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Chapter 15

ENTREPRENEURIAL FINANCE. Chapter 15. FINANCIAL DISTRESS: TURNAROUND OPPORTUNITY OR LIQUIDATION. Chapter 15 : Learning Objectives. Explain financial distress Define and describe insolvency Describe how ventures emerge from financial distress

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Chapter 15

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

  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. 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. 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. 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. Balance Sheet Insolvency:Northland Industries Year 0Year 1Year 2 Curr. Assets $100 k $100 k $100 k Fix. Assets 100 k100 k100 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 k100 k -50 k Total Debt & Equity 200 k 200 k 200 k

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

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

  13. Operations Restructuring: Revenue Expansion Scenario B.A.U Restructured 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. Operations Restructuring: Cost-Cutting Scenario B.A.U Restructured 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. Asset Restructuring • Involves improving the working capital to sales relationship and/or selling off fixed assets

  16. 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. 600493 Total Working Cap 1,100 912 A/P 200 200 Accruals 100 100 Loans 800612 Total Liabilities 1,100 912

  17. 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 days60.0 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

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

  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

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