Prospects for recovery and digitalisation status

By Matthias Müller, MSc Finance and Information Management, BSc Economics, Volker Riedel, Graduate Degree in Economics, Tax and Accounting, and Dr Michael Rozijn, Attorney-at-Law in Germany and Certified Specialist in IT Law

Over the last year, the German economy has faced one of its biggest challenges in decades. Studies show that innovative companies are significantly more resilient to economic crises than non-innovative companies. The coronavirus has only confirmed this. Especially negatively affected were companies that were digital stragglers even before the pandemic. These companies were slow to develop the digital competences needed to sell products online or implement digital productivity measures such as those enabling staff to work effectively from home. The “German Mittelstand Digitalisation Index” survey for 2020/2021 found that 80% of digital pioneers have weathered the coronavirus crisis well because their processes and business models were already extensively digitalised before the pandemic. By contrast, only 36% of other companies achieved comparable results.

Despite some initial “digital euphoria” early on in the pandemic, it seems that not all companies have moved forward with their digital transformation in the same way. A survey carried out by KfW in January 2021 found that while 33% of SMEs questioned had increased/initiated/resumed their digitalisation activities,
another 33% had undertaken no activities at all, and 5% had reduced them. Among companies existentially threatened by the crisis, a full 15% had reduced their digitalisation efforts or ceased them altogether. This may have been due to lack of funds.

But there is some hope: With speedy and modern restructuring, companies can treat the current situation as an opportunity and use digital transformation as a solid foundation for a successful turnaround. CFOs in particular are suited to the role of “digital transformer”, because they are best placed to set growth incentives for innovation. In this article, we will show what factors need to be considered and how digital transformation affects commercial success over the medium to long term.

Although digital transformation, through technology, is shaping change processes across entire industries and societies, it begins within companies. The fundamental requirement is for data to be converted from analogue to digital. This is followed by digital transformation of company processes. The data generated as a result can be analysed using business analytics methods and tools. Business analytics is defined as a process for determining facts based on data and algorithms. Business decisions can then be taken on the basis of those facts. It is important to note that digital transformation is a continuous process. There will always be new technologies which can be put to profitable use.

Some economists now think of data as a third relevant factor of production alongside capital and labour. Many of today’s most innovative companies, such as Netflix and Google, have data – used to create intelligent products and processes – to thank for their decisive competitive edge. Targeted measures to leverage a company’s digital “data trove” offer management an opportunity to move away from heuristic-based decision-making, which is subjective and vulnerable to error, towards an objective, evidence-based approach. Business analytics methods can be used throughout the entire management cycle, from objective- setting through to steering the company.

On the financial side, the ability to tap new markets, launch innovative products and better satisfy customer requirements offer potential for top-line growth. Focussed data analysis allows weaknesses in process quality, reliability and speed to be identified, producing cost savings through to the bottom line.

Today, then, digital transformation is increasingly data-driven. But it takes more than data alone to steer a company to sustainable success. The following digitalisation matrix breaks down the most important factors.

The cornerstone of any company is its business model, which is aligned with its vision and implemented via its strategy. The company will also be in a market- specific competitive environment. To achieve sustainable success, it must, alongside internal factors, keep a constant eye on current market dynamics and technological developments within that market. Within the company, the well-coordinated interplay between humans and machines (technology) is a key determiner of success.

Without a doubt, technology is the “enabler” of digital transformation. The right-hand side of the matrix, dealing with technologies, is divided into three sections. The most vital technologies – the basic technologies – take priority to begin with. To deploy advanced and future technologies profitably requires experience. To use artificial intelligence (AI), for example, lots of suitable, high-quality data is needed. This requires modern enterprise resource planning (ERP) and storage systems, without which the data cannot be provided in the first place.

On the left-hand side are the people: the company’s employees and customers. It cannot be emphasised enough here that people, and not technology, always come first.

  • The management are the starting point: they provide the incentives for innovative digitalisation and define and implement the strategy. A digital mindset, careful change management and a commitment to seeing the transformation through are essential.
  • Next is a corporate culture that fosters innovation, where achievement is rewarded, risks can be taken and mistakes are allowed. The importance of culture in digital transformation cannot be stressed enough. Unfortunately it is frequently underestimated. The digital organisation of today is orientedtowards creative entrepreneurship, and not just at management level. It is agile and characterised by flat hierarchies. Interdisciplinary collaboration and accountability are valued.
  • The culture is shaped, lived and upheld by an organisation’s employees. They are the engine that keeps a company moving, and as such are the key to success. While the recruitment of “digital natives” (an attractive corporate culture is essential here) plays a major role, loyal, experienced employees must also be given the opportunity to learn and develop.
  • Finally, alongside all of this, it is essential to take the customer experience as the starting point and work backwards to the technology from there. Not the other way round.

Data and processes form the central pillar of the matrix and are the element that connects people and technology.

  • If a company’s employees are its engine, in the digital age, data is its fuel. Data provides facts which can be used to make profitable decisions. To use data effectively requires both the right technologies to generate, gather and store the data and the people to analyse, interpret and model it, again using technology.
  • Efficient, effective and precisely controlled processes form the second component of this pillar. Operational excellence, again at the interface between people and technology, is the name of the game here. Modern digital process analysis, using process mining and analytics, for example, enables data-related weaknesses in end-to-end processes to be identified and remedied.

How is digital transformation of benefit in business recovery? In general, the purpose of recovery efforts is to ensure that a company can remain in the market profitably for the long term. In preparation, it must be determined whether the organisation is capable of recovery and whether recovery is worthwhile. For these to be the case, it must be possible for the company to return to competitiveness and profitability in the relevant market.

Experience has shown that many companies are in need of recovery because they failed to embark on the process of digital transformation early enough. In a stakeholder/strategy crisis, such companies will have neglected to define a (coherent) digitalisation strategy and make investments. In a product and sales crisis, their competitors will be closer to the market and the needs of customers. The shortcomings become even more apparent when an “earnings crisis” arises, because analogue processes will be ineffective and inefficient and cost structures uncompetitive.

At the liquidity crisis stage, it is almost too late to embark on the transformation that is so urgently needed. Inadequate cashflows and lack of trust on the part of shareholders and creditors make it more difficult to find the liquid funds needed to make investments.

The more advanced the crisis is, the more complex the turnaround process will be and the more challenging it will be to incorporate digital transformation into that process. It is imperative to do so, however, in the interests of long-term competitiveness in particular. Otherwise, the company will once again be at risk of being left behind by the market post-recovery. Additionally, modern business analytics tools with sufficient data to work with will provide companies with rapid insight into the situation they are facing and enable them to develop a robust response. Speed, transparency and reliability create trust.

A modern recovery process geared towards long-term success will, alongside the “traditional” aspects of financing and restructuring, also take into account digitalisation of a company from both a strategic market perspective and an operational, value-creation perspective. The aim is to restore competitiveness while also gaining the trust of all stakeholders in the recovery effort, which will significantly improve the chances of success.

The scoring model shown below can be used to shed light on a company’s financial strength and digitalisation status. The “digital transformation score” analyses and assesses the current situation and any untapped potential in detail against criteria taken from the digitalisation matrix. At the same time, the “financing score” rates the company’s financial strengths. It evaluates earning power and identifies the potential of possible forms of financing required for investment.

The scoring model shows the trade-off between the short-term cost of investments and the medium-to-long-term competitiveness that digital transformation of a company’s business model brings. In the “win” scenario, a company’s financial strength may dip in the short term due to necessary investments and the resulting reduced net financial flows, increased debt and/or reduced debt-toequity ratio, but the longer term outlook is more promising. In the “lose” scenario, the company’s financial strength is stabler in the short term. But this security is deceptive, as over the long term a less innovative company will have weaknesses on the sales and cost sides, which will result in a downward spiral of crises and, in the worst case, insolvency.

Over the years, the courts have outlined the requirements that recovery reports and concepts must satisfy in order to stand up in court and so protect management and lenders in particular from liability and avoidance claims and prevent regulatory breaches or criminal insolvency offences. Recovery concepts, and therefore recovery reports, will increasingly address the subject of digitalisation in future. Given the importance of digitalisation for a company’s future viability, our interpretation of the requirements of the courts regarding recovery concepts leads us to believe not only that digitalisation-related aspects can contribute to successful recovery, but also that failing to take account of such issues at all, or paying them short shrift, may today already lead to a recovery concept being found to be inadequate or lacking in coherence.

While recovery concepts only become relevant when a company enters a crisis situation, the Act on the Stabilisation and Restructuring Framework for Businesses (Unternehmensstabilisierungs- und restrukturierungsgesetz, StaRUG), which transposes the EU Preventive Restructuring Directive and entered into force on 1 January 2021, introduced a general obligation to detect crises at an early stage. Section 1 (1) StaRUG requires the management of entities with limited liability to put in place a system for risk monitoring and early identification of crises, and to continuously keep track of developments that may jeopardise the continued existence of the undertaking. The term “early warning system” is not defined in the StaRUG or in the EU Directive. However, once a company is above a certain size, a system ensuring continuous, rolling monitoring is almost inconceivable without digital support.

If insufficient digitalisation is the direct cause, or an important cause, of the crisis that a company finds itself in, this must be specified when analysing the situation and identifying the causes of the crisis. The Federal Court of Justice (Bundesgerichtshof) views an analysis of the company’s financial position in relation to the relevant industry and the identification of any performance-related causes of the crisis as indispensable components of a recovery concept. If insufficient digitalisation is a direct cause of the crisis, therefore, the recovery concept must set out measures to remedy it. Insufficient digitalisation can be expected to be an increasingly frequent driver of crises necessitating recovery efforts.

But even if insufficient digitalisation is not (yet) a direct cause of a company’s crisis and the analysis of the company’s financial position as required by the courts determines that other performance-related or purely financial factors are to blame, it is still normally the case that greater attention needs to be paid to digitalisation. The Federal Court of Justice not only requires a recovery concept to contain a positive going-concern forecast; the measures envisaged must also be capable of achieving a sustainable recovery and restoring the company to profitability. Taken as a whole, the measures set out in the recovery concept must be objectively capable of producing a thorough recovery within a reasonable period. A level of digitalisation which no longer meets the requirements of the sector concerned will increasingly be a significant hindrance to sustainable recovery after the immediate crisis is dealt with. This is all the more true in light of the accelerating pace of transformation that the coronavirus pandemic has triggered in some sectors. Paralleling the tension between digitalisation and finances illustrated by the scoring model discussed above, it is possible for a choice not to invest in digitalisation to positively affect a company’s short-term financial and liquidity position, and thus the going-concern forecast, while also undermining competitiveness and thus prospects for sustainable recovery over the medium term.

Recovery reports and concepts are frequently prepared in accordance with the standard Requirements for Recovery Concepts (IDW S 6 – 2018) (Anforderungen an Sanierungskonzepte (IDW S 6 – 2018)) of the Institute of Public Auditors in Germany (IDW). Standard IDW S 6 seeks to reflect all requirements relating to recovery concepts found in the rulings of the Federal Court of Justice and the lower courts and provide specific information for businesses.

In response to the Federal Court of Justice’s requirement that a recovery concept must be aimed at and geared towards a thorough recovery of the undertaking concerned, standard IDW S 6 provides for a two-stage approach to determining whether a company is capable of recovery. The first step involves determining whether the forecast regarding a company’s prospects for survival as a going concern is positive, and in the second step, ascertaining the prospects for longterm continuation or competitiveness on the basis of that forecast. For the purposes of the standard, an undertaking is competitive if it has a viable business model, marketable products or services, capable employees, qualified management, functioning processes and the ability to change and adapt.

In light of the particular – and growing – importance that digitalisation already has in many industries, the most recent version of standard IDW S 6, which dates from 2018, explicitly refers to the challenges of digitalisation, albeit only as an example depending on the company’s business model. Regarding the internal and external analysis of the company’s position, for example, IDW S 6 requires an estimate of the extent to which the company is likely to be able to adapt to the challenges of digitalisation within a reasonable timeframe. Elsewhere in IDW S 6, digitalisation is also mentioned in connection with the criterion of competitiveness. It states that alongside employee potential, competitiveness is also frequently founded on “the company’s ability to change and adapt to external developments (in connection with the challenges of digitalisation, for example)”.

Where the situation is not clear in a particular case, it would appear advisable to at least state in the recovery concept whether digitalisation is a key factor in the undertaking’s business model. If it is, further explanations regarding the degree of dependency on digitalisation, the current status and the prospects for achievement of an adequate level of digitalisation will be expected. To ensure a systematic and robust basis for these statements, it is advisable to use structured methods to analyse digitalisation status. Various methodologies and services are available, including online self-assessments and benchmarking approaches. As long as the method selected is not unsuitable, generally or in the specific case at hand, it will have no bearing on the legal assessment under insolvency law. The scope of the description and the level of detail it provides will vary from case to case, depending on the size of the company concerned and the importance of digitalisation for the relevant industry and business model.

This raises a question: at what point can failure to take account of a company’s digital positioning, or doing so inadequately or inaccurately, result in a recovery concept being considered to lack coherence, and to what extent can this question be examined in court? As far as we can determine, there are no court rulings relating to consideration of digitalisation status in a recovery programme. This is surely partly due to the fact that a failure to assess an organisation’s digitalisation status in a recovery concept, or a flawed assessment, must be blatant in order for a party entitled to make an application (insolvency administrator, creditor) to use it as the basis for a compensation claim and grounds for an action to that effect. Evidence of this will generally be unavailable, due partly to the lack of unified standards.

Regarding recognition of the starting position and forecasts regarding feasibility, the Federal Court of Justice applies the standard of the “impartial industry expert”. For example, it requires poor prospects for the relevant industry to be taken into account when developing a recovery concept.16 The perspective of an impartial industry expert can also be applied when assessing digitalisation status, which will normally mean commissioning reports from court-appointed experts. As the choice of recovery measures and trends in the competitive environment are based on forecasts, the expert will often need to assess only whether the description, analysis and forecast are sufficiently well founded and coherent in terms of the facts, and whether the planned digital equipment and orientation measures and associated estimates are clear and justifiable. Other than in cases where digitalisation is addressed on an incorrect factual basis or ignored altogether, or cases in which the subject is addressed using means which are clearly unsuitable or inadequate, the procedural hurdles to showing a flaw in the recovery concept in relation to digitalisation status would probably be relatively high. Accordingly, it can be assumed that despite its major importance for successful and sustainable recovery, digitalisation will, for the time being, play a secondary role as far as the courts are concerned.

The rulings of the courts, standard IDW S 6, and the legislation all reflect a clear trend: a company’s digitalisation status is becoming increasingly important for both avoiding and overcoming business difficulties. Obligations relating to a minimum standard of digitalisation depending on a company’s size, legal form and industry can be drawn both from the rulings of the courts regarding recovery concepts and from the latest version of standard IDW S 6. In requiring the establishment of early warning systems, the EU Restructuring and Insolvency Directive and the German StaRUG also establish requirements which will often demand digital support. But no specific conclusions regarding any yardstick for digitalisation can be drawn from these, which will make it extremely difficult to test these obligations and requirements in court.

Even so, an in-depth digitalisation-focussed analysis of a company’s business model and processes from a business perspective is already essential for ensuring a robust recovery concept. A forward-looking digitalisation strategy will not only impact a company’s success over the medium to long term; it will also significantly influence the immediate outcome of a recovery programme. Only robust business models can generate the vital trust on the part of the relevant stakeholders, namely creditors, banks, and investors.

Matthias Müller, MSc Finance and Information Management, BSc Economics, supports clients with projects on all aspects of recovery, restructuring, financing and insolvency. His area of specific focus is on issues arising at the interface between law and business.

Volker Riedel, holder of a graduate degree in economics, tax and accounting, is Managing Partner at Dr. Wieselhuber & Partner GmbH and advises family-run businesses, investors and insolvency administrators on challenging financing issues, restructuring and commercial solutions in insolvency-related situations.

Prospects for recovery and digitalisation status

The essay is available for download here.