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For an organization in financial trouble, an understanding of its “liquidation value” and who gets what is essential.
Liquidation value is the value of the monetized components of the business, such as accounts receivables, equipment, etc., should the business not be sold as an ongoing concern.
Who gets what is then a function of creditor claims on specific assets.
Why is this understanding so important?
Because this information is needed to understand the worst case scenario from the perspective of the creditors and those who have guaranteed or given collateral to creditors.
This is what alternatives are evaluated against.
Some creditors, such as senior secured lenders, might be able to get paid in full by selling the parts and choose to do so. That leaves junior creditors out to dry. And, since those junior creditors may have guarantees, liens on assets outside the business, etc., this can create a problem for owners. Also, if it is possible to sell the business for more as a matter of concern, that sale process may take funding. Senior, fully secured creditors have no reason to fund such a sale if they can get paid by liquidating, so junior creditors or ownership must fund it.
Determining Liquidation Value
Determining liquidation value is
usually simple
.
List out the assets, then figure out what they can be sold for — individually, not collectively as a business.
First, there are the obvious assets: accounts receivables, inventory, and fixed assets.
Asset-based lenders will often lend 75% to 85% on current accounts receivables. That is a good starting point. Keep in mind that when going out of business, there will be claims from customers against those receivables. Some will be bogus (e.g., the customer is just trying to take advantage of the situation), but many will be legitimate. For example, if you are in the “project” business — construction, IT development, etc. —customers are going to use the money they owe you to complete the project. Big box stores hold back payment to cover returns, etc.
Next, consider Inventory, which has lots of quirks.
If it is finished goods, can it be resold in the general marketplace (if someone else's name is on the packaging, probably not)? Generally, those who buy liquidated inventory want a 50% gross margin and want to sell it for half off regular price. So for retail goods, 50% off the
retail
price and a 50% margin. For other finished goods, the same logic usually applies. Like retail goods, if the product is targeted towards a particular customer or customers, expected liquidation value goes down. Raw materials are often freight-dependent. For equipment, get an appraisal. Same for owner-occupied real estate. Computer equipment is typically worth much less than people think.
Finally, consider intangible assets.
This includes brand names, proprietary software, intellectual property, customer lists, and so on. This may also include contracts that can be assigned, real estate leases that can be sublet, and financial assets. In one situation, for example, I sold a loan back to an employee who funded his stock purchase from him. While I didn't get 100% on the dollar, it was likely not economically collectible in the first place.
Develop a Creditor “Waterfall”
As the name suggests,
with a creditor waterfall, money from liquidated assets
flows
top down:
first senior secured creditors get paid, then junior secured creditors, and so forth, until there are no more funds. The concept is simple, however in practice, it can be complicated.
For example, several years ago, I liquidated a high-end party rental company.
In order, here is how the proceeds were distributed…
- To the State for unpaid sales taxes
- Expenses incurred to sell the assets
- To unpaid employees
- To the senior secured lender, who was not paid in full
- Nothing to the junior secured lender.
Next, the two buildings were sold. For the first building, the proceeds, in order, went to:
- A different senior lender with the senior mortgage on the building
- The senior lender to the business that had a second mortgage on the building
- The small remainder from the first building then went to the junior secured lender to the business that had a third mortgage on that building.
The proceeds of the second building went to:
- The senior mortgage on the building
- Half of what remained went to one 50/50 building owner who was not a business owner
- The other half went to a mortgage on the business owner's half of the property (bridge financing to fund negative cash flow during the sale process) and then to the junior secured lender to the business. The junior secured lender did not have a mortgage on that building but did have personal guarantees from both business owners. The junior secured lender was not paid in full.
- Nothing from these sales proceeds went to vendors.
So, how to figure all this out?
First, read all loan documents and see what liens are on what business assets.
Have a legal assistant run a lien check with all of the relevant government listings so you don't miss any liens. Typically, a senior secured lender will have a first lien on all assets, but often, there are individual loans with liens on various pieces of equipment. Look for guarantees and liens outside of the business.
Next, lay out the expected liquidation value for the assets and lay out the waterfall.
Look for effective claims on specific assets that will keep some or all of the proceeds out of the waterfall. Customer damage claims against their open invoices is one example. Another common claim is landlord claims against inventory in third-party warehouses.
Finally, estimate the costs to run the liquidation.
It is not just lawyers and consultants — it is all the operating costs incurred during the process, such as payroll, rent, and utilities. (For more on who to keep on staff during a liquidation read
here
.)
Putting It All Together
The final piece needs to take into account how certain creditors might react.
Not everything is black and white, so there is almost always some negotiation involved.
For example, a current client of mine is shut down and liquidating. The senior lender is secured by all of the assets of the company and by the owner's homes and a large life insurance policy. There are three junior secured lenders as well.
The lender has grown inpatient collecting the remaining receivables, as large retailers are holding things up for returns, etc., and because they can. That lender wants to collect on the life insurance policy and be paid and done. However, the owner wants to keep the life insurance and wants to buy the senior secured loan so as to control the junior secured lenders.
Therefore, a negotiation is underway that is only possible because both parties have done a liquidation analysis.
A Few Tips
Get help.
Not just from a financial advisor skilled in this sort of analysis, but from experts in liquidating the
particular
assets (there are specialists for just about any type). Machinery and equipment and real estate appraisers are obvious examples, but there are specialists in retail inventory, computer equipment, patents and trademarks, even IP addresses.
Pay attention to who is on first.
That is, who has the senior lien.
Look for potential outside “stickups.”
Outside parties that by right or might can grab some of the proceeds. A landlord holding inventory or customers not paying invoices for various reasons are two examples.
Internally developed intangibles
such as special software or proprietary data are often worth much less than the business thinks. After all, one reason the business may be in financial trouble is these internally developed items weren’t as commercially viable as hoped.
Final Thoughts
When a financially troubled business is sold off for parts,
the only way to ensure that all parties involved receive (or attempt to receive) their fair share, is for there to be a clear understanding of that business’s liquidation value.
A thorough analysis of the various components and expert guidance regarding the creditor waterfall are essential pieces to this complicated puzzle.
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