Considerations for companies in distress

As calls for an easing of the draconian lockdown restrictions imposed by government go unheeded, more and more companies are losing the battle and will end up in business rescue or liquidation in the near future.

Even before the lockdown, imposed in response to the global spread of the coronavirus, a number of businesses had already shut down.

“We are going to see a massive increase in the number distress sales of businesses soon,” says Joshua Janks, partner at law firm Bowmans. “It is inevitable.”

Businesses will instinctively try to survive by cutting costs in any way imaginable.

“However, you have to weigh that up against the long-term sustainability of the assets or business,” says Janks, adding that if such cuts are not sustainable it may be preferable to rather focus on retaining as much value in the business as possible.

This will ensure a better return if there has to be a distress sale.

Stefan Steyn, senior business rescue practitioner at Business Rescue Partner, says the two key considerations in determining the ‘state of the business’ are its cash burn rate and operating leverage.

Cash burn rate

The cash burn rate must be slower than the cash conversion rate. If you have 20 days of cash left in a cycle but your cash conversion rate is 28 days, there is a problem.

“If the difference in days is increasing month to month and you do not have increased payment terms with creditors then the demise will be even faster,” says Steyn.

Operating leverage

Operating leverage is gross profit less costs (labour and property) divided by turnover. In most industries, there is cause for concern if this amount is less than 10%. And if the ratio is below the industry benchmark for three consecutive months, then there are problems for that business.

“Most companies do not do these calculations because their financial statements are often not up to date or the information in the financials or management accounts is [viewed] in isolation and not used to monitor trends on an ongoing basis,” says Steyn.

Protect the cash

Although it sounds impossible at times like this, companies are advised not to run out of cash and then become desperate, says Tim Stokes, attorney and business rescue practitioner.

“There are sharks out there that will pick up businesses for next to nothing because the [owners] are in a desperate situation and have left themselves with few options.”

When considering whether to fund companies in distress, FyreFem Fund Managers will be looking at the results reported for the six months to December last year, says CEO Cathy Goddard-Edwards.

If a company was in distress before the arrival of Covid-19 the chances of obtaining funding will be slim.

Companies need to carve out time to get on top of the things that are too high in administration and too process-orientated for a prospective funder to handle, she says.

“Ensure that all the minutes of meetings are up to date, that all material legal agreements are on file such as insurance policies, lease agreements, and any guarantees or sureties the company has signed; have a complete list of assets and any employee related provisions.”

The Southern African Venture Capital and Private Equity Association (Savca) has launched an initiative asking members with excess capacity to volunteer their skills and expertise to help businesses that are in distress or facing an immediate crisis.

The value of a ‘fresh pair of eyes’

Savca CEO Tanya van Lill says companies need a combination of bridging finance and legal and business expertise to offer a fresh pair of eyes in terms of cost-saving opportunities or new revenue streams.

She says their members are focusing their attention on companies in which they are already invested and making sure they can weather the storm.

The reality is that businesses need to ensure that as much output as possible is deferred rather than destroyed.

However, the initial move to what is now described as Level 5 lockdown restrictions on March 26 gave very few companies the opportunity to do so.

The ‘informal’ business rescue option

Eric Levenstein, head of the business rescue and insolvency practice at Werksmans, says that when creditors begin to get aggressive and when threats of applications for liquidations become an issue, it is time to consider business rescue.

The company can engage with some or all of its creditors informally – outside of a formal business rescue process – with regards to restructuring the company.

The company will not have the benefit of a moratorium that will prevent creditors from enforcing their claims, but this will create an opportunity to negotiate and agree on a ‘prepackaged’ sale of a distressed company.

“A prepack will only work in circumstances where the company has a small group of creditors who are prepared to work with the company prior to the commencement of any formal business rescue proceedings.”

In this way, says Levenstein, a commercial transaction can be finalised without the cost of a formal business rescue process, which can be expensive.

Janks says that if the sale of the business becomes inevitable, the need to move fast becomes crucial. “It is a difficult decision and very emotional – but is it a critical point.”

The more desperate the situation becomes, he says, the greater the potential for value in the business to be destroyed due to poor decisions.

Listen to Nompu Siziba’s interview with Banking Association of South AfricaMD Bongiwe Kunene: