Whatever the business valuation prior to a liquidator being appointed, the final value of assets will almost certainly be lower.
Why is this? Partly, it’s because the total assets of a business are ‘greater than the sum of the parts’. Liquidation breaks the business down and hocks off individual assets, leaving the ‘value of the business as a whole’ lost. Other general value-decreasing factors include:
- The reputational ‘stain’ of insolvency processes. Knowing a company is being wound up doesn’t make potential purchasers excited about the value of that company’s assets. Instead they see it as an opportunity to get a bargain (i.e. a fire sale).
- Liquidator fees. While business owners/shareholders seek to maximise asset value (they are last in the pecking order after unsecured creditors), insolvency practitioners/liquidators have no such incentive. Insolvency practitioners bill on an hourly basis, and are first in the pecking order. They will be paid irrespective of whether unsecured creditors or owners get paid. The system is designed for liquidator’s to be impartial but on the other hand they lack strong economic incentives.
In this article, we dig beneath these general factors and analyse some of the specific asset classes that are likely to reduce in value in a liquidation. We then look at what steps may be taken in an attempt to preserve asset value.
What are the assets of the business that may lose value?
In recent doctoral research, the University of Sydney’s Professor Jason Harris looked at the asset classes that are at substantial risk of losing value in an insolvent liquidation. Here we look at each of the asset classes identified by Professor Harris, and explain why there is a reduction in value:
- Trading stock. This covers anything the business acquires, produces or manufactures as part of their core business trade. These assets tend to lose value on liquidation. Why is that? Two words: fire sale. In a winding up, goods have to be sold quickly both to meet regulated timelines for a winding up, but also due to the pressure on both insolvency practitioners and creditors to ‘get it over and done with’. Furthermore, in some cases, trading stock will also be works-in-progress (e.g. a cabinet-maker’s half-finished set of drawers), which have little value in their unfinished state
- Book debts. ‘Book debts’ cover all amounts owing from debtors at the time of liquidation. These tend to lose value in liquidation as, like all debt transfer, there is a risk of non-recovery, as well as transaction and enforcement costs for the debt purchaser. The construction industry in particular is notorious for non-payment of progress claims after a liquidation.
- Long-term leases. Long-term leases (whether in land or personal property) are usually terminated when a company goes into liquidation as part of the original lease agreement (note, while there is a stay on enforcing these ‘ipso facto’ clauses in cases of voluntary administration, this is not so with liquidation).
- Executory contracts. This is a contract which both parties have agreed to, but where performance has not been completed by both parties. This includes many asset management, advisory contracts or service provision agreements. As they cannot be straightforwardly assigned to other parties, this can mean a significant value loss in the case of winding up.
- Intellectual property rights (such as licensing rights). These can be difficult to value in a liquidation scenario because the business utilising the intellectual property has been shut down. Furthermore, the benefit of that IP is likely to be linked up with the ‘know-how’ possessed by the original business owners. This means that IP rights can go for significantly less in a winding up than they otherwise would.
- Specialist plant and equipment. The resale value may be low, as there could be few buyers for specialty equipment.
Are there better ways to preserve asset value?
Given the impact of an insolvent liquidation on asset value, what options are available to preserve as much asset value as possible? Consider the options below:
- Pre-packs. In a ‘pre-pack’ (a ‘pre-packaged insolvency arrangement’), the assets of the original company are sold to a new company (often having directors in common with the original company). Pre-packs are effected in Australia via utilising the ‘safe harbour’ from insolvent trading, and then finalising the pre-pack through a liquidator or voluntary administrator. This can facilitate trading without significant loss of business goodwill, as the public and customers do not need to be aware of financial troubles until the pre-pack is finalised. This does still carry risks, however. As mentioned earlier, it can be difficult to assess the value of many of these assets. If anything was sold at under market value, the directors face a risk of litigation upon liquidation – as this could be considered a ‘creditor-defeating disposition’ (read more in our Complete Guide to Illegal Phoenix Activity). Further, a recent case has generously interpreted the value of goodwill and the future income of a business in favour of the liquidator when the director entered into a pre-pack the day before appointing a liquidator (the Intellicoms case).
- Small business debt restructuring. This is a new restructuring option, so it does not yet have a significant track record. However, this could be a good option for businesses that come under the debt limit (less than $1 million in debt). For more information, read our Complete Guide to the Small Business Restructuring Process.
- Voluntary administration. On appointment, the voluntary administrator will attempt to forge a compromise between creditors, known as a ‘deed of company arrangement’ or ‘DOCA’. Appointing the voluntary administrator can preserve construction contracts, franchise agreements and leases. However, this is a short-lived protection, and given the poor success rate of voluntary administration, it is unlikely to result in a good outcome for most companies. Careful due diligence is recommended before relying on voluntary administration.
Liquidation has a significant impact on the value of assets. This is for multiple reasons; the reputational damage of insolvency processes, the fees of insolvency professionals, the inevitable price drop during a fire sale and specific asset classes which rely on the business continuing to retain asset value. For these reasons, it is often better to sell assets before an insolvency process begins (though note, if this occurs after insolvency the transaction might be voidable).
Where an insolvency process is inevitable, it is usually best to sell via a pre-pack or commence a small business debt restructuring (where the business is eligible). Where these options are pursued, it is important to obtain professional advice to reduce the chance of later litigation from unsecured creditors ‘out of the money’. Otherwise, if there is no hope of saving a business, sensible pre-liquidation actions such as collecting receivables, selling stock, selling equipment and other steps could soften the blow of a liquidation.