Using a Valuation Expert to Help with Chapter 11 Bankruptcy
The novel coronavirus (COVID-19) pandemic has caused many businesses to temporarily shut down or scale back operations. Slowly, states are allowing businesses to reopen to the public, but it may be too late for some businesses to bounce back.
When the economy went into lockdown mode, some small businesses — including certain brick-and-mortar boutiques, niche manufacturers, and family-owned restaurants — were already struggling and lacked financial resources to weather the downturn. And federal relief efforts weren't enough to cover their losses.
As a result, the number of businesses filing for bankruptcy is expected to skyrocket this summer. Here's an overview of the options under the U.S. Bankruptcy Code — and how a business valuation expert can be a valuable asset during this process.
Two Main Options for Businesses
When filing for bankruptcy, business owners have two options:
1. Chapter 7 bankruptcy (liquidation). This is what typically comes to mind when you hear the word “bankruptcy.” A court-appointed trustee sells the company's assets and distributes proceeds to creditors in a specific order set forth in the bankruptcy code. Businesses that file under Chapter 7 generally sell their assets and then close their doors forever.
2. Chapter 11 bankruptcy (reorganization). Some bankrupt companies continue to operate. Under Chapter 11 filings, the company retains its assets as a “debtor in possession.” Meanwhile, owners relinquish control to a court-appointed turnaround specialist who works with creditors and the bankruptcy court to come up with a turnaround plan. A court-imposed reorganization protects the company's assets from creditors until the plan is devised and approved.
Typically, a Chapter 11 bankruptcy proceeding offers protection of business assets while restructuring the following types of debts:
- Priority tax debts,
- Secured debts,
- Unsecured debts, and
- Leases and contract debts.
The bankruptcy process starts with a petition to the bankruptcy court. A voluntary petition is filed by the debtor. Conversely, an involuntary petition is filed by creditors after certain conditions have been met.
In either event, the business typically has about four months to develop the reorganization plan. However, if “just cause” for a delay can be shown, the court may grant a business up to 18 months after the filing of the petition to develop its plan. Eventually, the goal is for the business to emerge from the bankruptcy in better financial shape.
Important: Historically, Chapter 11 was too cost-prohibitive for many smaller businesses. Recent changes to the bankruptcy laws — along with a temporary provision of the Coronavirus Aid, Relief, and Economic Security (CARES) Act — provide greater access to bankruptcy protection under Chapter 11 for small businesses. (See “Doors Open for Small Businesses to Reorganize,” below.)
Businesses contemplating bankruptcy often benefit from the input of an experienced business valuation expert. Specialists with experience in accounting, valuation, and mergers and acquisitions (M&As) can help:
- Assess the severity of the financial crisis,
- Determine whether liquidation or reorganization makes sense, and
- Provide financial insight on everything from selling assets to shareholder disputes.
The recovery process starts by identifying ways the troubled business might regain control of its cash flows. After working with the business to establish a daily cash budget to stop the immediate bleeding, a financial expert can determine which form of bankruptcy is more appropriate — Chapter 7 (liquidation) or Chapter 11 (reorganization). There might also be a third option: Take steps to avoid bankruptcy altogether.
The expert can develop financial projections for several reorganization options, including best, probable, and worst-case scenarios. Using a Z-score formula, he or she begins to assess a struggling company's financial strength and estimate the risk and probability of whether the business will go bankrupt.
When a company's liquidation value exceeds going concern value, most experts recommend that it consider filing for Chapter 7 bankruptcy protection. Liquidation value is often seen as a “floor” for a company's value. For insolvent businesses that can't pay their debts, a financial expert might act as a court-appointed receiver and turnaround consultant who can facilitate the liquidation process — including winding down operations and paying out creditors in order of legal preference.
If, on the other hand, a Chapter 11 filing is deemed appropriate, a financial expert can help “sell” a reorganization strategy, such as debt forgiveness and restructuring, to lenders and other creditors. Due to the tight credit market and recent conservatism of lenders, many loans are overcollateralized. By appraising assets (including inventory, equipment, and receivables), a valuation expert can assist in renegotiating working capital covenants. As debt terms are eased, cash can be freed up.
In some cases, a reorganization might call for divestitures of unprofitable segments, so the company's owners can refocus on core operations. Or a distressed business might solicit offers to buy the company or its assets. A valuation expert can help your client find potential buyers and evaluate whether divestitures and offers appear reasonable.
When minority shareholders or creditors contest a divestiture or sale, distribution, or other transaction, a valuation expert can write a fairness opinion to help demonstrate that management exercised good judgment in analyzing a transaction. Fairness opinions are especially important when transactions involve related parties or if the CFO's compensation package includes a “golden parachute” clause.
Another unfortunate side effect of financial distress is disputes between controlling and minority shareholders. A valuation expert can help bridge the two sides by objectively estimating what the company and its underlying assets are worth. The expert also can help the parties identify assets that aren't on the balance sheet — including contingent legal and tax liabilities, customer lists, brand names and business goodwill — and explain the tax implications of buyout terms, such as installment sales and earnouts.
Doors Open for Small Businesses to Reorganize
The Small Business Reorganization Act (SMRA) provides greater access to Chapter 11 for small businesses. Additionally, the Coronavirus Aid, Relief, and Economic Security (CARES) Act raises the threshold to qualify for this protection. Here's what small business owners should know.
Effective on February 19, 2020, the SMRA creates a new subchapter (Subchapter V) of the U.S. Bankruptcy Code. To be eligible for relief under Subchapter V, a debtor (whether an entity or an individual) must have total debt not exceeding $2,725,625 (subject to adjustment every three years).
The SMRA contains provisions for the following key improvements:
Streamlined reorganizations. The new law will facilitate small business reorganizations by eliminating certain procedural requirements and reducing costs. Significantly, no one except the business debtor will be able to propose a plan of reorganization. Plus, the debtor won't be required to obtain approval or solicit votes for plan confirmation. Absent a court order, there will be no unsecured creditor committees under the new law. The new law also will require the court to hold a status conference within 60 days of the petition filing, giving the debtor 90 days to file its plan.
New value rule. The law will repeal the requirement that equity holders of the small business debtor must provide “new value” to retain their equity interest without fully paying off creditors. Instead, the plan must be nondiscriminatory and “fair and equitable.” In addition, similar to Chapter 13, the debtor's entire projected disposable income must be applied to payments or the value of property to be distributed can't amount to less than the debtor's projected disposable income.
Trustee appointments. A standing trustee will be appointed to serve as the trustee for the bankruptcy estate. The revised version of Chapter 11 allows the trustee to preside over the reorganization and monitor its progress.
Administrative expense claims. Currently, a debtor must pay, on the effective date of the plan, any administrative expense claims, including claims incurred by the debtor for goods and services after a petition has been filed. Under the new law, a small business debtor is permitted to stretch payment of administrative expense claims over the term of the plan, giving this class of debtors a distinct advantage.
Residential mortgages. The new law eliminates the prohibition against a small business debtor modifying his or her residential mortgages. The debtor has more leeway if the underlying loan wasn't used to acquire the residence and was used primarily for the debtor's small business. Otherwise, secured lenders will continue to have the same protections as in other Chapter 11 cases.
Discharges. The new law provides that the court must grant the debtor a discharge after completing payments within the first three years of the plan or a longer period of up to five years established by the judge. The discharge relieves the debtor of personal liability for all debts under the plan except for amounts due after the last payment date and certain non-dischargeable debts.
CARES Act Provision
In addition to the improvements under the SMRA, Congress decided to temporarily increase the eligibility debt ceiling from $2,725,625 to $7,500,000 for new Subchapter V cases filed between March 28, 2020, and March 27, 2021. Thereafter, the debt limit will revert to $2,725,625 (adjusted every three years).
This change will make more small businesses eligible for Chapter 11 in the midst of the novel coronavirus (COVID-19) crisis. However, the CARES Act permanently eliminates the eligibility to file for Subchapter V relief for any affiliate of a public company.
We Can Help
Increased bankruptcy filings are likely in the coming months due to the economic conditions caused by COVID-19, the simplified process for small business Chapter 11 filings under the Small Business Reorganization Act and the temporarily heightened debt limits under the CARES Act. Contact a business valuation professional to facilitate the bankruptcy process and, if possible, get your business back on track.