A Primer on Option Valuation in Restructuring

The restructuring of a financially distressed but viable business firm creates an unusual and complex valuation problem. The distressed business has taken on too much debt and must adjust its capital structure to preserve value. The goal of the process is to emerge with a new capital structure that allows the firm to raise funds for future projects. But that requires a two-pronged valuation. On the one hand, the old claims on the firm must be reconciled to determine who is owed what. On the other hand, the value available to pay those claims derives from the firm’s prospects at creating value in the future. The claims are determined by a backward-looking inquiry while the pay-outs are determined by a forward-looking valuation.

For the forward-looking valuation, conventional approaches distribute ownership to the various claimants as if a sale had occurred. This ties the distribution rights to the value of the firm at the moment of restructuring, which artificially destroys option value that otherwise belongs to the junior stakeholders. This destruction of option value has distributional effects that can distort the incentives and behaviour of those running a firm, both in distress and in the period leading up to distress.

This chapter reviews how restructuring procedures today destroy option value. It then explores the foundations of an alternative approach that values and preserves option value.