According to data collected by the U.S. Bankruptcy Courts, business bankruptcies declined from 60,750 (or 4% of total filings) in 2009, just after the 2008 financial meltdown to approximately 22,750 in 2019 (or approximately 3%). With overwhelming challenges ahead as a result of the Coronavirus Pandemic, the question is not if these filings will go up over the next 12 months but by how much.
Before I dig into valuing a business in bankruptcy, let’s review the relevant “chapters” of the U.S. Bankruptcy Code. These “filings” are as follows;
- Chapter 7 – a liquidation proceeding where assets are sold by a trustee to repay unsecured creditors and, in the case of a business filing, the Company ceases operation;
- Chapter 11 – a reorganization where a Company (as well as individuals) negotiate a plan with its creditors to pay a portion of the amount outstanding while remaining in business.
What is Value in a Bankruptcy?
The U.S. Bankruptcy Code defines “insolvent” as
“…financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at a fair valuation…”.
It is at this time, when a business is insolvent, that an appraiser comes in to determine the value of the Company’s assets. However, there is no definition of value in the U.S. Bankruptcy Code, only the guidance that;
“Such value shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property, and in conjunction with any hearing on such disposition or use or on a plan affecting such creditor’s interest.”.
The value of the Company depends on the type of filing and the recovery plan if the company is to survive as a going concern. In a Chapter 7 filing, the asset value is based on a liquidation approach (orderly or forced) based on the expected timing set forth by a bankruptcy trustee. In a Chapter 11 filing, the value is based on a going concern approach, also dependent on the proposed timing, but tied to a financial and operational plan for reorganization that impacts the capital structure of the business.
Valuing a Business in Chapter 11 as a Going Concern
Under a Chapter 11 reorganization, the approval of a reorganization plan depends on whether the parties can negotiate a favorable outcome for the Company (or debtor) and the unsecured creditors. When this path to resolution fails, the U.S. Bankruptcy Court needs to rule on this insolvency and whether the reorganization plan proposed suggests that the value of the business is less than its liabilities. While this plan may include the sale of assets, subsidiaries or other court-mandated transactions, it always assumes that the Company will continue as a going concern that requires a valuation.
For example, in a recent court case, a valuation expert for the debtor concluded that the value of the business burdened with $317 million of debt was between $180 million and $220 million (midpoint of $200 million) while the expert for the unsecured creditors’ expert pegged the value between $335 million to $445 million (midpoint of $390 million). In effect, the unsecured creditors concluded that the business was solvent and that they are responsible for 100% of the liabilities of the business. The Court determined that both experts were highly qualified and used the same valuation methods and weightings. The differences came down to their selection of comparable companies. The final decision agreed with the debtor’s expert and the plan was approved and the terms “crammed down” to the unsecured creditors who had to take a haircut on the amount owed to them.
Other key components or potential issues faced by an expert in valuing a business in bankruptcy include;
- Forecast – The appraiser needs to determine the strength of the forecast in a proposed reorganization plan and whether a management-prepared projection shows bias towards a low case scenario.
- Diligence – In court cases, either side will hire appraisers to determine the value of the Company as a result of the reorganization plan. This adversarial situation reinforces the importance of the appraisers’ diligence and strong support for key assumptions and inputs.
- Comparables – As noted above, the question of comparability is key in the defense of the value determined using a market approach. Comparing a small niche software company to Google lacks, among other things, strength based on size, business model and portfolio of revenue streams. There is also a question as to how actively traded companies compare to a bankrupt company with inactive or no recent trading history.
- New Debt – Determination of the interest rates available to the debtor and changes in the capital structure are key in determining the Company’s risk profile before and after the reorganization plan. Also important is the assumption of potential balloon payments and the need for asset sales or refinancing when these payments are due.
- Hindsight – The court will accept a “known or knowable rule” but discourages the use of hindsight which may lead to bias.
- Taxes – A consideration of the debtor’s tax situation including the possible utilization of NOLs and a change in ownership after the reorganization.
A Small Business in Bankruptcy
The above example underscores a frequent adage of appraisers that a big company is much easier to value than a smaller one. Whether it’s the lack of detailed financial information or the presence of operating agreements that may trigger a specific approach to and allocation of enterprise value, small businesses are almost always an extension of the individual owner operator and therefore always unique. In particular, professional service businesses in bankruptcy (such as an electrical contractor or a barber shop) may lack the ability to realize value, especially in Chapter 7 filings, for intangible assets that will remain with the business owner. Additionally, a market approach requires the use of different datasets that compare control transactions as opposed to publicly traded companies. Otherwise, the same issues above apply but with limited financial and management resources, a full detailed plan and forecast may not be part of an appraiser’s available information.
Unfortunately, the current health and economic crisis will likely cause an uptick in business bankruptcies and situations where appraisers need to determine value in unique and distressed situations.
Exit Strategies values control and minority ownership interests of private businesses for tax, financial reporting, ownership transfer, strategic and bankruptcy purposes. If you’d like help in this regard or have any related questions, contact Al at email@example.com.