Outside financial advisers typically estimate the reorganization value, but it is ultimately determined based on negotiations by the parties involved in the bankruptcy process. The terms of the plan underlying the reorganization are determined after extensive arms-length negotiations between the interested parties as overseen and approved by the court. The reorganization value is typically based on discounted pro forma cash flow projections that were determined as part of the reorganization plan, with a view to achieving maximum value for the business. Once determined, the reorganization value provides a foundation for estimating the value to be received by the entity’s creditors and equity holders. In a business combination, a purchase price is negotiated between a specific buyer and seller.
The reorganization value used in a bankruptcy proceeding is different from business enterprise value. A company’s enterprise value represents the fair value of its interest-bearing debt and equity capital, while the reorganization value can be derived from the enterprise value by adding back non-interest-bearing liabilities.
Capital Structure Considerations: Once the reorganization value has been established, consideration should be given to the capital structure of the entity upon emergence. The restructuring process often gives rise to multiple classes of securities (stock options, warrants, etc.), each with different rights and privileges. As such, the fair value of each security should be determined in the context of the company’s overall value.
Determining the fair value of share-based payment awards for a company emerging from bankruptcy presents some unique challenges. Valuation assumptions used in option-pricing models for share options and similar instruments measured on, and subsequent to, emergence should be carefully analyzed and evaluated. Historical employee exercise behavior and historical volatility measures may no longer reflect the expected volatility of the emerging entity’s share price. ASC 718-10-S99, which reflects the codification of certain SEC guidance on share-payments in Staff Accounting Bulletin (SAB) Topic 14, can be used as a reference point to address these issues, as it provides guidance applicable to newly public entities measuring the cost of employee share options and similar instruments.
Asset Valuations: The approaches and techniques to value intangible and tangible assets for fresh-start accounting are generally similar to those used in accounting for business combinations. The primary intangible assets of a company are generally valued using some form of the income approach, with certain secondary intangible assets valued using an income and/or cost-based approach. Intangible assets commonly valued using the income approach include, but are not limited to, customer relationships, patents and trademarks. The cost approach tends to be used to value such intangible assets as internally developed software and assembled workforce.
Tangible assets are generally valued using the market approach and/or the cost approach. In applying the cost approach, it is common to make adjustments for physical and functional obsolescence for both fresh-start accounting and business combination valuations. However, the existence of economic obsolescence tends to be more prevalent in fresh-start accounting projects given the circumstances surrounding entities that file for bankruptcy. Appropriate quantification of economic obsolescence can require significant input from senior management and operations personnel. Valuation professionals knowledgeable of both financial valuation theory and tangible asset valuation concepts should be actively involved in the process to address this issue.