Valuation Will be the Fulcrum Issue in the Next Wave of Chapter 11 Cases
Valuing a debtor company’s assets is a crucial function in every Chapter 11 case. When the economy is in slow and steady growth mode, and markets are predicable, consensus can more easily be found for the value of a company or its assets.
But how does a company value its assets or the business with the unpredictability of COVID-19? The pandemic has created volatile public equity markets and economic upheaval for certain industries. This makes valuation more crucial and more difficult at a time when Chapter 11 is going to be the obvious tool for many businesses needing to deleverage, reorganize, or achieve an orderly sale or wind-down.
Valuation will be the fulcrum issue in the upcoming wave of Chapter 11 cases, and creative advocacy will be at a premium.
Traditional Valuation Approaches and the Bankruptcy Code
The two tried and true, traditional methods of business valuation – “the income approach” and “the market approach” – are regularly utilized and recognized in bankruptcy courts. With many businesses experiencing no or diminished cash-flow and the future of the economy uncertain, the traditional valuation approaches become less reliable and meaningful.
Valuation is central to the Chapter 11 process. It affects: (1) use of cash collateral during a Chapter 11 case; (2) the rights of secured creditors with regard to claim amounts and interest; (3) the rights of creditors when a 363 sale of assets is proposed; and (4) the rights of creditors to challenge confirmation of a Chapter 11 plan.
The Bankruptcy Code is almost silent on the definition of value. Section 506(a) is one of the only provisions that discusses valuation, and it states that: “value shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property . . . .” 11 U.S.C. § 506(a).
In many cases, valuation is the single most important issue affecting a reorganization’s success. This won’t When a company files for Chapter 11 protection, it ordinarily reassesses the entire business structure looking at operations, possible sales of assets, management, personnel, debt structures and every other aspect of the company. Included in this review is the valuation of the business and its assets. It is not only helpful to re-examine the company but it is required to confirm a Chapter 11 plan. This is normally done with the help of valuation experts. Without a pandemic, the methods of valuation are familiar, predictable, and steady.
Valuation in Pandemic-Era Chapter 11 Cases
The pandemic has wiped out many company’s ability to project future performance. For the worst-affected companies, financial data such as revenues and expenses, cash flow, net income, are at best skewed and at worst unknowable. How can there be a baseline paradigm for valuation without these normal markers? There really is no predictable model for valuation in an economic pandemic. This means that a “battle of the experts” will feature prominently in many Chapter 11 cases, and creative advocacy will be at a premium. It also means that parties are going to have to lay the valuation issue at the feet of bankruptcy judge and ask those legal experts (not business valuation experts) to value businesses with no predictable cash flow, revenue or expense numbers. All the uncertainty makes valuation of a business even more speculative.
Some of the changes brought on by COVID-19 will be visible in the testimony of expert witnesses. For example, a mechanical market approach analysis may not be appropriate because COVID-19 likely impacted other similar businesses on different scales. It may not be an apples to apples comparison. The most crucial factor for valuation will be the company’s balance sheet. After that, an expert will need to factor in such things as customer loyalties, brand value, and other considerations such the effect of force majeure contract provisions. Experts will need to examine existing or future commitments, cancelled business, and whether contracts or leases can be re-priced. Availability of government financial rescue opportunities will also be critical.
Likewise, experts will have to re-evaluate valuations considering such things as: (1) available capital; (2) COVID-19’s effect on human resources, supply chains, and the need for physical office space; (3) a COVID-19 discount rate under various market conditions perhaps forecasting the rate for years of pandemic conditions; (4) and whether a business can refinance debt in the short term if cash flow is a problem. All of these considerations are like discovering a new planet—we just don’t know what is out there or ahead.
Valuation of a business during this time is likely to yield some unpredictable results. At least if valuation is occurring within the confines of Chapter 11, there is a familiar process and statutory guideposts to lend some predictability. All businesses should be aware that valuation is the target that most unhappy creditors aim for to either force a company to liquidate or exert control over a company’s reorganization. For many companies, the strength of its balance sheet is going to be a primary valuation factor in these uncertain pandemic conditions.
Valuation is a critical component of every Chapter 11 case. In the coming wave of pandemic-driven business reorganizations and orderly wind downs, companies should seize the opportunity created by market uncertainty to push valuations favorable to their desired outcomes.
Robert Gonzales guides companies and their owners through financial workouts and Chapter 11 reorganizations, sales and orderly wind downs. He also represents Unsecured Creditors' Committees, asset buyers, and other parties in business bankruptcy cases. He is a 1994 graduate of Vanderbilt Law School.