Another round of bankruptcy newbie questions suggests it’s time to review small business valuation questions.
Our hypothetical debtor supports his family working in an incorporated business that he wants to continue operating. He is the only shareholder.
The scenario that prompted this post had the debtor reporting to his lawyer that the business was worth $100,000. That’s well beyond the available exemptions and, in this case, apparently beyond the debtor’s ability to fund in a Chapter 13.
My first reaction, knowing nothing about the business or the debtor, was fat chance!
Just the facts ma’am.
Here are the things I’d want to know from a client who makes such a claim:
- Does the business have assets
- Is there an SBA or other business loan encumbering the assets
- Is the corporation a party to a business lease
- Is the lease below market rate or particularly well sited
- Are there significant, collectable receivables
- What’s the debtor’s day to day role in the business
- What would it cost to hire someone to do for the business what the debtor does
Remember that the good will of a business is really a measure of its profits. If there are no profits above the value of the debtor’s labor, the business probably has no good will.
Why would a buyer pay more than the value of the assets to acquire this business rather than setting up a business on his own?
It’s important to isolate the debts for which the corporation is liable. If a bankruptcy trustee were to liquidate the corporation, what would inure to the benefit of the bankruptcy estate is only the net of assets v. liabilities of the entity.
A Chapter 7 trustee faced with liquidating a debtor owned corporation can either sell the business as a going concern or he can wind down the corporation, sell its assets, pay its debts, and pocket to net proceeds for the benefit of creditors.
Selling a going concern
Selling a business as a going concern is very challenging for a trustee, since he may have to man the business between filing and sale.
The trustee cannot count on the debtor to continue working there. The extent to which this is a barrier depends on the business: it’s probably fatal if the business is a knowledge-based business or a profession. Perhaps easier if it’s a fast food outlet.
Likewise, the sale of a professional practice, assuming it’s permitted under state law, faces another hurtle: the debtor. The trustee selling a law practice, for example, cannot deliver to the buyer a covenant not to compete.
The debtor is free to set up a new, competing practice next door to the old practice. What are the cases or files of existing clients worth to a buyer if he has to compete with the debtor-professional?
Don’t forget the costs of the sale of a business. Typical business broker commissions are often 10% or more, eating in to the net return.
Selling the assets
The trustee’s alternative is to shut the business down, sell off the assets and pay the corporation’s bills.
Are the assets, including the lease, valuable? In a liquidation, rather than at retail?
Is there a market for them? Are the receivables collectible?
Does the corporation owe taxes, either sales or payroll?
All of those expenses will eat into the value of the corporation in a liquidation setting.
In Chapter 13, we analyze the distribution from the sale of the corporation, either as going concern or in wind down. Creditors have to get at least as much in 13 as they would have in Chapter 7.
Before there’s a distribution to creditors in 7, the expenses of administration are paid first. So, we take the trustee’s commission out of the net proceeds.
What does that leave for creditors on your facts?
Lawyer as skeptic
A client who seeks you out for bankruptcy and tells you his business is very valuable should expect some further questions.
The tension for the lawyer is that if the client continues to think the business is very valuable, that’s how he’ll answer the trustee’s question at the 341 meeting.
Your unenviable task is to shine a light on the client’s pipe dream.
Image courtesy of Flickr and VCULibraries.