Has your equity become negative after a merger?
In recent months, we have seen increased interest from our clients in addressing negative equity issues in the opening balance sheet following a merger of otherwise sound companies. This is mainly due to the historical values of assets recognised in the accounting and historical results that need not reflect the current situation of the merging entities.
Following a merger, the opening balance sheet of a successor limited liability or joint-stock company may show negative equity or the fact that the total loss of the successor company will achieve a level which, if paid from available funds, would cause accumulated losses to reach at least half of the company’s registered capital (or this can be reasonably assumed considering all circumstances). In such cases, Section 5a of the Company and Cooperative Restructuring Act (No. 125/2008 Sb.) prescribes special requirements and restrictions. Primarily, the merger date may not follow the preparation of the draft terms of the merger, and the merger may only be entered in the Commercial Register if parties involved in the merger submit an expert opinion substantiating that the restructuring will not result in insolvency of the successor company.
What is the content of such expert opinions?
They mainly analyse whether the successor company complies with the definition of insolvency. The term insolvency has two definitions in Section 3 of the Insolvency Act: (i) the inability to pay debts and (ii) excess debts. Therefore, an expert must analyse both aspects separately.
In respect of the inability to pay debts, the analysis focuses on whether the successor company will generate sufficient cash flows to cover its due cash as well as in-kind liabilities. These issues require close cooperation with the client in preparing a cash flow model. A merger may bring significant changes to the existing activities of the participating (merging) companies with a major impact on expected economic indicators.
When analysing over-indebtedness features, i.e. the situation when the sum of a company’s liabilities exceeds the value of assets, the company’s assets must be revalued to fair value. The point is that values presented in accounting have only a limited reporting capability derived from the historical reporting.
Negative equity in the successor company does not necessarily mean a threat of insolvency, because hidden reserves are usually not recognised in accounting. However, this assumption must be carefully examined and then clearly substantiated. If you find yourself in a similar situation, we would be pleased to help you find a solution.
