As businesses start to think about restarting after lockdown, a CVA may be a useful tool. A CVA, or Company Voluntary Arrangement, is an agreement between a company and its creditors to settle its debts. For companies that have a backlog of creditors and are now facing a business that may have to operate at a lower level of activity, finding a way to deal with historic debt is going to be vital.
What is a CVA?
A CVA is a formal insolvency process and supervised by an insolvency practitioner but crucially, the directors remain in control of the business. It is a very flexible tool. The company makes a proposal to its creditors which, if 75% of those voting on them by value accept, it is binding on all creditors. That 75 % can include associated creditors, but there is also a second test that means 50% of the non-associated creditors must not vote against it.
The proposal usually says something like, don’t force the business into liquidation now, allow it to continue to trade and a contribution from future profits will be made to pay a dividend to creditors. Typically, although it is highly case-specific, creditors are offered and accept 20-50% of their debts.
The CVA allows the company’s debts prior to the start of the CVA to be put on hold. This means that incoming cash after the start of the CVA can be used to fund the working capital of the business going forward and not in paying creditors. The reduced payment to creditors is spread over the life of the CVA. For businesses that find they are now only able to operate at 50% capacity this could be a useful tool in dealing with a backlog of debt.
How does a CVA work
To understand if a CVA is a viable option, it is important to understand the current financial position of the company and to look at forecasts for profit and loss along with cash flow. The first step is to produce a statement of affairs, a list of the realisable value of the assets and a list of the liability split into the different categories of creditors. A CVA must achieve a better result than a liquidation. If a creditor can expect a greater return in the short term by having the company liquidated then that is the likely outcome. So understanding what a creditor will get out of a liquidation will set the benchmark for the CVA. If liquidating suggests creditors will get 30p in the £, the CVA will need to offer more than that to be acceptable to creditors.
Once it is known what the minimum level of return required is, we need to understand what the business can produce in profits. For example, if a business has £500,000 of creditors and a statement of affairs is prepared which suggests that creditors could expect a dividend of 30p in the £, a CVA must be able to produce more than £150,000 of after-tax profits over the life of the CVA. At a 19% corporation tax rate, that means pre-tax profits of c£185,000 need to be generated to fund the contributions. Most CVA’s are for 5 years. This is because HMRC usually insists on a 5 year arrangement if they are a significant creditor. So in this example, pre-tax profits of £37,000 per annum will need to be generated to fund the CVA. If the forecast for the business is that it can generate more than this then creditors will expect this to increase the dividend to them.
In producing a forecast to support the CVA, it needs to be realistic. If the business has been generating losses which may be why it is insolvent, how is it going to suddenly change and start making significant profits to make a contribution to the creditors? Creditors need to believe the CVA will work.
As mentioned above, CVAs are flexible. A different approach may be for the business to source external funding and use that to make an offer to creditors. For example, the principal shareholder may believe in the business, but does not want or can’t afford to put in enough funds to pay all creditors. They could make an offer to put enough funds in to pay a dividend that would be better than a liquidation.
Although CVA’s are useful, they are not very common. In 2019, out of 17,224 corporate insolvencies, only 351 were CVAs. Why is this, when at first sight it is the answer to the problem? The answer is partly that the circumstances have to be right for a CVA to be viable. In the typical contribution out of future profit CVA, the business has to be able to make a sufficent profit to allow it to make contributions. This usually rules out a lot of potential CVAs.
There are some pitfalls for CVAs
Historically, the majority of CVA’s fail and the company ends up in liquidation anyway, usually further in debt than before. This failure rate is down to a number of reasons. Firstly, directors are too optimistic in the forecast for the business on which the proposal is based. It is common to underestimate the effect the CVA will have on customers and suppliers wanting to trade with the business. The CVA is noted on Companies House for all to see meaning it can be hard for businesses to attract customers or obtain credit from suppliers. Secondly, creditors can ask the directors to modify the proposal upwards so they get more. In the moment of crisis when the CVA is being considered directors often accept modifications that are going to be difficult to meet just to get the CVA approved.
By far the most common reason for failure is that the underlying cause of the insolvency is not addressed. It can be management, funding or a flaw in the business model. The CVA’s that do succeed change at least one of those causes. Introducing new management even on an interim basis should bring fresh eyes to the problem. Making sure there is enough cash in the business to fund the business plan means that the businesses will not slip into cash flow issues. Understanding and fixing what wasn’t working in the past is the most likely way to have a successful CVA.
For some, the difficulties of running a business under a CVA can be solved by restarting the business in a new company free of its previous history and debts. By placing the old company into liquidation and buying the business back in a new company will make more sense. It often means that creditors get a larger dividend as there is a sale of the business as a going concern rather than a liquidation sale. It removes the risk of relying on future trading to generate a contribution for the creditors. However, it does mean that the buyer of the business will need to fund the purchase of the business. Sometimes, this is done by way of instalments from the new business which puts the risk back on the creditors that the new business will be successful!!
Ultimately whether a CVA or liquidation is the best way forward will depend entirely on the individual circumstances of the company, its creditors and other stakeholders. Directors should seek professional advice on how best to help their business to survive.
