In this month’s case study we take a look at our client, Virat. Virat ran a digital marketing company that had traded quite well for a number of years. The business was badly affected by the covid pandemic, as many of his clients were impacted by lockdowns and suspended their marketing efforts. Like many business owners Virat was very optimistic, passionate about his business and protective of his employees. As we will see soon though, this resulted in him putting a series of “band-aids” over his problems rather than dealing with some underlying issues. Background Like many company directors, when cashflow tightened, Virat starting getting behind on his ATO obligations. He started using the “unofficial” second overdraft with the ATO pretty hard. This allowed him to maintain payments to his creditors and bought him a bit of time. He soon became concerned about how his ATO debt was growing, but still needed cash to meet his commitments. So, he needed to try something else. Virat arranged a debtor finance facility. The debtor financier gave him a chunk of cash against his invoices. Virat made his payments to creditors and had again given himself a bit more breathing space. When debtors are growing debtor finance can sometimes be the best solution. In this case though, sales were declining. All Virat had done was brought his debtor collections forward – he had not really solved the underlying issues he had, being lower sales and growing debts. By now Covid relief measures were in place. Virat received around $250,000 from JobKeeper and Cash Boost. This enabled him to keep going, pay wages and at least make enough payments to creditors to enter into payment plans. The whole time though, his ATO debt kept growing. He still needed cash, but was running out of options. The next thing Virat did was obtain a fintech loan. Fintech is a combination of the words financial and technology, and describes short term online lenders. These lenders usually only require minimal financial information and do not normally take a security interest over the business. Quick. Simple. Easy. Short term though, and usually at quite significant interest rates. Still, Virat was able to source some more funding and he kept going with his business. With the funds from the fintech loan soon exhausted though, Virat found himself back in the same situation. By now, the Government had introduced the Coronavirus Small and Medium Enterprise (SME) Guarantee Scheme. These loans are 50% guaranteed by the Government, and the lender does not take a security interest over the company. Virat applied for a $250,000 loan and was approved. His financials still looked pretty good, as these often lag behind the cashflow position of the business. So, Virat did everything you could imagine to keep his business afloat. He had bought time. Bought is the key word here, because this comes with a cost in terms of interest and repayment commitments. Virat then faced the situation where Government relief measures were coming to an end and the ATO was ready to recommence recovery action for outstanding debts. ATO debt collection largely went into hibernation during 2020, with outstanding tax commitments growing by $7bn in one year. Now they are waking up, and they have a lot of debts to recover. Let’s have a look at the position Virat ended up in:
Assets
Debtors - $400,000
Motor Vehicles - $130,000
Loan to Virat - $300,000
Cash at Bank - $20,000
Total - 850,000
Liabilities
Debtor Finance - $300,000
Motor Vehicle Finance - $125,000
Major bank (Loan & Overdraft) - $ 350,000
Fintech Loan - $50,000
Coronavirus SME Loan - $250,000
Trade Creditors - $280,000
ATO (GST, PAYG & Super) - $800,000
Total - $2,155,000
Virat’s debts have grown considerable following the downturn in business. New debts have been acquired and the ATO debt now represents an insurmountable liability for the business. Virat had thought things would turn around, but he faced a rolling series of lockdowns. Now he is worried that the ATO are going to start pursuing him for the debts. The interest rates and repayments are starting to bite too. Virat was very passionate about his business and he wanted to continue in the industry.
A few important points to note are:
The major bank had not taken a security interest over the company for the business loan and overdraft. Normally, we would have expected them to, but they had not.
The fintech lender did not have a security interest. They relied on a personal guarantee from Virat and a caveatable interest clause within the loan agreement. This enables them to put a caveat on any property in Virat’s name should they remain unpaid, so they did not register a security interest.
The Coronavirus SME loan was not secured against the company either. Not registering an interest was part of the package made available by the Government. While the Government guarantees 50% of the loan, Virat personally guaranteed 100%.
The debtor financier did have a security interest over the company and a specific charge over the debtor book. This is important, as the business cannot be sold unless the securityholder is paid out or consents to the sale.
Virat did not have the ability to make any meaningful settlement offers to creditors.
Cashflow was improving, and Virat remained optimistic about the future, but the business is now burdened with insurmountable legacy debt. So, even though things were looking up, he simply cannot manage his debt load.
Strategy
Given that Virat did not have the funds to negotiate settlements with his creditors, and he wanted to continue to pursue his interest in the industry, we recommended a business restructure. Sometimes called a phoenix, business restructures are completely legal if done properly and correctly. In this case that meant;
Setting up a new company to act as the new trading entity.
Arranging a debtor finance facility in the name of a new entity to provide cashflow for initial trading.
Collecting as many debtors as possible and satisfying the security interest of the debtor financier.
Valuing the business assets and goodwill. For the restructure to be legal, a fair market price must be paid.
Arranging the reassignment of the motor vehicle finance, and the new entity making a payment to the company for the equity in the vehicles.
Re-employing all staff in the new entity and assuming responsibility for all employee entitlements. Unrelated party employee entitlements were offset against the purchase price for the business and its assets.
Setting up new service provider agreements in the name of the new entity (phone, internet, electricity etc).
Outcome
In Virat’s case, the business and its assets were valued at $50,000. Virat was able to borrow some money from family to buy the business. The company was able to collect most of the debtors, enough to payout the debtor financier with a little left over. The motor vehicles were sold to the new company, with a payment of $5,000 to reflect the equity in those assets. The company’s position after this process was as follows:
Assets
Debtors - $30,000
Loan to Virat - $300,000
Cash at Bank - $145,000
Total - $475,000
Liabilities
Major bank (Loan & Overdraft) - $350,000
Fintech Loan - $50,000
Coronavirus SME Loan - $250,000
Trade Creditors - $280,000
ATO (GST, PAYG & Superannuation) - $800,000
Total $ 1,730,000
The cash has gone up from $20,000 to $145,000. The company received:
$70,000 from debtor collections after the debtor financier was paid.
$ 5,000 for the equity in the motor vehicles purchased by the new entity.
$50,000 from the sale of the business and its assets.
The debtor finance and motor vehicle finance has been paid out, and all security interests satisfied. All employees have retained employment and all their entitlements have been preserved in the name of the new entity. To bring finality to the affairs of the old company Virat could now appoint a liquidator. The liquidator is now in position to collect the remaining debtors, make any claims they may have and distribute funds to the unsecured creditors.
Virat’s new entity is now able to trade and it is not burdened by the legacy debts of the old company. Virat has retained control, and the ability to generate an income in the future. While he did everything he could to keep the business afloat, this was an expensive exercise, and acting sooner to address the underlying problems of the business would have reduced the costs and the stress that he had experienced.
Virat still has some personal issues to deal with. The liquidator will make a claim for the loan that he owes the company and he has personal guarantees to the major bank, the fintech lender, for the Coronavirus SME Loan and to trade creditors, but that is a story for another day.
We discussed this case study in detail in our last webinar 3 March.