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

2. 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

3. 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

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

5. 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)

6. 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

7. 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

8. 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>

9. BALANCE SHEET INSOLVENCY Northland Industries
Year 0 Year 1 Year 2
Curr. Assets $100 k $100 k $100 k
Fix. Assets k k k
Total Assets k k k
Total Debt k k
Cmn. Stock k k k
R. E k k
Total Equity k k k
Total Debt & Equity k k k

10. 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

11. CASH FLOW INSOLVENCY Westland Industries
Year 0 Year 1 Year 2
Sales $ 50 k $100 k $-100 k
Operating Expenses k k k
EBITDA k k k
Interest k k
EBIT k k

12. 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

13. PRINCIPAL INDUCED CASH FLOW INSOLVENCY: Eastland Industries
Year 0 Year 1 Year 2
Net income (loss) $ 0 k $ -70 k $ 20 k
+Depreciation k k
-Increase in NWC k k k
-Increase in GFA k
+Equity/debt issues k k
-Debt repayment k
Net cash build (burn) k

14. RESOLVING FINANCIAL DISTRESS
Operations Restructuring
Financial Restructuring
Asset Restructuring

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

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

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

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

19. ASSET RESTRUCTURING: Restructured Working Capital Scenario
B.A.U Restructured
Partial I/S
Revenues $5,000 k $5,000 k
CGS - 3, ,000
Partial B/S
Cash
A/R
Inv
Total Working Cap ,
A/P
Accruals
Loans
Total Liabilities 1,

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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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.

28. 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

29. 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

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