Small Business Restructures: navigating the current economic climate

Rebecca Archer

Welcome to Beyond the Numbers with Grant Thornton – a podcast exploring trends in business and the marketplace. 

I’m Rebecca Archer and today I am joined by Financial Advisory Partners John McInerney and Cameron Crichton. The Small Business Restructure (SBR) program was introduced in 2021 and offers a cost-effective pathway for businesses to restructure and compromise up to $1m in debt. In the challenging economic conditions, this strategy is becoming more prevalent when businesses are facing financial distress. 

So, do we see an uptick in SBRs in challenging times, and how can distressed businesses start the process? 

Welcome John & Cameron!

Cameron Crichton

Thanks for having me, Rebecca.

John McInerney

Yeah, good morning.

Rebecca Archer

So SBRs were introduced in 2021. Why didn't we see this regime used much through the COVID-19 pandemic?

Cameron Crichton

It's a good question, Rebecca. I mean, they came into force at the start of calendar year 2021, and that was, if everyone remembers, it's a bit of a ways back now, but that was kind of the end of the first phase of the lockdowns, and I think it was expected that there was going to be a flood of insolvencies.  The idea of a tsunami of insolvencies was still a phrase that was getting thrown around at that particular point in time, but I think the economic reality was that it just wasn't required. 

It was also a novel procedure, which hadn't been tested and probably wasn't widely known.  But I think probably the bigger driving force was that it really wasn't required, and the reason it wasn't really required at that point in time was that we had about $300b worth of government stimulus that had been pushed into the economy during the course of FY21, and on top of that, another $250b worth of indirect support. 

So, to give some context to that number, I think iron ore for FY21 contributed $136b to the Australian economy. So it's fair to say that those stimulus measures had a massive boosting effect in terms of the liquidity of a lot of businesses in Australia, and so, most of these businesses were generally flush with cash. They weren't actually distressed like everyone was expecting, and this is kind of reflected… if you look at creditor default days back then, they were historical lows, and it wasn't really until the start of 2023 that we started to see the creditor default days starting to finally tick back up again.

So, it wasn't really the case that they were necessarily required. We also had the ATO, which was very much in a supportive setting at that time.  The ATO is debt doubled over that same period of time because it wasn't collecting.  So that also had a stimulatory effect of probably about $30b.

So big parcels of stimulus. 

The procedure really was to support distressed businesses, but the distress that everyone expected was going to be there wasn't actually there. So that's probably, the key reason why it was a bit of a slow uptake.

John McInerney

Yeah. I think the ASIC stats show that in the last six months, about 50 per cent of all SBRs have been conducted. So, they're sort of growing exponentially as the stress continues.

Rebecca Archer

So, it sounds like there was a bit of a delayed effect for business from the COVID-19 pandemic because of all of that stimulus. So, we are then, as you say, experiencing a bit of an uptick in the activation of this kind of policy now, is that right?

Cameron Crichton

Yeah, that's right. I mean, there's a whole lot of reasons there, and you talk about the delayed impact of COVID, well we're talking very much generally here. 

I think it's fair to say that some sectors, like foreign based tourism, were acutely impacted by COVID. And hospitality, again, if we remember, hospitality businesses were the first ones to get locked down during Alpha. They suffered greatly. So, I think when we talk about, overall, the economy being quite supported during that period of time, that is very much a generalisation, and there were certain pockets that were acutely distressed. 

But, yes, overall, I think we're now starting to see the combination of cost-of-living intersecting with increased cost of business, and, yes, that's starting to trigger an increase in participation, not just in SBRs, but more generally in insolvency processes themselves.

Rebecca Archer

So, an SBR takes a Director in Possession model. Can you explain exactly what that is, and why it's actually a positive for business operators?

John McInerney

Yeah, sure thing. Well, the Director in Possession model is a key feature of the SBR process and really the first of its kind here in Australia. What that means is that once the companies in the SBR process, the Directors continue to maintain control and continue to actively manage the business operations on a day-to-day basis, and there is no interference from an external administrator. 

That is very much unlike what would happen in a voluntary administration or a liquidation process, where that external administrator would take control. It's a key benefit for the Director and the company, and in turn its creditors, because firstly, the Director doesn't lose control, right. They can continue to make day to day decisions and make informed decisions about the company's business. 

It also allows continuity. So, for continuity for employees, staff and also suppliers. 

In all of the SBRs that I've done, I've never turned up to a business and I've never addressed staff, and I haven't had to take control of assets. Effectively, for us as restructuring practitioners, it's effectively a desk job, and with all of that, with us as external administrators, being removed from controlling and managing the day-to-day business affairs, it's really cost-effective, and that cost effectiveness is very important in terms of maximising the outcomes here, because a lot of these businesses don't have a lot of money to start with and can't afford the other types of insolvency processes. 

So, by stripping out of that part of our cost, it maximises the dividend return available to creditors, and also gives the company more working capital to be able to survive through the SBR process. 

With all of that said, though, there are still some concerns regarding the Debtor in Possession model, and some of the things that I've seen is that some creditors are concerned that the Director is continuing to control and the Director is the person that they blame for them not being paid, right, and they get concerned about providing further goods or supply on credit when the goods they've already provided haven't been paid for. 

Rebecca Archer

And John, can you also maybe explain how a Registered Liquidator can work with business Directors to try and achieve the best possible outcomes for that business?

John McInerney

Yeah, sure. Look, a really great feature of the SBR is that as restructuring practitioners, we can get really involved in the company's business, and we work really closely with its Directors and their accountant, and so, in the first instance, we understand the nature of the business, the reasons why it's suffered this fate, and then start to look at, well, you know, what can be done to improve that. 

You know, a lot of that improvement type activity is done by the Director and the accountant, and we then sort of provide some guidance, but primarily we focus on, well, what money could be available from the company today in six months or in twelve months, and what can the company offer up to its creditors in full and final satisfaction of their debt? So, you know, a debt compromise, cents in the dollar. 

So, we're working really closely with the Director and the accountant to come up with that plan, and then we also liaise with key creditors, and in 80 per cent of all these matters, the ATO is the largest creditor, and they've invited us to speak to them and even provide a draft copy of our report to them before it goes to print so that they can get a look in and they can provide some feedback and they can sort of tell us whether it's something they'd likely support.

Something else also is the process forces the company and its Director and its accountant to prepare a cash flow forecast, which is critical. A lot of business owners, when they think about their accountant, think about the person who delivers them some historical financials and a tax bill. They don't really see the benefit of what an accountant can deliver. 

So forward cash flow is critical. It assesses when money is coming in and when money's going out, and you can tell when you've properly prepared something like that, where you're going to face a bit of a crunch. So, the process forces the company to prepare that because creditors want that when they're voting on the plan. So that in itself provides for a better opportunity for ongoing viability and better decision making.

Rebecca Archer

Thanks so much for that explanation. So, it seems like it's quite a fulsome process, really, lots of options, and it seems like, you know, nothing's left unturned to be able to try to find the best solutions. I'm wondering how the economic climate impacts the decision-making process for small business restructuring?

Cameron Crichton

Yeah, I might take that one, Rebecca. I mean, I think when you look at the economic climate – it’s a bit of a broad question – there's probably two things going on in there. One is the economic drivers, and how is that impacting the performance of the business? And then the other question is, what's the attitude of key counterparties in the economy at the moment to the debt that they're carrying? 

So, both of those things have changed pretty substantially – probably in the last 18 months. We've gone from on the debt collection side, we've gone from COVID full care and support settings, particularly with the ATO, where there's been no collection activity at all over those COVID years. They're now reverting to basically what we all remember the ATO to be, which is a bit of a hard marker, and that's because their debt – it increased by $30b over that period. It literally doubled in the privately owned business space.

So the ATO is very much a catalyst for activity in not just SBRs, but in insolvencies generally. When the ATO issues one of its primary tools, which is called a Director Penalty Notice, that forces the Director to engage with their advisors around dealing with the issues. Otherwise, whatever the company's liabilities are will be transferred to the Director personally. 

So that's very much a catalyst, and that is having an impact, but when you look at the actual performance of the businesses, I think we have to look at that as well, and it's important to remember that the Small Business Restructures, they're not really an operational restructuring tool. You can move around the edges around trying to change the operations of the business, but small business restructure is primarily founded on a business which is profitable, and so you need to be able to demonstrate profitability. That's what John was touching on before with the cash flow forecast, is being able to demonstrate to the counterparties that the business itself is profitable going forward, and that if we remove these legacy liabilities from its cash burden, then it will actually succeed. That's the key message that's being sold in the proposal. 

And so, when you look at the profitability, a lot of these businesses are suffering. At the moment, this is what we've seen is inflation has kicked off.  So it started with material price inflation. The cost inputs, whatever it was you're buying, you're paying a hell of a lot more for it.  More recently, in the last year or so, it's moved across into labor cost inflation, and that's the one which has got everyone worried because it seems to be persisting.  It's really hurting some sectors more so than others, like construction and hospitality, are really suffering from the increased cost of labour, and not just the cost of labour, but just getting people to turn up to work, right, and create some stability in their operations.

So, you've got increasing costs coming up, but then more recently, we've seen the cost-of-living pressure biting in the discretionary spending space, and so, revenues are getting pushed down in some areas. So, that's not a happy place, if you're a business owner that's exposed to cost of living pressures in terms of its top line revenue, but also continuing inflation in their cost structure, eventually you get to a point where the two intersect. That means you've got an unprofitable business, and if you've got an unprofitable business, an SBR probably isn't going to be the right tool unless you can find a solution to that profit problem.

So, it's, I guess, a long answer to your question, but the catalyst is there, and certainly there's more engagement from…it's not just the ATO, it can be trade creditors, it can be landlords, for instance, anyone who's got an accumulated debt. That's kind of the environment that we're in right now, but it's also putting a lot more pressure on businesses to actually find a profitable solution for their operations.

Rebecca Archer

You mentioned the profitability there, but I'm sure there's also other criteria for an SBR. What happens if a company doesn't meet those?

John McInerney

To begin with, the qualifying criteria consists of a company having less than $1m in total liabilities. Its tax reporting obligations must be up to date. So, BAS returns, FBT, income tax returns, and employee entitlements that are due and payable must be paid. Things such as wages and superannuation, accrued entitlements for leave and long service leave, etcetera, provided that they're not due and payable. You know, they don't form part of the assessment criteria. 

So, we have had a number of entities have come to us who haven't immediately qualified, and some of the things that we've been involved in is the Directors themselves, who may be owed money by the company forgiving that debt in full, to allow the company to come below the $1m total liability threshold. The other is, of course, the company lodging its returns. But I must say, if a company has been very delinquent in not lodging and all of a sudden decides to lodge to qualify, it's not favourably looked on by the ATO, because the ATO is looking to support good taxpayer behaviour, and non-lodgment doesn't fit that criteria.

Rebecca Archer

So, John, how often can a company Director access an SBR? Is this something where it's an unlimited type of program to them, or is it capped?

John McInerney

It is capped, and it's capped for a very good reason, and it's capped to one in every seven years. So, you know, a Director can only avail themselves of this process one in every seven years.  It doesn't mean a group of companies can't go through the process at the same time, and we've had a number of matters where there's been, you know, five or more companies all going through the SBR process. 

Now, that's key, because the company can achieve a fairly significant debt compromise through this process. And, you know, without that safeguard, there's certainly a risk that Directors abuse this process to, you know, avoid paying their dues.

Rebecca Archer

Cam, can you talk to us about the kind of main industry groups that are taking up SBR plans?

Cameron Crichton

Sure. Sure. Look, this is just, I guess, a factual response when you look at the ASIC data. So, our regulator publishes the information periodically, and I think the June numbers were the most recent that's been published – June ’24, that is. At that point in time, we looked at, of the 150 odd SBRs, that had been undertaken, 46 were in construction, 30 were in hospitality, and 24 were in services, and that's broadly, I guess, reflective of, I guess, John and my experience in conducting SBRs. I think those numbers probably haven't changed, or the mix, but those numbers hasn't really changed a lot over the last sort of twelve months. 

The one to watch out is probably retail. I think everyone's sort of waiting for where we're going to see more small retailers pulled into processes such as these. They're still pretty small at seven in the June numbers, but I think the expectation is, as discretionary spending pulls back even further, that we'll probably see some retailers, maybe, as they start to run out of stock and their cash cost starts to increase, we might see some more retailers participating in the process. 

I think another contributor, other than the economic environment, is the ATO.  The ATO has particular focuses in certain industries, and it's been no secret they've had a bit of a close look at some of the subcontractors in the building and construction game for the last twelve months. Certain areas where they've considered a bit higher risk for noncompliance in their tax affairs. That can result in, I guess, harsher, more accelerated collection activity by the ATO, and that can be a trigger for engagement with a professional and possibly a formal process, whether it's an SBR or VA for that matter, or liquidation.

John McInerney

With the ATO, it's worthwhile pointing out, while we keep on mentioning the ATO, in an SRB, a plan is accepted or made if the majority in value of creditors vote in favor of the plan. Unlike a voluntary administration, where it's both number of creditors and value of creditors voting in favour, and statistics show, and I think Cam has mentioned that 80 per cent of all the liquidations or administrations, the ATO is the largest creditor, and that's certainly what we're seeing in most of the SBR matters. So, if the ATO, being the largest creditor, is supportive of the plan, then the plan is accepted. So, we do very much focus a lot of what we do to deal with the ATO's concerns.

Rebecca Archer

What percentage of businesses continue after they've undergone a small business restructure?

John McInerney

Following on from Cam's threads and relying on ASIC statistics… statistics released in around January 2023 indicated that the success rate on the SBRS was at around 90 per cent, fairly significant, and of that 90 per cent, 65 per cent had come out the other side. 

Now, it's still early days. The SBR process and the plan phase can run out for three years, and so, time will tell as to how successful it actually is, but I'm optimistic, and I believe, you know, it will be more successful than the voluntary administration regime, particularly for small businesses, and what's key to that is giving the company that ability to maximise the working capital available to them by having a cost effective and streamlined process.

Cameron Crichton

Just to continue on with John's point there, when you compare the SBR process with a voluntary administration process, and an SBR at its core is kind of like a mini accelerated VA, but the exit pathway for a voluntary administration is what's called a Deed of Company Arrangement, or a DOCA. It's a very expensive process, and often it's quite complex as well, so what's formulated under the DOCA can have contributions of money coming from half a dozen different sources, and there's always uncertainty with that. 

So, if you look at VAs and you compare them with an SBR – high cost, high complexity for a VA – SBR low cost, low complexity, and I think for that reason, we're probably a little more optimistic that we're going to see a far higher success rate, where if you revisited these businesses in five years’ time, they're not going to be failing again, which is one of the chief criticisms of the VA regime, is often these DOCAs are entered into, and then five years later, the same business goes under again.

Rebecca Archer 

Can you possibly share a success story of a small business that effectively turned around and thrived post restructure?

Cameron Crichton

Yeah, look, I've got one that I've done recently, which I'm quite happy with. It was a building subcontractor. So, its trigger point here wasn't the ATO. They had been compliant with their tax affairs, but they had bit of a perfect storm where they had a head contractor which collapsed. Now, that's no sort of surprise, I guess, when you look at the stats around head contractor failure over the last couple of years. 

The head contractor had gone down, so that taken them for a few hundred thousand dollars of debt there, and they'd been subject to a retrospective assessment by the OSR for payroll tax for some subcontractors that they were using. So, they'd been deemed to be employees, and that payroll tax attracted to that, that had hit them with about $750,000 worth of debt, which didn't actually exist prior to that assessment occurring. So, they never planned for that, and, of course, they didn't have the ability to pay it. 

So, you put that all together, and they had combined liabilities, which were just under a million dollars, and the greater the number of liabilities, the greater the value from the SBR process. So, they're just kissing under the threshold of a million dollars. We put a proposal forward and they ended up funding about $150,000 was the collective cost of running the process, including compressing the liabilities. 

The plan was supported by both the OSR and the ATO almost immediately, which is great.  While there is often a lot of reputational sensitivity around these processes customers were supportive and supply continued uninterrupted. I guess the end result was they got a $850,000 leg up out of going through the SBR.  

I think John touched on another benefit of the process I that when you run through this process six weeks with management, and you're working through them with the cash flow forecast, you're working through their historical financials and profitability forecasts, they're actually seeing the benefit of having some discipline around the financial management of the business.

John McInerney

Yeah, I've done a number of SBRs, and one example that I'd like to share is a very small SBR matter, and just to really sort of show that it works at both ends of the spectrum. 

There was a matter I was involved in where I was called in by the accountant whose client had come to the accountant saying he'd received a Director Penalty Notice owing the tax office $50,000, and that if in seven days he didn't do anything about it, he was going to be personally liable. So effectively, he sat on it for 14 days, not knowing what to do, sticking his head in the sand. They immediately called me up, and I talked through the process, and in that discussion, it came to light that there was in total around about $100,000 worth of unsecured liabilities, of which the ATO is $50,000. So, I thought, well, look, how does an SBR work here? Is it going to be beneficial? And ultimately deduced that, yes, it would be. 

So, the Director appointed me. The cost of the process was $25,000. The Director contributed $25,000 to go to creditors, and the Director had to borrow that money, but that allowed, you know, a return of $0.25 in the dollar, right, and so, it compromised $0.75 in the dollar on the debt, but if you look the net benefit, the Director effectively paid $50,000 to avoid the personal liability under the Director Penalty Notice, and the company was better off by $50,000.

Rebecca Archer 

So, Cameron and John, what would the one takeaway be that you would want businesses to hear from what we've been discussing today?

Cameron Crichton

I think the key takeaway is that, as it stands today, a well-planned SBR is almost guaranteed to succeed, and is unlikely to cause any adverse impact on the business. So, it's a golden opportunity. 

The message I like to get to everyone is there's a great opportunity here at the moment. It's worthwhile seizing that opportunity, possibly before the restrictions around who can benefit might start to increase and the cost of going through the process becomes more onerous than it is currently.

John McInerney

Yeah, look, and I certainly echo that. My key takeaway is that, look, it's a great restructuring tool and Directors can retain control of their business and work with trusted advisors to deliver a good outcome.

Rebecca Archer 

John and Cameron, thank you so much for your time. Now, for those who are listening, who wish to connect and maybe delve a bit deeper into your work or explore potential ways that you could even assist them, what's the best way for them to reach out?

Cameron Crichton

The simplest way. We're on the Internet these days, so if you Google Grant Thornton SBR or small business restructure Grant Thornton, you will definitely find John and myself.

Rebecca Archer 

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