Category: Insolvency

Valuing a company, distressed or not, is the easy part; creating that value in the first place is the more challenging task. In transaction terms, value is determined by what a willing buyer will pay to a willing seller. Add distress to the equation, and the “game” could affect stakeholder class outcomes (secured lenders, mezzanine lenders, unsecured creditors, equity holders) in substantially different ways.

Given Covid-19, investing in and disposing of under-performing companies/distressed companies is increasing in interest. The following are key considerations in creating and obtaining “value” in the sale of a distressed organization.

6 Tips to Obtaining Value in a Distressed Organization

Strategy and Timeline: Spend time assessing the company’s strengths, weaknesses, opportunities, and threats to develop a believable recovery and operating strategy. Simultaneously, the company should develop a liquidation strategy and associated timeline. Time is money. Moving swiftly and gaining the buy-in for all stakeholders is important. The team should weigh the tradeoffs of taking additional time to execute a transaction versus the risk and cost of running the company. Make an assessment. In some cases, it’s worth it to negotiate with vendors, customers, lenders and other vested stakeholders.

Revised Financial Forecasts, Cash Flows and Budgets: Create short- to intermediate-term cash flow forecasts, budgets and revised financial statements. Financial statements should contain reasonable adjustments to EBITDA for non-recurring and other extraordinary expenses. Furthermore, they should be shown in a manner that is easy to defend and assist the buyer in understanding the cost of the “distress.” Since the past results are typically negative, specific emphasis should be put on forecasting near-term numbers to illustrate the opportunity and potential value to a buyer. The financial statements should also include a forecast for multiple years (five years) and include an accompanying balance sheet.

Financial Support: If required, speak with your secured lender to offer additional support or availability to assure that the company can get through the transaction. Of course, there will be give and take with the secured lender in terms of cost and time. If additional capital in required, you will need to provide a specific timeline and illustrate how the secured lender’s “position” is improved or at worst, not harmed. Try to create a win-win situation with the secured lender by offering incentives (higher interest rates, fees, etc.) to the secured lender.

Due Diligence: Contract a reputable third-party firm to conduct sell-side due diligence and provide seller diligence support for any potential buyer. Diligence services are being used more in transactions, especially in distressed sales. Key considerations in determining whether to use these services are: reducing time to close, identifying potential problems and risks prior to starting the process, justifying adjustments relating to the distress and giving the buyer with an independent analysis of the company’s historical performance.

Focus On Go-Forward Performance: The traditional transaction will focus most value expectations on historical performance. This methodology does not hold true for a distressed company. The team must focus the potential buyer on the potential opportunity as evidenced by a “run rate” EBITDA of forecasted EBITDA, which reflects the expected improvements.

Management: It is important to critically and honestly assess key managers. In particular, with distressed transactions, carefully evaluate management capabilities and their ability to execute on the turnaround post-transaction. Sometimes potential buyers will have already identified the management team. However, buyers frequently assess the existing management/ownership for their ability and desire to continue with the company. Because of the past challenging financial history of the company, continuing management, if asked to stay on, is frequently compensated with bonuses, increased fringes and other forms of incentive pay.

Companies in distress, with proper assessments and processes put into practice, can survive and even thrive in a challenging economy.

EMAGroup advises companies in transition, focusing on Special Situations, Capital Solutions, Enterprise Performance Improvement, and Insolvency Strategies to create value-driven solutions. For more information, visit: https://www.ema-group.com.

Client Situation:

An underperforming $223 million revenue family office investment (mall-based beauty salons) was originally acquired from a public company with the expectation that its store operations could be improved. The goal was to increase profitability by significantly streamlining back office costs and improving gross margins through a lower-cost supply chain.

• The Company had been rationalizing its salon footprint, closing underperforming locations.
• Company could not easily improve customer traffic “across the board” as performance at each salon was heavily dependent on the stylists at each location and also foot traffic at the mall.
• The Company continued to use the prior owner’s POS system which was used for inventory replenishment and payroll tracking.
• Because the prior owner had “rolled up” various salons and concepts, there were nearly as many compensation programs as there were salons.
• The family office was capital-constrained; thus, it was not able to update the décor of the salons, many of which were “tired” in appearance.
• The company was in violation of certain financial and operating metrics required under the sale agreement with the prior owner.

Challenges:

• In some malls, the company operated multiple locations under different formats. By closing underperforming locations, the company hoped that those stylists and customers would relocate to the other location in the same mall or relocate to a mall in the general vicinity. However, consolidating stylists (and their customers) proved to be difficult. Because the other mall location was a different format, this was unattractive to the stylist. And, the next closest salon may not have been convenient for the stylist and/or their customers. Closing locations caused too much dilution in revenues.
• Replicating performance of the higher-performing locations was dependent upon the quality and number of stylists at each location. The artistic talent of the stylists is not something which can easily be transmitted across the salon base.
• As the client rationalized its locations, regional and district managers were stretched thin across a broader coverage area, reducing their effectiveness at training and sharing “best practices.”
• The Company was never able to wean itself off the prior owner’s POS system which was used for inventory replenishment and payroll; thus, the savings on shifting to a lower-cost supply chain never materialized.
• Management was not able to transition the employees to a single compensation program through a lower-cost third-party payroll service.

Solution:

EMA’s significant experience in the retail, consumer products and personal services industries was highly beneficial to this particular situation and enabled EMA to quickly make assessments.

• EMA reviewed the financial and operational data, including the detailed 4-wall cash models prepared by the management company’s analysts. EMA was able to analyze trends from comparable historic performance and project the company’s results under various scenarios. Further, EMA assisted the company in developing various materials used to introduce the company to potential investors.
• EMA outlined options for exiting the investment, identified potential wind down liabilities to the management team and the family office under various scenarios, prepared a path which ended the cash outlays by the family office, liquidated the excess salons without wanted publicity and met the terms of the settlement agreement.
• A settlement was reached with the prior owner which required certain of the salons to be sold. The form of the sale was subject to further negotiation.
• After presenting various options for exiting the remaining business and effecting the sale under the settlement agreement, the company agreed to use an ABC to transact the sale and wind down the excess salons. The secured lender agreed to the transaction and the structure did not require assignment of leases. By using an ABC instead of a Chapter 7 liquidation, the transaction closed without any disruption to approximately 250 salons which meant about 1,500 jobs were saved. Further, the family office was able to immediately stop funding operations when the assignment occurred.

Lessons Learned:

An ABC is an effective process to liquidate a business in a timely, cost-effective manner while avoiding unwanted publicity. While bankruptcy provides helpful features, such as the automatic stay, assignment provisions for executory contracts, and cram down on secured lenders, it is also cumbersome, expensive and public. Owners seeking to quickly wind down an investment or transition the business to buyer with minimal disruption may find an ABC to be the right process.

EMAGroup advises companies in transition, focusing on Special Situations, Capital Solutions, Enterprise Performance Improvement, and Insolvency Strategies to create value-driven solutions. For more information, visit: https://www.ema-group.com.

When a company has exhausted all available remedies to turn itself around and wishes to wind down its business in an orderly manner, an Assignment for the Benefit of Creditors^[1] (“ABC”) can be a cost-effective and relatively quick way to sell the assets and distribute the proceeds to creditors. Assignments are creations of state law, so unlike bankruptcy, which is governed by a uniform federal code, the laws governing assignments will vary across each state.

Here’s how an ABC proceeding compares with bankruptcy^[2]:

Who can file an Assignment for the Benefit of Creditors?

Nearly any insolvent business can avail itself of an ABC. The company must obtain shareholder approval which may make it impractical for a public company to avail itself of an ABC. A board resolution is also required authorizing the assignment.

How does an assignment start?

An assignment begins with the company (the “assignor”) reaching an agreement with the firm or individual (the “assignee”) who will act as a fiduciary on behalf of the assignor’s creditors. The agreement will transfer all rights, title and interest to the assignee who then liquidates the assets and distributes proceeds to the creditors.

What are positive attributes of an assignment?

• The sale of assets under an assignment are completed faster than a 363 sale in bankruptcy because assignments do not require a court process. There are no pleadings, bid procedures, and sales motions to file.
• Management and the assignee work collaboratively on preparing communications about the assignment. This alleviates negative publicity of the winddown whereas a bankruptcy liquidation is a very public process.
• Management controls the selection of the assignee. In bankruptcy, there are many parties with a voice in the process, such as the court, the Office of the United States Trustee and the unsecured creditors committee. And, in a Chapter 7 bankruptcy, a trustee will be appointed to sell the assets.
• An assignment does not cost nearly as much as a 363 sale in bankruptcy. The assignor only has to pay the assignee’s fees and costs. In a bankruptcy, the debtor not only has to pay for its professionals, but also the unsecured committee’s professionals. Furthermore, since the bankruptcy process is so much longer than the assignment, the debtor has to pay for both sets of professionals over a longer period of time.
• An assignment provides a way to shield the officers, directors and the buyer from litigation of a fraudulent transfer of the assets to the buyer.
• The ability to complete the sale quickly by the assignee reduces the disruption caused by a bankruptcy filing and helps to maintain continuity of the business thus saving jobs.

What are the limitations of an assignment?

• An assignment does not provide an automatic stay which means creditors can continue to pursue actions against the assignor. However, since the secured lender is a cooperating party in an assignment, the risk of the secured lender foreclosing on its collateral is unlikely.
• An assignee cannot assign executory contracts to the buyer. The assignee must get the contract counterparts, such as a landlord, to agree to accept the buyer as the new obligor.
• An assignee cannot sell assets “free and clear” of liens or “cram down” the secured lender as in bankruptcy. Thus, the secured lender must agree to the sale if the secured lender isn’t going to be paid in full with the sales proceeds.

What does the assignee do during the pre-assignment period?

From the commencement of the assignment until the date the assets are transferred to the assignee, the assignee will be working with management in conducting its due diligence on the background of the company, the liabilities, any litigation, reviewing debt agreements and collateral positions, and ascertaining the highest and best offer for the assets (reviewing the company’s marketing efforts as well as performing its own marketing efforts, if necessary). It is during this period that most of the cost of the assignee will be incurred.

What does the assignee do during the assignment?

Upon the effective date of the assignment, the assignor transfers its assets to the assignee. The assignee often then immediately sells the assets. The assignee will contact the unsecured creditors and notify them of the assignment and the bar date which is the deadline for the creditors to file their claims. The assignee will distribute proceeds from the sale, if any^[3], to the unsecured creditors.

Companies in distress should consider an Assignment for the Benefit of Creditors vs. bankruptcy to more more quickly satisfy creditors, conserve any remaining capital, avoid negative publicity and benefit from a more timely dissolution.

EMAGroup advises companies in transition, focusing on Special Situations, Capital Solutions, Enterprise Performance Improvement, and Insolvency Strategies to create value-driven solutions. For more information, visit: https://www.ema-group.com.

^[1] An ABC is a state law creation, so rules and regulations vary by state. It is important to retain counsel familiar with the assignment laws applicable to your state.

^[2] In California

^[3] As is often the case, the sale proceeds are not sufficient to pay the secured lender’s claims in full which means there are not distributions to the unsecured creditors.

Underperforming or insolvent companies usually have a flawed or broken business model. With the onset of Covid-19, weaknesses in an operation get amplified. What was an annoyance is now sapping working capital and resources from your core and more profitable business operations. Focus on what needs to change and think in terms of how to run a world-class business.

Middle-market companies owned by entrepreneurs, closely-held family operations, and private equity investors all make similar mistakes but for different reasons. For non-investor-owned businesses, it is easy to get comfortable earning enough but not dealing with the tough personnel, operational, customer or product issues. Private equity firms focus on growth, leverage and short-term performance gains. Consequently, they will accept new sales revenue for growth that is not profitable. Debt leverage and short-term performance gains mean limited investment in capital expenditures and innovation. So, whether you are an owner, investor, or a lender who wants to help a borrower, consider the following red flags and how to fix them.

In this new Covid-19 business environment, beware of these red flags:

1. Lack of access to timely and accurate operating and financial reporting. These issues did not matter as much when there was a solid flow of business and a consistent supply chain. But all that has changed and now a better roadmap is needed. You cannot properly run a business without good detailed and timely data. It may be time to update or invest in improved data systems.
2. Keeping marginal product lines and customers that were intended to grow into sources of higher contribution and profitability, but the transition never occurred. Consider phasing out product lines and customers that are not contributing to the bottom line.
3. Sub-optimal utilization of equipment. Investment in equipment that is not optimally-operated because of downtime, change-over requirements, missed software upgrades, preventative maintenance, or lack of proper production planning. It may be time to sell outdated equipment.
4. Unfavorable variances on unit labor and material costs. Companies frequently lose sight of or do not update costs standards, and do not want to implement price increases. If you are not meeting or exceeding industry benchmarks, figure out why.
5. Cutting production labor but not wanting to touch administrative overheads. In every business cycle and in every type of organization or ownership structure, administrative costs can get bloated. It may be time to evaluate not only a reduction in production labor costs but administrative personnel as well.
   
   Tougher times may call for tougher measures that ultimately contribute to improvement in the enterprise overall.

EMAGroup advises companies in transition, focusing on Special Situations, Capital Solutions, Enterprise Performance Improvement, and Insolvency Strategies to create value-driven solutions. For more information, visit: https://www.ema-group.com.