Mattresses Floorboards and Concrete Establishing Valuation Parameters for the Troubled Business

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Dec/Jan 2000

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It is the call we all want—a new client, in trouble. With luck, they will have millions in assets and a
business that can be reorganized. With a lesser amount of luck, they will be a failing dot.com with an
intriguing name (blowmillions.com), used servers, customer lists and a few mochaccino-makers. What to
do?

Each troubled situation results from a confluence of events and factors—some good, some bad—that
together are problematic enough to cause a business to become distressed. So where to start? As a course
of action, there are three issues to resolve:

<ul>
<li>What caused the distress?

</li><li>Is the business enterprise viable, or can it be made viable?

</li><li>What are the benchmarks for determining a business's value that can be allocated to creditors and
other claimants?</li></ul>

<h3>Causation</h3>

Knowing how a business got into trouble is a necessary first step to fixing it. Without understanding
causation, the problems may continue unchecked, preventing the success of a potential restructuring or
reorganization. The causes of any specific business failure may be innumerable, but other than extraordinary
events, there are usually several leading contenders.

Too much debt. Over the past decade, a principal cause of many chapter 11 filings was the incurrence
of too much debt by companies that were incapable of growing revenues or increasing earnings in amounts
sufficient to repay or refinance the debt. One result is a focus by debt-laden companies on maximizing
short-term cash flow and foregoing beneficial long-term business initiatives. That focus invariably sacrifices
key growth opportunities, potentially hastening the journey to troubled status. A mechanically easy solution
is to re-equitize the balance sheet. But that process, while well-understood with many precedents, is almost
always adversarial and fraught with delay, litigation and a great deal of jockeying for value.

Competitive conditions. Natural competitive market forces are a leading cause of business failure.
Competition forces continual changes in the marketplace, and companies unable to compete will need to
develop new products and/or distribution channels and/or reduce costs in order to remain competitive.
Failing to maintain a long-term competitive position will ultimately force a company to seek a merger
partner or to cease operations.

Management controls. Where too much debt or competition does not cause a company to become
distressed, inadequate managements can always fill the void. Management inattention, inability and
improper use of financial and other information, among others, are all recipes for business failure. For
example, many companies don't know their own costs of manufacturing, and as a result, do not price their
products appropriately. Or they do not understand the elasticity of demand for their product and the
market's willingness to absorb price increases, thereby denuding themselves of profits. Other companies,
especially smaller ones, operate on old rules of thumb rather than empirical information, then find out too
late that the old rules don't apply anymore.

<h3>Viability</h3>

While causation may be important, viability is the key to a reorganization. Can a troubled business be
reorganized, and if so, can it be reorganized (1) on a stand-alone basis, (2) with new equity investment or
(3) with a new strategic partner or acquiror? The key component is whether the company is or will be
capable of generating enough cash flow to fund its operations, permit new investments in working capital,
fixed assets and intellectual property, and compete successfully in the marketplace.

So having identified the causes of distress and assessed viability, what value is there and how is it to
be measured? For a viable business, the best measure of value is enterprise value—the value available to
allocate the amount total of new debt and new equity of a restructured company. And it is this value that
forms the basis of allocations among creditors and other claimants.

Liquidation Value. Liquidation value usually forms the lowest common denominator of realizable value.
It is the estimated proceeds from closing a business's operation and selling its assets without receiving any
consideration for going-concern or franchise value. Typically, inventory will sell for some percentage of
its dollar costs, receivables will be collected over time (often with some difficulty and many unanticipated
disputes over amounts owed), and fixed assets will be sold by auctioneers.

Present Value. The key valuation determinant of enterprise value should be the present value (PV) of
all future cash flows from operations, net income taxes and capital expenditures, plus or minus the net
change in working capital. While the best theoretical measurement, it is the most difficult to ascertain. PV
calculations discount estimated results forecast years into the future, and these forecast amounts, by their
very nature, are impractical if not impossible to predict with significant reliability. An additional
complication is the range of discount rates used in the PV analysis. Table 1 illustrates the
magnitude of changes in value resulting from relatively small changes in discount rates and estimated future
annual average cash flows.

The chart assumes the perpetuity of estimated future average annual net cash flows. More commonly,
PV calculations discount net cash flows for a series of years (three to five is typical) as well as a future
terminal value, the latter often representing almost half of the total PV. Table 2 provides an
illustration.

Financial professionals typically shortcut the difficult task of forecasting future cash flows by using
multiples of EBITDA (earnings before interest, taxes, depreciation and amortization) or net income for the
most recent 12-month period or as a proxy for PV. Given the greater certainty of utilizing more recent
information, such shortcuts have more than practicality favoring their use.<a href="#1" name="1a">1</a>

It is important to remember that in utilizing PV or EBITDA multiples, there is a presupposition that the
troubled company will be viable once restructured and reorganized.

Going-concern Sale of Assets and Business Operations. Notwithstanding the theoretical and practical
underpinnings of PV and valuation multiples, the best test of enterprise value is to conduct an auction of
the troubled company's assets and business operations and see what third-party buyers and/or investors are
willing to pay. However, this can be a difficult process because of the following:

<ul>
<li>Troubled businesses are often in such a state of flux that baseline levels of revenue and cash flow cannot
be determined, nor can baseline levels of value.

</li><li>It is difficult to elicit initial bids as prospective bidders have strong motivations not to bid first and
not to offer full-value bids.

<ul><li>Bidders worry that the troubled company will continue to deteriorate and that their bids may be
too high.

</li><li>Bidders fear being not only the first bidder but also the only bidder, thereby potentially bidding too
much.

</li><li>Bidders want to avoid the auction problem inherent in chapter 11's and don't want their bids
shopped.

</li><li>Bidders don't like the complexity and uncertainty of the process.

</li><li>Bidders don't want to invest large amounts of time and resources to bid unless they know a
transaction will be consummated.</li></ul></li></ul>

A properly conducted auction process allows creditors to get a realistic view of immediately available
value. However, it is important to emphasize that bidders will not submit their best proposals unless they
are certain that a transaction can be consummated. On the other hand, there are significant advantages to
bidders ranging from potentially advantageous asset acquisitions, to free-and-clear title of assets, to the
benefit of participating in a known process. Before embarking on a sale process, the estimated value from
such a sale should be carefully compared to the valuation estimates derived from a PV or similar
methodological approach.

Inferences. In reviewing alternative valuation criterion, the key is to determine what approach provides
the highest value and what has to occur to realize that value. If a business is bleeding cash, an immediate
cessation of activities and liquidation of assets may be the best available course of action. If a business's
present value is greater than its liquidation value, the decision then is to weigh the pursuit of a stand-alone
plan of reorganization, with and without new sources of capital, against the sale of assets and business
operations.

With some form of stand-alone plan of reorganization, there are two key issues: (1) the need for and
the availability of new capital and (2) the capability of existing management to execute a turnaround. If new
capital is required and unavailable (or available on unreasonable terms), then a third-party sale may be the
only course of action. Similarly, if confidence in management is lacking and no identifiable substitutes
are available, a sale may also be the only course of action.

Until all the dynamics are settled and valuation parameters conclusively established, a creditor or
claimant would never know where they might land: on mattresses, floorboards or concrete.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> Ignoring, of course, the previous comment about using old rules of thumb. For valuation purposes, these valuation shortcuts tend to
work and are based on empirical results. <a href="#1a">Return to article</a>

Journal Authors

Harvey L. Tepner

Journal Date

Friday, December 1, 2000 - 12:00