FINANCIAL DISTRESSS; TURNAROUND OPPORTUNITY OR LIQUIDATION ENTREPRENEURIAL FINANCE Leach & Melicher Chapter 14 FINANCIAL DISTRESSS; TURNAROUND OPPORTUNITY OR LIQUIDATION © 2003 South-Western College Publishing

CHAPTER 14 : LEARNING OBJECTIVES Explain financial distress Define and describe insolvency Describe how ventures emerge from financial distress Describe how private reorganizations and liquidations take place

CHAPTER 14 : LEARNING OBJECTIVES Describe reorganization under Chapter 11 of the U.S. Bankruptcy laws Describe liquidation under Chapter 7 of the U.S. Bankruptcy laws

LIFE CYCLE APPROACH: VENTURE OPERATING AND FINANCIAL DECISIONS Development stage Startup stage Survival stage Rapid growth stage Maturity stage

FINANCIAL DISTRESS Financial distress: when cash flow is insufficient to meet current debt obligations Insolvent: 1. Venture with negative book equity or net worth (balance sheet perspective) 2. Venture with cash flows insufficient to meet current debt obligations (cash flow perspective)

FINANCIAL DISTRESS AND LOANS Loan default – failure to meet interest or principal payments when due Protective clauses in case of default: 1. Acceleration provision provides all future interest and principal obligations on loan become due immediately upon default

FINANCIAL DISTRESS AND LOANS Protective clauses in case of default: 2. Cross-default provision provides that defaulting on one loan places all others in default 3. Foreclosure – legal process used by creditors to try to collect amounts owed on loans in default

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>

BALANCE SHEET INSOLVENCY Northland Industries Year 0 Year 1 Year 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 Cmn. Stock 200 k 200 k 200 k R. E. 0 -100 k -250 k Total Equity 200 k 100 k -50 k Total Debt & Equity 200 k 200 k 200 k

CASH FLOW INSOLVENCY Exists when a venture’s cash flow is insufficient to meet its current contractual debt obligations Example: Westland Industries: Initial equity investment $100,000 buys 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

CASH FLOW INSOLVENCY Westland Industries Year 0 Year 1 Year 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

PRINCIPAL-INDUCED CASH FLOW INSOLVENCY Example: Eastland Industries End of Yr 0: Invest $100,000 each in current assets & fixed assets; No debt 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 End of year 2 repayment of debt = $50,000

PRINCIPAL INDUCED CASH FLOW INSOLVENCY: Eastland Industries Year 0 Year 1 Year 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

RESOLVING FINANCIAL DISTRESS Operations Restructuring Financial Restructuring Asset Restructuring

OPERATIONS RESTRUCTURING Involves growing revenues relative to costs and/or cutting costs relative to the venture’s revenues

OPERATIONS RESTRUCTURING: Revenue Expansion Scenario B.A.U Restructured Revenues $5,000 k $6,000 k Variable Exp. CGS=60% Sales - 3,000 - 3,600 Fixed Exp: G&A -1,000 -1,000 Marketing -1,000 -1,000 EBITDA 0 400

OPERATIONS RESTRUCTURING: Cost-Cutting Scenario B.A.U Restructured Revenues $5,000 k $5,000 k Variable Exp. CGS=60% Sales - 3,000 - 3,000 Fixed Exp: G&A -1,000 - 600 Marketing -1,000 -1,000 EBITDA 0 400

ASSET RESTRUCTURING Involves improving the working capital to sales relationship and/or selling off fixed assets

ASSET RESTRUCTURING: Restructured Working Capital Scenario B.A.U Restructured 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

ASSET RESTRUCTURING: Restructured Working Capital Scenario B.A.U Industry Ave Days sales o/s 36.5 days 30.0 days Inv. conv. period 73.0 days 60.0 days Total Op. Cycle 109.5 days 90.0 days Restructured W.C. Forecast: Ave investment in A/R= $410,970 Ave investment in Inventory=$493,140

FINANCIAL RESTRUCTURING Financial restructuring – involves changing the contractual terms of the existing debt obligations and/or the composition of existing debt claims against the venture Debt payment extension – involves 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

WORKOUTS AND LIQUIDATIONS Private Workouts: voluntary agreement between a venture’s owners and its creditor 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

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

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 their 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

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

BANKRUPTCY RESULTS 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

LEGAL REORGANIZATION PROCESS 1. Bankruptcy petition is filed with bankruptcy court for protection under Chapter 11 while firm attempts to reorganize 2. Bankruptcy judge accepts or rejects the petition. If accepted, a time frame is set. 3. Firm’s management is given 120 days to submit a reorg plan, with an additional 60 days allotted to get creditor and investor o.k.

LEGAL REORGANIZATION PROCESS 4. Creditor and stockholders are grouped into classes for voting process 5. Accepted plan is implemented by the exchange of old creditor claims and securities for new ones Absolute Priority Rule – sets a hierarchical order for the payment of claims

CHAPTER 7 – BANKRUPTCY LIQUIDATION PRIORITY 1. Administrative costs associated with the venture’s liquidation 2. Wages and other unpaid employee benefits 3. Specific consumer claims 4. Tax claims 5. Secured creditors

CHAPTER 7 – BANKRUPTCY LIQUIDATION PRIORITY (cont.) 6. Unfunded pension plan liabilities 7. General (unsecured) creditor claims 8. Preferred stockholders claims 9. Common stockholder claims