Option #3 Wind down &/or sale
Some of our clients have successfully steered themselves down this path.
It can be a tough path but if executed properly and fairly, it does have some advantages over an immediate insolvency appointment.
However, it can have high risks, particularly for directors or people who are seen to act as directors, as you will need to have a defensible position that no creditor was worse off as a result of continuing to operate the business. The law does not take kindly to directors ‘winging it’ while they try and reduce their personal obligations.
The required outcome:
Reduced liabilities (amounts owed) compared to an immediate insolvency appointment. This can often be achieved by selling the business and/or assets at ‘pre-insolvency appointment’ prices without the costs of an insolvency administrator conducting the sales process.
Often, this outcome is considered when the directors have personal guarantee obligations and an orderly wind down will reduce these obligations whilst not increasing the amount owing to other existing creditors.
What an orderly wind down requires:
- The 3 Cs – cash, capacity and capability
- Cash is needed to effect an orderly wind down. It will most likely come from:
- The conversion into cash of assets on hand – debtors, stock and plant and equipment.
- The capacity of the management team and other resources to implement an orderly wind down. If you are flat-out running the business then chances are you will need some additional resources to assist you manage the orderly wind down process – including making sure you don’t inadvertently make particular creditors worse off.
- The capability of the management team including a cool head under pressure and a high ethical and transparent stance when dealing with stakeholders.
- Energy and resourcefulness – this is not for the faint hearted, particularly if times are tough.
- A viable business model for the short term. This means that the business will be able to generate sufficient positive cashflow to pay all freshly incurred debt and hopefully reduce the amounts owing to existing creditors.
- An outcome which is defensible if a liquidator is appointed. Without limiting the scope of this critically important aspect, the following should as a minimum, be considered necessary:
- The value of any sale of assets needs to be supported by:
- A business valuation if being sold ‘in one line’ and an asset valuation if being sold ‘in one line’ or on a ‘break-up’ basis.
- There are 4 main business valuation methodologies which a valuer should consider and if applicable use or reject
for details of the 4 methodologies:
- Directors and their families who work in the business: are they being paid a commercial wage for the work they are doing and is this shown in the profit and loss?
- Rent: where a property is owned by a related party and it is used by the business, is it charging the business a fair market rent?
- Non-business expenses: are private expenses of the directors and their families being charged to the business?
- Sales: are there cash sales which are not disclosed in the profit and loss?
- When the assets are sold prior to the appointment of an insolvency practitioner, it is likely that an insolvency practitioner will consider the following issues upon their appointment:
- Have all methods of valuation been properly considered? If so, have the underlying assumptions been tested by the valuer to ensure that the most appropriate valuation method has been used. Typically an insolvency appointee will look at issues such as:
- Are there normalised profits?
- Are there future identifiable cashflows?
- Are there assets with a strategic value including IP or legally binding and transferable/assignable contracts etc?
- Are there any ‘industry norms’ which are used to value businesses in the industry?
- In the absence of any value which can be attributable to the above, it is possible that the value of ‘the business’ is reflected by the realisable value of the physical assets together with an allowance for goodwill associated with any intellectual property the business may hold (eg contact and communication details including web domains).
- Under such circumstances, a liquidator would anticipate there being, as a minimum, a valuation by a reputable asset valuer experienced in the area of the industry and insolvency.
- The sale needs to be supported by a validly executed sale contract, preferably prepared by a legal advisor who is experienced in commercial matters, with supporting schedules listing out what has been sold and what has not been sold.
- The cash paid by the purchaser needs to have been paid to the business, including any relevant GST.
- Agreed consensus on adopting the orderly wind down by the directors and shareholders.
4 Main Business Valuation Methodologies
#1 Price Earnings (PE) ratio
The use of the PE ratio is common in public companies and profitable private businesses.
It requires an assessment of the profits being generated by the business and adjustments to these profits to ‘normalise’ these profits if they do not reflect the earning capacity of the business. Some common examples of areas of adjustment:
It is not an appropriate method of valuation if the business has no historical or future anticipated profits.
#2 Discounted cashflows (DCF)
The use of the DCF methodology requires projected cashflows which show a positive cashflow being generated from the business and its assets.
Many smaller businesses cashflow correlates to their profitability.
It is not an appropriate method of valuation if the business cannot prepare or show future cashflows.
#3 Strategic value
The use of a strategic value is often where there is intellectual property, customer contracts, supply contracts etc which have a high value to other parties and which can be transferred to a third party. For example, a brand which has strategic value can result in a high sale value even if no profits have been generated.
For most SME businesses, they do not have ‘strategic value’ assets and so this method of valuation is not appropriate.
#4 Asset values
Where none of the above methods are not appropriate, the remaining method of valuation is often used; namely the value of the assets.
This is often done by an asset valuer who is experienced in valuing assets for insolvency appointments.
If this method is to be used, the issue can be what value should be used. If a business is insolvent and it is likely the business will have to be wound up and sold by an insolvency practitioner, it may be arguable that the value of the assets most applicable to use in a sale would be their orderly liquidation value rather than their fair market value.
What you do not want:
- Rarely are surprises good in an orderly wind down. More often than not, the ‘really bad news’ has not been dealt with and when it rises to the surface….. yuk!
- Insurmountable pressure from stakeholders.
- Pressure might arise from trade suppliers, the ATO, customers, employees or even management, directors or even shareholders.
If this pressure is too high, then it can undo an orderly wind down very quickly.
- Putting others at risk.
- To rob Peter to pay Paul is not a good idea. For starters, Peter will get really annoyed and he may even pursue you to the corners of the earth if he has to if he feels you have not treated him fairly.
- Personal liability issues for the directors.
- We often say, you cannot change the past, but you can control your future. One thing you don’t want to do is increase the personal liability for directors and guarantors. However, their risk is clearly secondary to the risk of third parties.