1. 1 Chapter 15 FINANCIAL DISTRESS: TURNAROUND OPPORTUNITY OR LIQUIDATION ENTREPRENEURIAL FINANCE

2. 2 Chapter 15 : Learning Objectives Explain financial distress Define and describe insolvency Describe how ventures emerge from financial distress Describe how private reorganizations and liquidations take place Describe reorganization under Chapter 11 of the U.S. Bankruptcy laws Describe liquidation under Chapter 7 of the U.S. Bankruptcy laws

3. 3 Financial Distress Financial distress: when cash flow is insufficient to meet current debt obligations Insolvent: venture with negative book equity or net worth (balance sheet perspective) venture with cash flows insufficient to meet current debt obligations (cash flow perspective)

4. 4 Financial Distress And Loans Loan default: failure to meet interest or principal payments when due Protective clauses in case of default: acceleration provision: provides all future interest and principal obligations on loan become due immediately upon default cross-default provision: provides that defaulting on one loan places all others in default Foreclosure: the legal process used by creditors to try to collect amounts owed on loans in default

5. 5 Balance Sheet Insolvency Exists when total debt exceeds total assets Example: Northland Industries: Initial equity investment $200,000 $100,000 spent for current assets $100,000 spent for fixed assets Net losses: Yr 1 = -$100,000, Yr 2 = -$150,000

6. 6 Balance Sheet Insolvency: Northland Industries Year 0Year 1Year 2 Curr. Assets$100 k$100 k$100 k Fix. Assets 100 k 100 k 100 k Total Assets 200 k 200 k 200 k Total Debt 0 200 k 200 k Common Stock 200 k 200 k 200 k Retained Earnings 0 -100 k -250 k Total Equity 200 k 100 k -50 k Total Debt & Equity 200 k 200 k 200 k

7. 7 Cash Flow Insolvency Cash Flow Insolvency: exists when a venture’s cash flow is insufficient to meet its current contractual debt obligations Example: Westland Industries Initial $100,000 equity investment for assets Yr 0: No sales; $50,000 start-up costs Sales=$100,000 in yr 1 & yr 2 Op expenses b/4 depreciation =75% of sales Interest yr 1 = $20,000; yr 2 = $40,000

8. 8 Cash Flow Insolvency Westland Industries Year 0Year 1Year 2 Sales$ 50 k$100 k$-100 k Operating Expenses -50 k -50 k - 75 k EBITDA 0 k 25 k 25 k Interest 0 -20 k -40 k EBIT 0 5 k - 15 k

9. 9 Principal-Induced Cash Flow Insolvency Example: Eastland Industries Yr 0: Equity investment of $100,000 in both current assets & fixed assets Depreciation: $20,000 in yrs 1 & 2 Yr 1: $70,000 net loss; Yr 2: Net inc. $20,000 Increase in NWC = $50,000 Yr 1; $70,000 in Yr 2; also $100,000 debt financing in Yr 1 End of year 2 repayment of debt = $50,000

10. 10 Principal Induced Cash Flow Insolvency: Eastland Industries Year 0Year 1Year 2 Net income (loss)$ 0 k$ -70 k$ 20 k +Depreciation 0 20 k 20 k -Increase in NWC -100 k -50 k -70 k -Increase in GFA -100 k 0 0 +Equity/debt issues 200 k 100 k 0 -Debt repayment 0 0 -50 k Net cash build (burn) 0 0 -80 k

11. 11 Resolving Financial Distress There are three ways - individually or in combination - for resolving financial distress: Operations Restructuring Financial Restructuring Asset Restructuring

12. 12 Operations Restructuring Involves growing revenues relative to costs and/or cutting costs relative to the venture’s revenues

13. 13 Operations Restructuring: Revenue Expansion Scenario B.A.URestructured Revenues$5,000 k$6,000 k Variable Exp. CGS (60% of Sales) - 3,000- 3,600 Fixed Exp: G&A-1,000 -1,000 Marketing-1,000 -1,000 EBITDA 0 400

14. 14 Operations Restructuring: Cost- Cutting Scenario B.A.URestructured Revenues$5,000 k$5,000 k Variable Exp. CGS (60% of Sales) - 3,000- 3,000 Fixed Exp: G&A-1,000 - 600 Marketing-1,000 -1,000 EBITDA 0 400

15. 15 Asset Restructuring Involves improving the working capital to sales relationship and/or selling off fixed assets

16. 16 Asset Restructuring: Restructured Working Capital Scenario B.A.URestructured Partial I/S Revenues$5,000 k $5,000 k CGS - 3,000 - 3,000 Partial B/S Cash 0 0 A/R 500 419 Inv. 600 493 Total Working Cap 1,100 912 A/P 200 200 Accruals 100 100 Loans 800 612 Total Liabilities 1,100 912

17. 17 Asset Restructuring: Restructured Working Capital Scenario B.A.UIndustry Ave Days sales o/s36.5 days30.0 days Inv. conv. period73.0 days60.0 days Total Op. Cycle 109.5 days90.0 days Restructured W.C. Forecast: Ave investment in A/R= $410,970 Ave investment in Inventory=$493,140

18. 18 Financial Restructuring Financial restructuring: changing the contractual terms of the existing debt obligations and/or the composition of existing debt claims against the venture Debt payment extension: postponing due dates for interest and principal payments on loans and payments on credit purchases Debt composition change: when creditors reduce their contractual claims against the venture

19. 19 Workouts And Liquidations Private Workouts: voluntary agreement between a venture’s owners and its creditors that provides for a financial restructuring of the venture’s outstanding debt Private Liquidations assignment: transfer of title to the venture’s assets to a third-party assignee or trustee

20. 20 Historical Development of Federal Bankruptcy Law 1898: first U.S. bankruptcy legislation 1938: major modification of 1998 law 1978: Federal Bankruptcy Reform Act basis for modern U.S. bankruptcy law 1986 & 1995: modern revisions were made to the 1978 law

21. 21 Two Important Fed Bankruptcy Law Chapters Chapter 11: provides for protection from creditors while a venture attempts to reorganize Chapter 7: specifies the procedures to be followed when liquidating a venture

22. 22 Federal Bankruptcy Law Bankrupt: occurs when a petition for bankruptcy is filed with a federal bankruptcy court Voluntary Bankruptcy Petition: petition for bankruptcy filed by the venture’s management Involuntary Bankruptcy Petition: petition for bankruptcy filed by the venture’s creditors

23. 23 Reasons For Legal Reorganizations Common Pool Problem: exists because individual creditors have the incentive to foreclose on the venture even though it is worth more as a going concern Automatic Stay Provision: restricts the ability of individual creditors to foreclose to try to recover individual claims Holdout Problem: exists when one or more of the creditors refuse to agree to the reorganization terms because of potential for a larger individual recovery

24. 24 Bankruptcy Results Cram Down Procedure: bankruptcy court accepts a reorganization plan for all creditors including dissenting creditor classes Debtor-In-Possession Financing: short-term financing, made senior to all existing unsecured debt, to help meet liquidity needs during the reorganization process Prepackaged Bankruptcy: an initial private attempt to convince a majority of the creditors to go along with a reorganization plan that will be proposed after the venture files under Chapter 11

25. 25 Legal Reorganization Process Bankruptcy petition is filed with bankruptcy court for protection under Chapter 11 while firm attempts to reorganize Bankruptcy judge accepts or rejects the petition. If accepted, a time frame is set. Firm’s management is given 120 days to submit a reorganization plan, with an additional 60 days allotted to get creditor and investor o.k. Creditor and stockholders are grouped into classes for voting process Accepted plan is implemented by the exchange of old creditor claims and securities for new ones

26. 26 Legal Reorganization Process Absolute Priority Rule: sets a hierarchical order for the payment of claims

27. 27 Chapter 7 – Bankruptcy Liquidation Priority Administrative costs associated with the venture’s liquidation Wages and other unpaid employee benefits Specific consumer claims Tax claims Secured creditors Unfunded pension plan liabilities General (unsecured) creditor claims Preferred stockholders claims Common stockholder claims