Court Determines Solvency with Detailed Analysis

Stadtmueller v. Fitzgerald (In re Epic Cycle Interactive, Inc.), 2014 Bank. LEXIS 2622 (June 6, 2014)

A recent Chapter 7 bankruptcy case involving a startup provides insight into an expert’s approach to a debtor’s going concern value and shows how the court determined solvency.

This Chapter 7 bankruptcy case centered on a loan between the defendants, the founder of a company that embodied “every sense of the term ‘start-up,’” according to the Bankruptcy Court, and the founder’s mother. The company developed and marketed website design software. The initial funds in 1998 came from close family and friends, but in subsequent years the company also obtained funding from venture capital (VC) firms. By 2005, it pursued expansion, culminating in the acquisition of an advertising distribution network company. It also secured large contracts with CBS and newspapers belonging to the Tribune group. The debtor required additional financing to ensure its ability to perform on the contracts. At the end of 2007, VC firms provided bridge financing in exchange for which they received so-called bridge notes that bore 10% annual interest, payable on demand or at a specific date, and that automatically converted to equity shares if a qualifying financing transaction occurred.

In need of an additional $100,000, the founder turned to his mother; she agreed to make a loan that had a 60-day maturity, after which she could either ask for repayment or convert the note to equity. The note had a pari passu provision to ensure equal treatment with the VC’s bridge notes. Upon maturity, the mother demanded repayment, which prompted the debtor to wire the funds on February 22, 2008, at full face value, plus interest.

In January 2008, the VC funds filed suit against the founder and the company, alleging breach of contract and fiduciary duty. Settlement efforts on the debtor’s part went nowhere. On February 28, 2008, the VC firms formally demanded repayment of the outstanding bridge note, and, in April 2008, they obtained an order of attachment on the debtor’s assets. On April 22, 2008, the debtor filed for Chapter 11 bankruptcy (S.D. Cal.), which the court later converted to Chapter 7 bankruptcy.

The trustee sued under the Bankruptcy Code’s Section 547 to recover the loan payment to the founder’s mother. To succeed on his claim, the trustee had to show that the debtor was insolvent on the date of transfer, February 22, 2008. Solvency was the only critical element in dispute, and both sides offered expert testimony to support their positions.

The starting point for the experts’ analyses was the court’s pretrial finding that the company had to be valued as a going concern for three reasons: (1) by late 2007, it had entered into lucrative contracts that were not in default; (2) it was generating substantial gross revenues; and (3) for more than a year after filing for bankruptcy, it operated as a debtor-in-possession.

The trustee’s expert was a CPA, who, since 1989, focused on handling bankruptcy matters. For his analysis, he identified asset by asset to determine the fair market price for each asset category. Specifically, he used the book value of each asset, as it appeared on the balance sheets, and made a series of adjustments (discussed below). He clarified that his definition of the fair market price assumed that the assets “had been sold as a unit in a prudent manner and within a reasonable time.”

The expert reviewed the company’s 2007, 2008, and 2009 corporate income tax returns and compared them to the company’s balance sheets for January 31, 2008, February 21, 2008, February 29, 2008, April 22, 2008, and June 30, 2008. He also analyzed the debtor’s bank statements for the first three months of 2008.

Under his analysis, the debtor’s assets on February 21 amounted to $1.35 million and its liabilities to over $1.82 million. Therefore, the debtor was insolvent by over $477,000. On February 29, its assets were worth nearly $809,000 and its liabilities totaled over $1.4 million. Its insolvency had increased to over $600,000. Consequently, he said, the debtor was insolvent when it repaid the $100,000 loan.

The defendants’ solvency expert also was a CPA, with 40 years of experience, including 10 years as corporate controller and CFO. He interviewed the company’s founder and reviewed the debtor’s disclosure statements, tax returns, and operating reports. He placed great weight on the debtor’s December 31, 2007 balance sheet because, he said, a CPA had prepared it and the debtor had included it in its 2008 tax return, under penalty of perjury. But the expert acknowledged that the internal accounting in this case closely matched the tax return statements. He asserted the opposing expert’s report was not a true going concern valuation but a liquidation analysis.

The defendants’ expert found that the company’s 2008 tax return reported assets of over $2.5 million as of January 1, 2008, and total liabilities of over $1.86 million. Therefore, on that date, the company was solvent by over $646,000.

For April 22, 2008, the expert used the bankruptcy schedules, rather than the internally produced balance sheet, because the schedules were filed under penalty of perjury. He made a number of adjustments (discussed below) and arrived at nearly $1.17 million in assets. He also adjusted the liabilities to arrive at a total of nearly $890,000. By his calculation, the debtor was solvent on that day. Since the debtor was solvent at both data points, it necessarily was solvent on the transaction date, the defendants’ expert concluded.

The defendants also retained a certified auctioneer who assigned a liquidation value to the debtor’s fixed assets comprising a “piecemeal auction valuation” of the assets on December 9, 2008. If the system had been sold as an operational data center, it likely would have brought in $148,000, the auctioneer said. He added that in 2008 there were many sales of older computer equipment and it was a buyer’s market.

The court found all the expert witnesses “generally credible” but on balance thought the defendants’ expert’s analysis provided the more reliable going concern value. The “most expeditious” way to assess solvency, the court said, was asset by asset. It did so by relying on the debtor’s balance sheets and “applying both experts’ logic where appropriate.” In terms of adjustments, the disagreements focused on the following:

(1) Accounts receivable. The trustee’s expert reduced the amount by 18% to account for doubtful accounts, but failed to consider the debtor’s actual performance in collecting its receivables. In contrast, the defendants’ expert used a 15% discount based on the debtor’s past history of cash collections.

The court adopted the 15% discount.

(2) Security deposit. The debtor had a $72,800—book value—cash security deposit related to obligations to its landlord. The trustee’s expert assigned zero value to it noting that the account had dwindled to $800 by the time the debtor filed for bankruptcy and thought it unlikely that the debtor would have been able to convert this asset to cash on February 22, 2008.

The defendants challenged that assumption, and the court found it was an unpersuasive ex postanalysis. The point was to rely on information available on the transfer date. Since the trustee did not propose a “principled way to discount this asset, other than at zero or full book value,” the court adopted the $72,800 value for both dates.

(3) Letter of credit. Among the assets on the balance sheet was an item called “letter of credit” for $161,200. It pertained to the debtor’s licensing rights to a computer game for which it paid royalties to the license holder. If the debtor missed a payment, the licensor had the right to draw on the deposit account. If the debtor performed, it had the right to the full funds.

The trustee’s expert understood that, between June 2009 and April 2010, the debtor was able to recover $150,000 of the letter of credit. As for information available on the transaction date, he believed the debtor would have been unable to convert the asset to cash on February 21 or February 29 and, therefore, discounted its value to zero.

The defendants’ expert thought it should be given book value, in line with valuing the debtor as a going concern.

The court pointed out that a hypothetical buyer would assess the likelihood of the debtor’s performing on the contract. Neither its performance nor its failure to perform was a certainty. Since the trustee failed to offer a way to discount the value, the court adopted the $161,200 book value.

(4) Prepaid expenses. The balance sheet included over $33,600 in prepaid utility deposits, which the trustee’s expert valued at zero, saying this asset could not be converted to cash.

The court found a zero valuation unpersuasive. There was a possibility that the debtor might assign the lease interest and preserve some value in the accounts. Lacking evidence of how to discount the amount, the court accepted book value.

(5) Fixed assets. The fixed assets consisted primarily of computer equipment, whose book value was over $418,400. The trustee’s expert discounted it to $101,300 based on an admittedly novel formula whose underlying logic was far from persuasive, the court said. The court also disregarded the net book value the defendants’ solvency expert proposed.

Instead, the court relied on the auctioneer’s liquidation valuation. It found the assets were worth slightly over $248,900 on February 21, 2008, and February 29, 2008. This figure, it said, equaled the sum of the $74,100 and $64,200 liquidation figures from the auctioneer’s report, multiplied by two to represent the computers’ “fully operational” value and deducting a 10% sales commission. Even though the auctioneer’s valuation related to December 2008, his analysis was more reliable than the defendants’ expert’s valuation.

(6) Goodwill and intangible assets. The debtor’s balance sheet amortized goodwill of approximately $110,000 on the relevant dates. The trustee’s expert discounted it to zero saying the debtor would have been unable to sell it. He noted that, by 2007, the debtor showed a retained earnings deficit of $4.8 million and concluded its assets would not have generated a premium.

The defendants’ expert relied on a liquidation report an accounting and auditing firm had prepared and proposed a $100,000 intangible asset value. He said that offers to buy the advertising distribution company at a significant premium and the debtor’s long-term revenue contracts supported that figure.

The court agreed with the trustee’s expert that the debtor’s goodwill balance sheet entry should be excluded. “The appearance of goodwill on [the debtor’s] balance sheet more than likely represented a specific asset purchase, rather than the intangible value attributable to [it] as an enterprise,” it noted. It was unlikely that the debtor could generate any value from the historic cost to satisfy creditors’ claims.

But the court agreed with the defendants’ expert that a prospective buyer of the debtor as a going concern would place an economic value on the contracts the company had secured and on its ability to perform. Therefore, the court accepted the defendants’ expert’s $100,000 intangible asset figure.

(7) Liabilities. The experts’ disagreement centered on the treatment of the VC firms’ bridge notes: whether the court should discount for the possibility that they would convert to equity and what the appropriate discount rate would be.

The trustee’s expert credited the liabilities at face value. The defendants’ expert was under the mistaken impression that the parties had agreed to write down the loan balance by $250,000.

The court pointed out that neither expert performed a contingency analysis for the court. But hostility between the VC firms and the debtors and other facts suggested that a conversion was a “virtual uncertainty” as of the transfer date. Therefore, the court found it was appropriate to assign face value to all liabilities on the relevant dates.

The court concluded that, on February 21, 2008, the debtor’s assets exceeded liabilities by nearly $99,300. On February 29, 2008, its liabilities exceeded assets by nearly $11,200. The net loss for 2008 as of February 21 was nearly $341,460; as of February 29, it was nearly $450,540. This meant there was a deficit of nearly $109,080 in eight days. By extension, the court found the company lost $13,635 a day, which led it to conclude that on February 22 the debtor’s assets still exceeded its liabilities by over $85,600. Accordingly, the court found the debtor was solvent and the trustee was unable to recover the loan repaid to the founder’s mother.

At Rosenfarb LLC we produce well supported, well-reasoned and well communicated solvency analysis reports that withstand the rigors of litigation. We are a firm of forensic accounting and valuation experts. We understand business, have keen insights and always connect the dots. We understand the litigation process. We frame the issues simply and in alignment with the litigation strategy. We use logic to support our opinions, while creating compelling stories. We are sincere, professional and credible. We are accounting experts with legal acumen.

Rosenfarb LLC
Phone: (855) 415-1100
Info@Rosenfarb.com
www.rosenfarb.com