Business Valuations in Distressed Situations

1. Dr. Clive Vlieland-Boddy Business Valuations in Distressed Situations

2. Question Why would you buy a house from a bank who had repossessed it from the original lender?

3. Answer! Yes… You are expecting a great deal. You would have to do your homework You would not want to assume any unknown liabilities. You would want to make sure exactly what you are buying

4. Outline Business valuations in distressed situations Motives for buying a failed business. Risks & Rewards Survey of evidence on the economic merits of mergers, LBOs, and the Daimler-Chrysler merger. Funding bankruptcy purchases

5. Why buy a bankrupt company? Insolvent or nearly insolvent companies can present an attractive opportunity to purchase assets on the cheap, or at least at a significantly reduced cost.  A buyer purchasing assets from a troubled company wants to be as sure as possible that it is buying only the target's assets. Not also taking on all of the troubled company’s liabilities.   Several different strategies exist for balancing the risks with the potentially substantial rewards of a distressed asset acquisition.  

6. Bankruptcy offers opportunities to identify desirable prospects. A business in bankruptcy may represent a good strategic fit, a desirable product line extension, additional distribution or market share capability. Buyers can also benefit from an "inefficient" market for assets in bankruptcy. The target company’s assets and business operations are likely to be undervalued and may be acquired at a discount to their true or intrinsic values.

7. Bankruptcy offers opportunities to identify desirable prospects. Contd... The mystique of the bankruptcy process often obscures the free flow of market information that might otherwise be available. Unless one knows where to look, meaningful information becomes much harder to find.

8. Bankruptcy offers opportunities to identify desirable prospects. Contd... Compounding these "inefficiencies" are factors such as The complexity and general lack of understanding of the bankruptcy process, The perceived lack of reliable financial information. The time commitment necessary to consummate bankruptcy acquisitions. Fear of uncertain outcomes. 8

9. What should you pay for a business in Financial Difficulty Normally such business are either sold as a going concern or as a break up. Often best to buy the business without the liabilities. In other words just buy the business or trade and relevant assets. Leave the liabilities behind. Hopefully you should get a good deal as the transaction is not normally done at Market Price. It is a distressed sale.

10. Valuing a Business Valuation used should be similar to any standard method. However, there is little time so normally you would expect to look at Asset values. Also need to consider: Going concern or liquidation values? Minority interest or controlling interest?

11. Assets or Equity? When an acquiring firm purchases a target, it often assumes the target’s liabilities. In Bankruptcy it is often better not to assume any liabilities as all too often some are not known or cannot be established with reasonable accuracy. If you are to accept liabilities even some sort of assurances are all too often useless.

12. Dead or Alive? Liquidation value is the cash generated by terminating the business. Going concern value is the present value of the future cash flows from continuing to operate the business. Usually the fair market value (FMV) is the higher of the two values.

13. The Fair Market Value of a Business Is Usually the Higher of Its Liquidation Value and Its Going-Concern Value

14. Liquidation Value Usually grossly underestimates value. Really a distressed sale value. Based on a desperate seller and a buyer only motivated by price.

15. Book Value Usually provides a conservative value. Is the value in the books of the business based on original Historic Cost.

16. Asset Value Normally based on the Market Value of the Net Assets. (Assets – Liabilities) Should normally be based on the buyer and seller being under no pressure.

17. Goodwill Price paid over and above the Market Value of the Net Assets.

18. Gross Margin Valuation Consider what contribution the new enterprise will add. Often it can be brought in house and no extra overheads would be incurred. Example: Acquiring a similar internet selling business or Car dealership. Synergies!

19. Problems With Present Value Approaches to Valuation In comparison with valuing a project, valuing a business Has a longer life (indefinite) Has cash flows that grow over time, as opposed to decline over time Has cash flows that go to the owner only when management chooses to distribute them

20. Problems with Comparable Trade Values (Known as Market Values) Part art and part science. Difficult to find exact comparables In bankruptcy this is made even more difficult to find.

21. Subjective Estimates Examine historical growth as well as analysts’ expectations about future growth. Try and establish accurate Asset Values. Minimize the use of guess work.

22. Financial Reasons for a acquisition Synergies are especially important in M&A’s Cost savings in manufacturing, marketing, distribution and overhead. Better access to financial markets. Enhanced investment opportunities. Often companies in financial distress can benefit by merger with a competitor.

23. Synergies M & A’s are all about synergies. Putting two businesses together and making more as a result. Sadly most acquisitions over state this. They thus pay more than they should.

24. Essential Steps to take! A firm should realistically evaluate the potential of the reorganized assets, Identify solutions to the company's underlying problems Negotiate effectively with creditors for a reorganization plan they will accept. Take steps to uncover unknown facts about the business. Due diligence is key when buying a bankrupt property.

25. A thorough investigation of all aspects of the transaction may reveal such negatives as environmental problems outstanding obligations not recognized in bankruptcy claims unresolved matters related to taxes or employees. You should also assess the damage that may have been done to the bankrupt business's customer and vendor relations. Customers may have moved on, and skittish vendors may want special guarantees or cash in advance. Essential Steps to take!

26. Then…. Meet with stakeholders. As soon as bankruptcy is filed, communicate your interest to key players. Work to establish your credibility as a potential buyer. Develop negotiating strategies. To win required agreement from creditors (more than half must accept your reorganization plan), you will need to identify and satisfy the interests of all parties. Line up financing. Your ability to finance the acquisition will depend on the quality of the company's assets, the strength of the lender's security position, and the credibility of your business plan.

27. Other Considerations The terms of the deal are made public. Affected parties are included in, and may complicate, the negotiations of the stalking horse bid and the bid procedures. Buyers need to understand that their offers typically may be subject to higher and better bids.

28. The Bankruptcy Code represents An attempt to strike a balance between a debtor’s ability to clean its own house and creditors’ rights to protect their interests. This balancing comes into sharp focus in the process of confirming a Chapter 11 plan of reorganization. The debtor is given the exclusive right to file its own plan in the first 120 days.

29. The Bankruptcy Code represents For a buyer, this creates opportunities to participate on either a "friendly" basis (i.e., with the support of the debtor and/or its management under a consensual plan), or on a "hostile" basis (through a competing creditors’ plan). This provides a buyer with a great deal of flexibility; and acquisition strategies will vary depending on the approach.

30. Key Consideration for Chapter 11 One of the statutory tests in Chapter 11 for whether unsecured creditors can be compelled to accept treatment over their opposition. i.e., the "best interest of creditors" test. Whether the creditors will receive more than they would under a Chapter 7 liquidation. The judge must me confident that the Unsecured creditors will be better off.

31. Undervalued Assets One of the most compelling reasons to acquire a business in bankruptcy is to obtain assets which are undervalued because of the overall distressed situation. Buyers with patience and who understand the bankruptcy process can be well rewarded.

32. Lower Expectations Generally, bankruptcy sets the stage for bargain prices by lowering the expectations of all involved. The act of filing bankruptcy is often a dose of reality for owners and/or management who have previously held high expectations regarding the value of their business. It jolts creditors who cling to unrealistic expectations. This fosters a new willingness to accept much less than might have been previously been expected.

33. Lower Expectations. Contd.. Owners are motivated to part with equity control or accept new investors This may allow them continue to participate in the reorganized business or get out from under personal liabilities and guarantees 33

34. Lower Expectations. Contd.. Secured creditors suffering from "lender fatigue" or lack of faith in the debtor or its management may be more willing to accept a reduction in the amount owed in order to exit the credit as quickly as possible Unsecured trade creditors may be unwilling to fight for the last dollar as long as the reorganized business continues as a customer. 34

35. Unsecured creditors Unsecured creditors are conditioned to expect the meagre proceeds of a "fire sale," rather than an orderly disposition or reorganization of a business designed to capture going concern value. Even in cases where an operating business remains intact, premiums based on going concern value may be minimized because of the bankruptcy factor. Buyers can bargain hard with unsecured creditors who know all too well that, on liquidation, they will receive nothing. There are few counterpoints in negotiations with a cash buyer who states, "Take a haircut now, or I’ll pay even less later.

36. Access to Financial Information A common perception is that the financial records of a business in bankruptcy are always in disarray. This may or may not be the case. In any event, there are numerous ways to obtain meaningful financial information from a business in bankruptcy. A buyer should remember that all formal financial reporting by the debtor in the bankruptcy case is done under oath.

37. Debtor’s Obligation to Provide Information To begin with, the debtor has a duty to provide the following basic financial information: a complete list of creditors; a schedule of all of assets and liabilities; a schedule of current income and expenditures; statement of affairs. This required financial information is in addition to whatever is regularly maintained in the debtor’s books and records.

38. Committee’s Duty to Investigate The Creditors’ committee has the duty to "investigate the acts, conduct, assets, liabilities and financial condition of the debtor. To review the operation of the debtor’s business and the desirability of the continuance of such business, Any other matter relevant to the case or the formulation of a plan

39. Financing a Bankruptcy Business

40. Sources of New Funds • Traditional Lending Institutions • Commercial banks • Asset Based Lenders • Private Equity/Hedge Funds • Equity Investment will require control of the company • Second Lien or “B” loan • Private Investors • Venture Capitalists

41. Financing This can be difficult for as there will be words of caution. Secured Creditors can be encouraged even compelled to continue. (Inherent Leverage) Ensure that you have tested the plan. You must answer the following key questions: Why will you succeed when others failed What will the extent of the stigma be What new factors do you add to the equation that will change failure into success.

42. Inherent Leverage Buying out of bankruptcy offers the opportunity for leverage. Usually, there is some amount of secured debt already in place. In a typical non-bankruptcy transaction, the buyer would have to obtain new financing. In bankruptcy existing secured creditors can be compelled to remain in place.

43. Empirical Evidence

44. The Empirical Evidence Do corporate restructurings create value? The premiums paid by acquirers indicate that the shareholders of target firms benefit. There is evidence that the shareholders of acquiring firms also benefit, as shares have risen on the merger announcement. This pattern has reversed over time.

45. Other Studies Porter study found that the more unrelated the target’s business was to the acquirer’s business, the greater the chance of failure. He concluded that many, if not all, acquisitions are unsuccessful. Kaplan found that in management buyouts or LBOs, ROA increased substantially. The carrot of increased ownership and stick of heavy debt served to focus management’s attention.

46. Venture Capital Funding

47. Funding with Venture Capital This is possible but tends to be specialised VC’s Normal Valuations will be employed Definitely Equity Kickers. Often Debt Capital with conversion rights.

48. The Venture Capital Method of Valuation Venture capitalists (VCs) make high-risk, high-return investments in early stage companies with horizons of 5 or 6 years. Investments are staged. Startup Early stage Mezzanine

49. Valuation Issues VCs specialize in different stages. Risk changes over time, as do required returns. Option-like features in multiple stages. Cash flows are negative for most of the early life of the firm.

50. Why Do Venture Capitalists Demand Such High Returns? High risk, to compensate for investing time in evaluating many proposals and money in several firms, most of which will fail. High target rates have worked over time. VCs provide advice and guidance to startups, not just money. Adjust for excessive optimism on the part of entrepreneurs.