A leveraged buyout (LBO) can be an effective way to acquire a company with minimal equity.  However, the increased financing costs associated with an LBO can cause financial distress or even bankruptcy if the company’s prospects change or if the debt-paying capacity of the business was overestimated.  Further, in the event of bankruptcy, selling shareholders, lenders and directors face exposure if the distributions associated with the transaction are found to be fraudulent conveyances.  The consequences of fraudulent conveyance are severe, as courts have been known to unwind transactions or void security interests.  According to the U.S. Bankruptcy Code, the Uniform Fraudulent Transfers Act and the Uniform Fraudulent Conveyance Act, a transaction may be voided if a business entity participated in any of the following:

• Was insolvent on the date that such transfer was made or such obligation was incurred or became insolvent as a result of such transfer or obligation
• Was engaged in business or a transaction, or was about to engage in business or a transaction, for which any property remaining with the debtor resulted in an unreasonably small capital base
• Intended to incur, or believed that the debtor would incur, debts that would be beyond the debtor’s ability to pay as such debts matured

The Prudent Response

Because of these issues, lenders and directors have increasingly turned towards solvency opinions to demonstrate that a leveraged transaction is not likely to harm the other stakeholders of the company.  A solvency opinion employs the use of three tests, all of which must be satisfied in order for a company to be considered solvent.  These tests include a balance sheet test, a cash flow test and a capital adequacy test.

The balance sheet test determines whether, at the date of the transaction, the fair saleable value of a company’s assets exceeds its liabilities.  In performing this test, the assets of the company are valued on a going-concern basis and then netted against the liabilities of the company. 

The cash flow test is used to analyze the ability of a company to service its debts as they come due through expected earnings, accumulated balances or additional borrowing capacity.  The company must also avoid violating its loan covenants in order to pass this test.  Overall, this test is based on a review of various scenarios and their resulting financial outcomes.

The capital adequacy test determines whether a company has sufficient capital to support operations in the event that performance is below expectations.  Various tests are performed to assess whether the company can survive financially, assuming reasonable business fluctuations.  In performing this test, existing working capital and the availability of committed credit is analyzed.  The test is passed if the company will likely survive in the event of a reasonably foreseeable downturn.

The preparation of a solvency opinion requires valuation expertise, in-depth knowledge of the bankruptcy code and the fraudulent conveyance acts as well as experience with mergers and acquisitions.  Independence of the deal and audit issues is also a key requirement.  Accordingly, the use of a nationally recognized valuation firm is recommended.  CBIZ Valuation Group professionals have prepared solvency opinions for organizations ranging from small manufacturing firms to some of the largest LBOs in history.