was overbuilt its totally depressing compared to the place busting at the seams.
You raise important points about managing the contingent liabilities associated with real estate. Here are a couple of suggestions:First, free rent in a long term lease should be accounted for by averaging the rent over the entire term of the lease and expensing that average cost during the term of the free rent. That is a GAAP concept which should be respected for every company.Tenant improvements should be depreciated over the initial term of the lease.Leases should be carefully negotiated as it relates to the default provisions and the Landlord’s remedies. It is not unreasonable to negotiate a 6 months liquidated damages provision in the event of a Tenant monetary default and the application of any security deposit to that liquidated damages provision.Real estate is state law and most states provide that the Landlord is entitled to recover the NPV of your rental stream minus the NPV of a replacement tenant plus the cost of eviction and reletting (including tenant improvements and leasing commissions). The Landlord is typically unlikely to be entitled to collect all of the rent you owe. You have to know the law cold.As to term, sign short term leases with lots and lots of renewal options and limitations on how much the rent can be hiked at the time of renewal. A CPI mechanism is not unreasonable.As to how lease are configured pertaining to who pays the operating expenses:Gross leases — fixed amount of rent, Landlord pays everythingBase year leases — Landlord pays base year expenses and Tenant pays all increases thereafterNet leases — Tenant pays its prorata share of all operating expensesIt is very, very important to define “operating expenses” beyond the obvious property taxes, insurance, utilities and maintenance. The devil is in the details.Last comment — binding arbitration in the city where the real estate is located is a good way to solve disputes. It is less costly, less cumbersome and it is easier to reach the equities of a situation.
Insight into the real estate industry like that is exactly why I sought out a meeting with you in the first place.Now wouldn’t it be great if there was a company that provided high-quality leads to property managers to help budget cash flows properly? Oh wait!
Somewhere in this comment are the secrets to how to negotiate your living space.Why is it that you can’t ask for a rent deduction instead of X months free, considering GAAP ands all. I feel like less of my friends would screw up renting knowing this.
OK, here is the reason why real estate owners and developers are willing to provide “free rent”. Shhh, it is a secret.When you give free rent, you are, in effect, averaging down the real cost of the lease but for financing purposes once the free rent period has expired, you are financing or selling a rental stream which has a higher capitalized value.This is also why real estate owners and developers like to have a gradually increasing rental stream over the term of the lease. They are going to sell or refinance the property when the rental stream is higher and thereby recognize a higher capitalized value.Example — 12 month lease @ $100 per month w/ 2 months freeTotal cash flow = $1,000 ($100 x 10 months)Average rent payment = $83.33Assumed cap rate = 6%Capitalized value of average rent payment = $1,388.89 ($83.33/0.06)Capitalized value of last month’s rent payment = $1,666.67 ($100/0.06)Increase in capitalized value = $277.78 or 20%You rent up the office space or apartments providing a spot of free rent and then you go to the market and finance or sell after the free rent period has expired.On a $20MM property you create 20% incremental value by being patient and knowing how to market the property to tenants and are rewarded with an additional $4MM in your pocket.The game is even juicier if you have a built in escalation such as —Year 1 rent = $100Year 2 = $103Year 3 = $106Year 4 = $109Year 5 = $112Now the values look like this —Year 5 capitalized value = $1,866.67 ($112/0.06)Increase in capitalized value = $477.78 or 34.4%Again, your nominal $20MM building is now worth $26,880,000 and in the interim you have manufactured a bit of depreciation and interest deduction.This is how developers get rich by giving out free rent. This is the mildly advanced real estate finance course but not very.And now you know why free rent isn’t free.Don’t tell anyone.
I won’t unless I can get them to swear into the cult of JLMisms.
I always try for short term leases with lots of renewal options and I am willing to pay up for the flexibility. But even so, NY landlords are not into those kinds of deals for some reason
Informative as always Fred. You are absolutely right on the importance of reading the footnotes of the financial reports to find these off balance sheet liabilities; in fact, footnotes are the best place to learn about all the little “secrets” of a company. And of course, due diligence is critical to anything you are looking to invest in.Cheers.
Great post. Typically this done to hide debt for two reasons 1) have lower cost of borrowing (higher risk profile/debt higher the borrowing costs and 2) avoid breaking debt covenants including limits on debt or financial ratios like debt:equity, etc. Remember also that some of this is legally acceptable (operating leases like rents, leased assets like aircrafts, etc) and some not (of the Enron variety!).Hence Fred’s point is critical “So you have to dig deeper and understand what is really going on before putting your capital at risk.”Thanks FredSenith
Great post. As Gillian Tett tells the story, the off-balance sheet status of most “special interest vehicles” (SIVs) (which made up the shadow banking system) was a key factor in the credit market seizure that occurred in late 2008.I still cannot figure out how these were permitted given the role of SPVs and SPEs in the Enron collapse. Can it be that changing the acronym and industry is all that it takes to perpetrate the same kind of fraud?Financial regulatory reform has been frustrating. The White House talks about transparency and accountability, but what affirmative steps have been taken to increase these in a way that will scale with growth and globalization. Most of the reforms are simply band-aids, like Sarbox, which will only aid administrative costs on top of higher taxes.What about reforming the requirements for financial statements? Why not use modern technology to better leverage our cognitive capabilities to spot problems and deter fraud? Require public disclosure of more raw data from public companies — a move that could simultaneously lower administrative costs and increase transparency and accountability. None of the more creative solutions to our problems are being explored because of the basic lack of understanding of scaling problems to monitoring and enforcement.
An honest man runs an honest business and is compelled — not “inclined”, mind you, “compelled” — to conduct his affairs honestly in things great and small.A dishonest man is inclined to run a dishonest business and this flaw does not come in a single bottle. It trades in kegs and six packs and cases. He who cheats at golf, cheats in business.The dilemma is quite simple — no amount of regulation transforms a dishonest man into an honest man. No amount of draftsmanship makes a crook into a vicar.Only clear rules, periodic scrutiny and enforcement will identify and ultimately eliminate dishonesty in business.Writing rules is not enforcement. We already have enough rules. The problem is in the enforcement. Bernie Madoff was not going to be dissuaded by another set of rules. He was off the reservation long ago.This is why I am in favor of public beheadings on the steps of the NYSE for financial misdealings. But, hey, I could be wrong?
Totally agree. When we over regulate we put the burden on the honest, who have to do more and more things to comply (and also pay the taxes that pay the regulation and its enforcers). The dishonest ones will always find the hole in the rule to do what they intend to do. We have to punish the group that deserve to be punished, not the other one.
My younger brother is with you on the beheadingsI worry about beheading an honest man
There is a huge new industry in this idea. I may have to become an entrepreneur if someone else doesn’t step up and do this. It is absolutely the future.
If you do, I’d like to know early.
In wandering into the subject of due diligence, I urge you to develop your own due diligence checklist — a written bound checklist — which catalogs every single element of concern.Take a look at a well crafted public company balance sheet and identify every footnote subject (e.g. insider relationships/self dealing) and craft a question which deals with evey one of those subjects. Read the footnotes carefully and get them explained to you by whomever prepared them.I have been an acquirer of troubled businesses through the years and I have a 17 page Due Diligence checklist which I have developed over 30 years. Every year I add a few things to it.The checklist is not only useful to me but it provides guidance for my people to understand, assimilate and embrace the new operating unit in real time. It makes the cracks through which things fall just that much tighter.Make folks use the checklist, check it off and retain the evidence that shows it to be completed. Bind this stuff together and put it in a transaction file. It will prove invaluable in the months and years ahead.And, guess what, we have said “no” to a few deals and we have gotten hugely better prices as a result of confronting the seller with the reality of the transaction.READ: The Checklist Manifesto
I think like most of us, you paid a very expensive tuition for each page.
As usual, words to live by
In a startup company, what’s the number one off balance sheet item (or items) to look out for beyond real estate? I’m wondering if it is hidden liabilities of making stuff versus cash flow, yet I’m curious if there are other, graver Enron like ones that I should stay away from because it screams: Dishonest! Dishonest!
Equipment leases
Fred,I am just starting to learn about the VC industry and your blog has been a great start, especially your MBA Mondays. Do you have any recommendations for learning more, especially books you particularly like? I looked at some of the books you’ve recommended, but they are not really about VC (e.g. The Happiness Project). Any recommended reading? I am working on a business plan to pitch and would love some further insights into the VC industry before I begin shopping it around.Thanks!
I don’t read business books. I read biographies and novels
For those interested in playing along at home, take a look at Best Buy’s footnotes and try to figure out how big their lease obligations are.
Nice. We should have a prize for anyone who gets it right
@FredWilson, be interested in your thoughts on the following comments about liabilities that were and were not covered in your post as discussed back and forth with our CFO:1.) Guarantees of indebtedness by the Company (could be of shareholders, affiliates with common ownership, venture partners, etc.)2.) lease commitments are a good one to look for, and even with public companies, the operating lease disclosure does not detail whether the leases are above market rate, for example. Also, the language on renewal options may make the voluntary renewal more of a fait accompli than it appears.3.) legal and environmental exposures are a big area of “undisclosed” as at some level they are subjectively judged. This should includes claims of any kind, whether filed legally or not. Employee related claims can be huge issues.4.) potential overtime claims be staff, especially “consutants” who may not pass the scrutiny test of whether they should really be employees. This could involve areas like overtime, etc.5.) purchase commitments at established prices (made but not yet executed)6.) customer sales agreements that are in effect money losers (loss contracts)7.) sales and purchase commitments with a “timing” factor (i.e. They can be assigned to a third party.8.) make whole payments in financing agreements.9.) “related party transactions” should be listed in minute detail, because often those details will lead to other activity not otherwise disclosed10.) severance and change of control liabilites.11.) noncompete agreements or the lack thereof.12.) the cash flow statement will tell you much about whether the earnings are questionable13.) patent searches and related (make sure the business is not a patent/Independent contractor defedant waiting to happen)14.) Incurred but not reported claims liabilities for medical and property/casualty (if self insured) usually involve some level of estimate.15.) make sure the statements are on an accrual basis in accordance with GAAP.16.) tax is too large an area to cover in one comment. Many businesses are taking very aggressive tax positions that are not disclosed.
You are watching many people’s backs through this post.
I’m interested to hear what you have to say about under compensated staff relative to market. I assume this would not fall under the “Off Balance Sheet Liabilities”, but it’s an interesting topic. I’ve been a part of diligence where over and under compensation were concerns. Both are challenges, but the under compensation may be a less obvious time bomb.
Recently read that GAAP is about to change to put lease obligations on the balance sheet. That’s going to really change the drivers of lease negotiations and you might see more pressure on landlords to do shorter terms with options. I believe you’ll still be able to expense the option but anything you’re committed to will be a liability.