What does it mean when a business’ book-value or BV is negative?
First a short definition. Book Value (BV), also referred to as ‘Equity’ is capital which owners choose to invest in a business in anticipation of receiving more of it in the future. It is useful to view it as a loan that owners have extended to the business.
Note that Assets = Liabilities + Book Value. The asset value of a business is divided into two parts. One part is owed to its Creditors, and the other owed to its Owners. Book value, explained above, is money the business owes to its owners. It is a plug value and is derived by removing liabilities from the assets. Typically, BVs are positive.
A negative BV would mean that Assets < Liabilities. When this happens, the Equity Owners owe to the business instead of the business owing them! You then have Equity-‘owers’ as opposed to Equity Owners. Who then pays for the assets? Only the creditors.
This idea is counter-intuitive. Suppose an auto-parts retailer has $10 of Assets, $15 of Liabilities, leading to -$5 of BV. This means that all of its Assets are owed to the creditors, and more! If the business liquidates tomorrow, and assets are sold as shown in the books, the creditors would be short $5. So who would owe the remaining $5 to the creditors? The Equity Owners, that’s who! Except they don’t, because of Limited Liability.
We have seen that mathematically, assets would have to become less than the liabilities for the BV to turn negative. But how does this happen practically? One instance is business bankruptcy. Asset value gets impaired either as a result of write-offs or due to earnings. Loans to creditors exceed assets. BV turns negative and when the business folds owners lose all of their invested capital. This is easy to understand.
Another instance when BV turns negative is when a business buys back its shares. In buybacks, the business effectively repays what it owes to its owners. It uses cash to do so and the Asset value reduces as does the BV. When this reduction reaches a point where asset value is less than the liabilities, BV becomes negative. At that point, the creditors have agreed to extend credit to this business, so that part of it maybe used by the business to buyback its shares and reduce the BV to the point that it becomes negative. What would happen in a business liquidates in such a situation? Normally, Equity-Owners would hope to recoup part of their capital (the loan they extended to the business). In this scenario, Equity-Owners have been fully repaid their loan and more. All at the expense of the Creditors.
Traditionally, a bank would be horrified by this scenario. It would immediately demand the business return their debt since it has no capacity to repay the full principal in the event of bankruptcy. So why own or lend to a negative book value business? Because all parties involved have great confidence in its going concern.
Upside for Equity owners is they continue to enjoy an increasing share of the right to future cash flows of the business. If and when the business issues Dividends, the continuing owners will enjoy that much greater portion of the cash that is handed out.
Downside for Equity owners: This has already been covered. If the business liquidates, Equity owners receive nothing.
Upside for Creditors: The creditors must trust the ability of the business to operate well and grow. The assumption is that the profitability of the business will comfortably service the debt and payables as well as pay off the principal. As for the long run, the debt may simply be in new hands tomorrow or the cash flows of business will grow the Assets until Book Value is in positive territory.
Downside for Creditors: Should the company falter and shut down, the Debt holders will most likely never retrieve all that is owed to them. I imagine that when Creditors choose to engage with a negative book value business, they accept this gamble on the strength of the business.
by Shabbar Husain Kothari