FIN_317 Paper

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Introduction

Welcome to Financing Entrepreneurships. In this lesson we will examine troubled ventures and financial distress.

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Topics

The following topics will be covered in this lesson:

Venture operating and financing overview;

The troubled venture and financial distress;

Resolving financial distress situations;

Private workouts and liquidations; and

Federal bankruptcy law

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Venture operating and financing overview

Well, we are going to end this lecture series on a bit of a depressing note, but an important one none the less. We are going to talk a little bit about financially troubled ventures and what can be done if such a situation arises. No venture starts out with the intention to fail but often this is the case. This is a risky business being an entrepreneur. So, while it is not the intention of a new venture the entrepreneur needs to be prepared for the eventuality that they will find themselves in a compromised position and need to look at ways to restructure or get out entirely.

It is likely that even a successful venture will find itself working through financial troubles as it moves through its lifecycle. In the different stages of the venture lifecycle the avenues available and complexity involved in managing these troubles change. Reorganization or discarding the venture in the early stages may be logistically easy because the financing is likely to have only come from the investor or his friends and family. Practically it may be more difficult because these people are not professional investors and are people that the entrepreneur has relationships with outside their professional capacity. This can make for difficult and awkward interactions.

When a venture moves into later stages and it has real assets and external investors the process of managing financial trouble can become even more difficult. Navigating through these troubles with restructuring or even liquidation becomes the job of the entrepreneur. At this stage simply walking away is not an option because there are real assets that need to be divided up if the business fails. Informal reorganizations are difficult because some ownership lies outside the entrepreneur’s inner circle.

Restructuring a struggling venture may be seen as desirable if the business still appears to have a future. Restructuring can consist of financial, operational or asset restructuring. Operational restricting looks to reduce the operational cost and cutting expenses. This could mean cuts in the workforce or reductions in overhead. Asset restructuring involves the selling of non essential assets to finance necessary activities. Financial restructuring will be the focus of this lecture and is usually the last bastion of hope before liquidation.

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Check Your Understanding

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The trouble venture and financial distress

There are many ways in which a venture can become troubled. There can be general mismanagement, there can be a mishandling of strategic issues and there can be problems with personnel management that can all lead to a venture being in a tough position that can jeopardize the future of the company. However, we will be primarily focused on the financial and accounting based origins of these issues.

Financial distress can be defined as when the cash flow of the venture is insufficient to meet current liabilities. These debt obligations could be internal like payroll obligations or they can be external like the service on existing debt.

Let’s look at a few of the things that can happen when a venture goes into financial distress. First is loan default. Loan default occurs when there is a failure to meet interest or principle payments when due on a loan. When this happens there are some loan provisions that can apply. The first to be aware of is the acceleration provision, which provides that all future interest and principle obligations on a loan become immediately due when default occurs. The second provision is the cross-default provision which provides that defaulting on one loan places all loans in default. When loan default occurs the lender can initiate foreclosure proceedings. Foreclosure is the legal process used by creditors to try to collect amounts owed on loans in default.

All of this brings us the idea of insolvency. This is very similar to financial distress but is formally defined as when a venture has a negative book equity or net worth position and/or when the cash flow is insufficient to meet debt payment obligations.

Let’s break down each of these types of insolvency. Balance sheet insolvency exists when a venture has a negative book equity or net worth because total debt exceeds total assets. This only occurs when the venture is using debt financing and is common in the early stages of the ventures life. We have said in the past that new ventures often operate at a loss but if the negative equity that is accumulating as a result of this out strips the capital coming in from equity investment the venture will become insolvent.

Next is cash flow insolvency. This exists when a venture’s cash flow is insufficient to meet its current contractual debt obligations. So this can be as simple as the sales not making enough to cover the expenses of operation and any debt service payments.

When cash problems arise it is important to determine if they are temporary or permanent issues. Making this determination accurately is important because the strategies and steps that are taken could vary widely based on this distinction. If the cash flow problem is only temporary then additional financing may be an avenue to explore. If the issue in long term and there does not appear to be a way to resolve it then borrowing more money will only put the venture further in the hole and increase the cost of failure. Here the venture may need to consider liquidating.

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Resolving financial distress situations

When a venture finds itself in financial distress there are really only a couple of avenues that are open and these are based on the severity and outlook of the distress situation itself. The first question that must be asked is if the situation can truly be turned around or if it represents a permanent problem. An entrepreneur has a lot more invested in the venture than just money. There is time and pride and a whole slew of other emotions that can effect making a good decision here. For these reasons entrepreneurs often want to believe that they can turn around a venture when the fact and situation don’t support it. The best thing an entrepreneur can do is take a step back and try to make a real objective assessment of the situation. Throwing good money after bad is never going to make a situation better, only worse.

One quarter of all businesses fail within the first two years of operation and half are done in four. If the entrepreneur finds himself in this situation with a permanent problem its best to concede defeat. From here two paths can be taken. One is a private liquidation were the assets are sold and terms are worked out privately. The second is filing for bankruptcy. This is usually done under chapter seven and the court will oversee the liquidation of assets.

What if the entrepreneur looks at the situation and decided that there really is an opportunity to right the ship. This would give rise to a true turnaround opportunity. The venture is then looking at restructuring and there are tree basic methods or areas that restructuring takes place. One or more of them will be engaged to make the turnaround possible. These are operational restructuring, asset restructuring and financial restructuring. Let’s take a look at each.

Operational restructuring involves growing revenues relative to costs and/or cutting costs relative to the venture’s revenues. The first part of this is growing revenues which mean increasing sales. Of course this will do little if you are not making any margin on these sales. Increasing sales in the short term can also be challenging. This can mean changes in strategy and management in general. Finding that that the business is in distress is a major indicator that the venture may need a change in direction and a change in some of its leadership. Marketing strategy may need to be redirected which could mean replacing the marketing manager. Operations may not be efficient so there may need to be some new strategy and new blood there as well. The reality is, however, that it is often much faster and easier to cut your way out of trouble in the short term. Cutting expenses while remaining as productive and maintaining quality is often the key goal of operational restructuring. This can mean renegotiating with suppliers, reducing waste and often reducing staff. The important thing to remember is that while you may be able to cut your way out of problems in the short term, in the long term growth is the only answer because at some point you will run out of things to cut.

The next type of restructuring we will look at is asset restructuring. Asset restructuring involves improving the working capital to sales relationship and/or selling off fixed assets. A venture can be profitable but if they cannot meet their working capital needs they will become insolvent. Working capital often gets tied up in two areas. One is account receivable and the other is inventories.

When days-sales-outstanding gets to long it could be because the venture is selling to borrowers that are not credit worthy. This could mean collecting late or not at all. There is often a lot of pressure to increase sales so this is an area that can be negatively impacted by this growth and pressure to bring in new clients. Restructuring assets can mean focusing on reducing collection period and bringing down the accounts receivable balance.

Inventories also eat up working capital. By having large reserves the venture may be trying to make sure that they have enough product and material on hand but again this can be expensive. Restructuring here could mean improving processes to reduce lead times.

The last area of asset restructuring is the outright sale of some of the venture’s asset to help fund any cash short fall and possibly reduce expenses if keeping these assets on hand means added expense. There may be unused property or equipment that can be sold or repurposed. Again this is all about efficiency.

Finally let’s look at financial restructuring. Financial restructuring involves changing the contractual terms of the existing debt obligations and/or the composition of the existing debt claims against the venture. This might mean changing the due dates or even the size of the principle and interest payments.

Debt payment extensions involve postponing due dates for interest and principle payments on loans and cash payments on credit purchases. Debt composition change occurs when creditors reduce their contractual claims against the venture.

Whether its payment extensions or dept composition changes, it all will require the buy-in and support of the creditor to make the financial restructuring happened.

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Check Your Understanding

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Private workouts and liquidations

When in financial distress the venture will need to work with their creditors to discuss and workout terms of a new agreement around the debt or to liquidate the business. If the creditors agree to any of these terms it will keep these matters private. If they cannot come to terms that is when the venture will usually seek bankruptcy protection.

A private workout is a voluntary agreement between a venture’s owners and its creditors that provides for a financial restructuring of the venture’s outstanding debt. One-half of public firms that find themselves in financial distress are able to work out deals like this privately. The reason for this is that these deal are typically quicker and far less costly than a formal bankruptcy proceeding for the bank so if they can come to terms that are reasonable they are much better off if the business can turn around and become profitable an pay its debt back in full.

Private workouts are much more prevalent when there are only a few creditors involved. The more complex the debt structure and the more players involved the more difficult it will be for everyone to come to terms on the deal. A few bank loans may be far easier to negotiate than a bond issue that has many holders.

But perhaps the venture has a permanent problem and need to completely liquidate because there is no real hope of turning the business around. These can also sometimes be handled privately and are termed private liquidations. Again a creditor may agree to this over a bankruptcy since it may save on legal fees and get them some portion of the money owed earlier. In early stage ventures this is often done through assignment. Assignment is the transfer of title of the venture’s assets to a third-party assignee or trustee. The assignee is then responsible for the sale of the assets and the distribution of the proceeds to the creditors in accordance to the terms that have been arranged. Often the amount raised from the sale will not entirely cover the amounts owed so the distribution may be worked out as percentages of the total owed.

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Federal bankruptcy law

So if you are a venture and you tried restructuring and working out deals privately with no success the final alternative is bankruptcy. A venture is bankrupt when a petition is filed with a federal bankruptcy court. There are approximately three-hundred federal bankruptcy courts and the petitions can be filled in one of two ways. When a petition for bankruptcy is filed by the venture’s management it is known as a voluntary bankruptcy petition. When the petition for bankruptcy is filed by the venture’s creditors it is termed an involuntary bankruptcy.

Modern bankruptcy is governed by the modern bankruptcy reform act of 1978. The modern version is really designed to help bring the parties together to come to the best possible arrangement around the loss to the creditors while reducing the damage to the venture and the ventures finances.

We have said that it is usually in the best interest of all parties to reach an agreement privately. So why would a venture end up in bankruptcy? Well there are a few problems that can arise that make it desirable for a venture to seek bankruptcy protection. Let’s look at a few of these.

The first is the common pool problem. This is when individual creditors have the incentive to foreclose on the venture even though it is worth more as a going concern. So if a venture continues to operate it may be able to payback all or a larger portion of what it owes compared to if it were too shuttered immediately. But if there are multiple creditors they may look to foreclose quickly in an effort to regain their investment in full. Bankruptcy courts can issue an automatic stay provision which is a restriction on the ability of individual creditors to foreclose to try to recover their individual claim. This can allow the venture to continue to operate and restructure. There will be some restrictions put on the business like not allowing it to operate to the disadvantage of its creditors. Creditors may also be given a say in major management decisions.

The holdout problem is the next problem we will look at. This is when one or more of the creditors refuse to agree to the reorganization terms because of the potential for a large individual recovery. If all but one of the creditors were to agree to a deal that would leave the business solvent and healthy the holdout could end up being paid out more or in full after the restructuring. A bankruptcy court can elevate this problem by making all creditors abide by the reached agreement if half of the number of creditors and two-thirds of the debt value holders vote to agree to the plan. This will reduce the incentive for everyone to try to hold out to get a larger piece of the pie. This can take one of two forms. First is a cram-down procedure where the bankruptcy court accepts a reorganized plan for all creditors, including dissenting creditor classes. The other is debtor-in-procedure financing which is short-term financing, made senior to all existing unsecured debt issued in order to help during the reorganization process.

So now that we have discussed some of the reasons that a venture may end up in bankruptcy let’s look at the steps that are involved in a legal reorganization process. This would be the process a firm would follow in a chapter eleven filing. The first one would be to actually file the petition for bankruptcy. Again this is done either voluntarily or involuntarily depending on if the firm or the creditor is the one that files. The next step would be for the judge to accept or reject the petition. If it is accepted there will be a timeline set forth for the filing of claims against the firm. Management may continue to operate the business once the filing is made but the firm must submit a restructuring plan usually within three months of the filing. The next step is for the court to group the claimants into classes for the purpose of voting. This is in accordance with the absolute priority rule which gives the hierarchical order for the payment of claims for firms in bankruptcy starting with senior creditors and ending with the existing common stockholders. They will then be able to vote on the proposed restructuring plans. The plans will be accepted or rejected in accordance with the rule we already discussed but even if they are rejected the judge can still use the cram-down procedure to force the plan through. Finally the plan will be implemented. This could involve agreed upon payments and new securities offerings. Terms of existing debt could be modified as a result.

If an agreement cannot be reached or the business is facing a truly permanent problem, bankruptcy liquidation may be the last option. The process for this chapter seven filing looks very much like that of the chapter eleven, However, in this process a trustee will be appointed to take control of the assets and liquidate them to pay out as large a portion of outstanding debt as possible.

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Check Your Understanding

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Summary

We have now reached the end of this lesson. Let’s take a look at what we’ve covered.

First we took an overview of a ventures operating and financing. We said that most ventures will deal with financial issues and trouble at some point during its life cycle. The complexity of the issues changes depending on the stage. It usually gets more complicated the further the venture is along its lifecycle. We then looked at the three types of restructuring that can be done: Financial, Operational and Asset Restructuring.

Next we looked at when a venture finds itself in distress and what some of the potential causes of this can be. We looked at loan default leading to foreclosure. We talked about things that can lead to insolvency and where they arise. The first was balance sheet insolvency and the second was cash flow insolvency.

We moved on to steps that can be taken in resolving financial distress. Problems are either permanent or represent a turnaround possibility. Permanent problems result in either private liquidation or bankruptcy liquidation. Turn around possibilities lead down the path of restructuring which can also be private or handled through bankruptcy.

We then looked at private workouts and liquidations. We said that when things can be handled privately they usual workout better for all involved since the costs are lower and the process can generally move a little quicker. Private liquidations involve an assignee that will handle title transfer sale of assets and distribution of proceeds.

Finally we discussed Bankruptcy. We saw that it could be initiated by the creditor or the venture firm. Since it is usually better to do things privately we looked at some of the issues that can lead to parties seeking a bankruptcy filing. Lastly, we looked at the legal reorganization process and legal liquidation.

This concludes this lesson.