Valuing a distressed company basically follows the same tenets as valuing a healthy one; yet the process of valuing a distressed firm, or a firm that has filed for bankruptcy, is far more complex and less understood. In fact, it’s one of the most discussed and debated topics within the valuation industry. While the underpinnings of valuation remain constant, the process of valuing a firm is more complex and less understood when distress is present, or bankruptcy has been filed. In my estimation, distressed valuation is where the science of valuation truly meets the art of the specialty. When approaching a distressed valuation engagement, it is important to understand the overall financial situation and the impact the distress may have on value estimation in order to arrive at a reasonable and reliable valuation.  

Step 1: Estimate the value of the company 

Determining the premise of value when estimating the value of the subject company is the first vital step in distressed company valuations, with liquidation value and going-concern value being the two most common choices. Liquidation value assumes the business will cease operations and its assets will be sold off piecemeal, either over a reasonable period (orderly) or as quickly as possible (forced). Often, applicable law will tighten up this premise of value by observing that going-concern value should be used unless the company is on its “death bed.” In contrast, going-concern value assumes the subject company will continue operations into the future. Generally, the appropriate determination of which premise to use is fact and case specific; its ad hoc nature does not detract from the important role each plays in a bankruptcy case. In the bankruptcy process, both premises may be used. Going-concern value may be the controlling premise when estimating reorganization value while liquidation value may be controlling when performing the best interest of the creditor test, even though both inquiries are housed in the same Bankruptcy Code section. 

Step 2: Establish the appropriate standard 

After establishing the premise of value, the second vital step the valuation expert must take is in establishing the appropriate standard. Here, the Bankruptcy Code and related state law statutes can be a bit vague, and the case law interpreting these provisions can be downright confusing. Engaging a professional with experience and expertise in this domain can assist with navigating these issues. Certain provisions of the Bankruptcy Code and related state law statutes dealing with distressed companies use terms such as “at a fair valuation.” In these contexts, it is generally understood that a value-in-exchange standard, such as fair market value, should be used. Other provisions require that the valuation be performed from the perspective of a specific party, leading to a value-in-place standard, such as investment value. Unfortunately, the case law that governs these types of valuations also complicates this determination by mixing the standards using statements such as “fair market value from the perspective of the unsecured creditors.” As a general rule, a solvency valuation is done using the fair market value standard while a determination regarding whether reasonably equivalent value was exchanged in a particular transaction uses something more akin to the investment standard. 

Step 3: Determine the base value 

Once premise and standard have been established, estimating the value of a distressed company typically starts with determining a “base” value using well-respected approaches such as the Market Approach (Guideline Publicly Traded Companies, and Guideline Transactions), the Income Approach (through the Discount Cash Flow methodology), and the Cost Approach. The value estimates from these methodologies are then adjusted to better represent the distressed company’s characteristics. Such adjustments are in relation to the factors used to determine the base value, with a focus on risk, future economic return, and growth of the subject company.  

• Market Approach: The Market Approach provides an estimate of the value by applying known valuation metrics (multiples) to the subject company, derived from guideline companies or transactions (guidelines) with similar characteristics. These guidelines are drawn from the subject company’s industry based on the belief that firms within an industry experience common financial risk and growth factors, such as overall demand for their products and services. 

One of the challenges in applying the Market Approach is accounting for the element of distress. While the guidelines may be similarly situated and in distress themselves, such facts are rarely experienced uniformly. Typically, the underlying guidelines are healthy and going concerns, or a combination of both healthy and distressed businesses, and are not experiencing the challenges of the subject company. It can be difficult to define exactly how the multiples should be adjusted to account for distress but that is the valuation practitioner’s charge. These adjustments need to be well researched, supported, and thoroughly explained, particularly in the context of litigation or the bankruptcy confirmation process. Not providing a well thought out analysis can lead to an estimate not being reliable or outright excluded. 

• Income Approach: A form of the Income Approach, the discounted cash flow method (DCF), may provide an estimate of value considered more reliable than the guideline approaches when examining a distressed company. This is because a DCF is based on the subject company’s specific projected cash flows as discounted by a risk level and growth rate relevant to those cash flows, all explicitly stated in the model itself. 

Experience has taught us that projected cash flows should not be accepted at face value. Rather, potential, aspirational, or aggressive growth or implicit bias in the projections should be considered. In the event the valuation practitioner determines the projections are not reasonable or reliable when made, and without applying hindsight, making the necessary and supportable adjustments is appropriate and essential. The suitable risk weighted discount rate will then be applied to the cash flows. This discount rate must reflect the risks associated with the business’s ability to generate future cash flows. 

The application of these approaches and the related adjustments in a world of distress is where professionals with valuation expertise, that are well-versed in distressed situations and bankruptcies, excel. They can bring a rare blend of deep knowledge and robust experience to every situation and can evaluate fiduciary duty and valuation issues prior to disputes. In addition, they can assist with valuation issues in the context of many stages of the bankruptcy and reorganization process. Finally, when the time comes, they can provide comprehensive analysis and trial testimony in contested motions, adversary proceedings, and civil trials on topics including solvency, asset stripping, reasonably equivalent value, cost accounting, and reorganization value. In short, if a business is experiencing financial distress, we can be of service as a trusted advisor or testifying expert.