From time to time, businesses can find themselves in some form of distress for a variety of reasons. It could be that the company is suffering from a dramatic drop in sales, an increase in raw material or labor costs, an unexpected safety incident, the loss of a customer, shortened vendor terms, credit restrictions due to a covenant bust, etc. The goal of this article is to help you understand the options available to a business in distress.
Seek advice of counsel early
When a business finds itself in distress, or forecasts a scenario of pending distress, turnaround or restructuring counsel should be sought immediately. This could include attorneys that specialize in restructuring and bankruptcy law, turnaround consulting firms, accounting firms that have a turnaround consulting practice, or investment bankers that have experience dealing with distressed companies. Business owners often wait too long to contact advisors with expertise in distressed situations, leaving too little time to make the appropriate adjustments, or obtain additional capital, for the business to continue as a going concern.
The below is not intended to be a comprehensive list of options available to a business owner but should provide many of the more common options available to a business, some of which can be used in conjunction with others to help the business emerge from the distress it is in.
· Improve business performance by increasing revenues or margins or decreasing expenses
· Sale of part or all of the assets of the business
· Refinancing/Restructuring/Selling the Senior Debt
· Bringing on additional equity or debt
· Reorganization through Bankruptcy or Foreclosure
Improve business performance by focusing on profit margins
Generally, the preferred way for a business owner to get out of distress is to find a way to improve business performance. The first thought of most business owners to get out of distress is to sell more (increase revenue). Although this can be an effective approach, it can actually exacerbate the problem if it involves slashing margins excessively to obtain new sales. Sometimes getting out of distress requires selling less and making the sales that do occur more profitable. Ultimately, there often isn’t much that a business can do in the short term to manage revenues, so it may require right sizing the business on the expense side of the P&L. This involves evaluating all the expenses to identify and cut non-essential spending, renegotiate vendor costs, reduce headcount etc.
Selling all or a portion of the business
Another consideration for a business is in distress is the profitability, cash flow, and value contribution of each business unit. Some businesses have multiple business units or product lines, and when evaluated separately, it may be the case that some segments are profitable while others are not. In this case, a business owner should evaluate whether to sell one or more segments of the business to “stop the bleeding” or to generate cash to keep the other part of the business alive.
Distressed businesses can be valuable to a wide variety of counterparties, and business owners shouldn’t simply assume that distress or unprofitability equates to zero value. Institutional capital firms (private equity, family offices, etc.) or strategic buyers (competitors or industry participants) may have interest in one or more aspects of the business such as market share, geographical footprint, technology, name recognition, personnel, etc. Business owners should consider whether to sell a part or all of the business to generate cash to survive.
Refinancing/Restructuring/Selling the senior debt
When a business is in distress, access to capital presents a perplexing situation: capital is of paramount importance, but current financing sources may be reducing their respective exposure to the business while new financing sources may be unwilling to lend to a business in distress. To further complicate matters, acquiring capital can be an extremely time-consuming process. It is generally a best practice to begin with the existing senior lender(s) to work to restructure the terms of the credit. The next option would be to seek new or additional lenders to refinance the note on terms that better align with the state of the business. As a final option, notes can be sold, and a business may choose to get out from under the credit by seeking a buyer for the note. Details of these options are below:
Restructure – As the risk profile of a loan changes, a lender will oftentimes need to adjust or restructure the loan to continue providing access to capital for a business in distress. By adding a combination of covenants, collateral, personal guarantees, or other assurances, the existing lender(s) may be able to get comfortable continuing to extend credit to the distressed business. Banks don’t want to lose money so sometimes continuing to provide capital to a business is the least risky alternative when compared to liquidating the assets of the business. However, some banks will be more able to work with a business in distress than others due to a variety of factors internal and external to the bank.
Refinance – If restructuring is not feasible, a business in distress may seek to refinance its debt with another lender(s). Depending on the severity of the distress, the business can likely expect the new credit to come at a higher cost of capital. In addition, non-traditional lenders can sometimes be more flexible with covenants and advance rates than traditional banks in times of distress.
Sell the Note – If the distress is dire, or the relationship between debtor and creditor is no longer stable, then the business may seek to find a buyer for the note. While there are many factors that impact a lender’s willingness to sell a note – this process usually brings together a lender who’s risk profile is more aligned with the current state of the business. Given the unregulated nature of many buyers, they can generally be more flexible and accommodating.
Raising debt or equity capital
Another option available to a business owner is to raise additional junior capital, either equity or debt. The specifics of these options are highly dependent on the dynamics of the business seeking the capital – preferred equity and subordinated debt are the most common forms of junior capital for businesses in distress.
The most common form of new capital in distress situations is preferred equity. With preferred equity, the equity provider will put in their money but in return will want a “preference” over the existing equity holders. This “preference” can come in various forms. Sometimes the preference is in the form of a rate of return that accumulates before the common equity holders get distributions. It can also take the form of preference in the event of a liquidation. Other times, the preferred equity holder will set return thresholds that once hit, then the common equity holders will get a higher % of the distributions than their common equity % would allow them to receive.
Another common form of new capital in a distress situation is subordinated debt. This is debt subordinated to or behind the senior lender. In this scenario, the subordinated lender will usually request a lien on the assets behind the bank so that the subordinated lender is ahead of the unsecured vendors. Because subordinated debt is behind the bank in priority, the cost of capital is higher than a traditional bank, but still cheaper than equity. The subordinated debt lender will sometimes require some warrants to purchase equity at a pre-determined price at closing as part of the transaction.
Although these are the two most common types of capital, there are many groups that will tailor solutions to meet the business’ needs. Each capital provider will have different preferences as well.
Reorganization through bankruptcy or foreclosure
Although sometimes perceived as the least desirable option in name, a business may require a restructuring to overcome the distress. There are many forms of bankruptcy, but the three most common are Chapter 7, Chapter 11, or out-of-court restructuring
Chapter 7 Bankruptcy is an outright liquidation of the assets of a business. If the business has no prospect for returning to profitability and positive cash flow, a Chapter 7 is the likely path for the business. A Chapter 11 Bankruptcy is a reorganization where the business continues after. If there is a way for the business to return to profitability and positive cash flow by selling off part of the business, cutting operating costs, or shedding past due obligations, then a Chapter 11 is the likely path for the business. An out-of-court restructuring involves a business approaching its creditors (vendors, banks, etc.) to structure payment plans or discounts for outstanding balances, modifications to existing agreements, etc. This option is often an interim step between successfully getting out of distress or going to a bankruptcy filing.
In a Chapter 11 proceeding, the Bankruptcy Court will generally halt all collection activities of creditors and help the company restructure its payments and amounts owed to vendors to allow the company to survive. In order to succeed in a Chapter 11 proceeding, the business has to have funding sufficient to pay court costs and continue to operate as a going concern if it no longer has the obligation of paying past due amounts owed to creditors. This funding is provided by a Debtor in Possession (DIP) lender.
There are other nuances to the bankruptcy process such as selling the entire company in an Article 9 or Section 363 sale with bankruptcy court oversight or having someone buy the senior and/or subordinated note and foreclosing on it but those are beyond the scope of this article.
Usually one of the two most important goals of a business owner in distress is to save their business, and consequently, their investment/equity in the business. The other item of importance is saving the jobs of those that have worked hard for the business owner. Other goals such as maintaining customer and vendor relationships or saving brand reputation can also be accomplished; however, oftentimes goals will conflict with one another and therefore must be prioritized. Being forced to make decisions in a distressed business environment can be extremely challenging, and it’s imperative that business owners prepare themselves to make the difficult decisions quickly and with as much information as possible.
About Infinity Capital Partners
Infinity offers a full-suite of investment banking services for small and middle-market businesses. Headquartered in Oklahoma City, OK, the company has established a reputation working with closely held businesses with the utmost integrity, discretion and professionalism. For more information about Infinity Capital Partners, including a list of current projects, please visit our website at www.infinitycappartners.com.