What Happens in Bankruptcy?
In a Chapter 7 Bankruptcy (Liquidation) the assets of a company are turned over to a trustee and distributed to its’ creditors. Secured claims are paid from the proceeds of liquidating the collateral which secured the claim. For example, mortgage lenders would have priority over the real estate of the company and equipment lenders would have priority over equipment that was lent on.
After secured creditors are paid, everything else is paid according to priorities established in the bankruptcy code. Costs of administration, like Attorney Fees : ), are paid first. Next, “Priority Claims” like unpaid wages and taxes are paid next. General unsecured claims are paid last. For practical matters, different investors are prioritized as follows:
- Secured Lenders
- Senior Bondholders
- Junior Bondholders & Other Unsecured Lenders
- Preferred Stockholders
- Common Stockholders
You must keep this structure in mind when you evaluate the price of common stock. For example, assume the following facts for Company A:
- Total Assets = $200,000
- Total Liabilities = $140,000 (Secured Debt, Bonds, & Preferred Stock)
- Total Outstanding Shares = 1000
Since Common Stockholders would be entitled to the remaining equity after paying off all other credtors, the value of all common stock would be worth $60,000 [$200k - $140k = $60k] . Since there are 1000 shares outstanding, each share is worth $6 [$60,000 ÷ 1000 = $6].
But what if the Assets are not really worth $200k because that number only reflects the over-inflated price you paid for the assets? What if the $200k book value represents the price of a cookie-cutter house in Stockton, California (filled with lots of ticky-tacky) that Company A purchased in the Summer of 2006 for a secured loan with 80% LTV, 10% cash (pulled from a revolving line of credit of course) and 10% of its own common stock?
In that case, if the house is really worth only $120,000 (as a grow house most likely!) then the value of each share of common stock is worth NEGATIVE $2 [$120,000 - $140,000 = -$20,000 ÷ 1000 = -$2]. Luckily, the law provides for limitation of liability for common stockholders.
September 16th, 2008 at 7:04 am
What does it mean when levered cash flow is a negative number. HMM? It is likely the accounting version of a double entendre. Double entendres are tricky. They always have a double meaning. Context will tell you which meaning is the relevant one.
September 30th, 2008 at 7:50 pm
[...] at the expense of the equity holders who are at the bottom of the bankruptcy totem pole. Click HERE to read my September 15th post about bankruptcy priorities. In my opinion, since they are already [...]
January 20th, 2009 at 12:59 pm
[...] stockholders when secured real property is the main asset class. Read my post titled “What Happens in Bankruptcy” for a clear understanding of shareholders place in the food [...]