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.)
Financial Insight (of a Valuation Expert)
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 earn-outs.
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 Certified Valuation Analyst Tom Bailey to learn how we can help via our contact form.
Councilor, Buchanan & Mitchell (CBM) is a professional services firm delivering tax, accounting and business advisory expertise throughout the Mid-Atlantic region from offices in Bethesda, MD and Washington, DC.