For the owner with cash, or access to financing, buying a struggling competitor, supplier or customer can be a real opportunity. When companies can’t cover their fixed costs, they sell at bargain prices to anyone with cash or financing. You might be on the seller side of things if your business is under pressure, too. Either way it’s the debt that makes or breaks a deal like this one. There are two big problems you have to look at. First, have you done enough due diligence to know what you’re getting into? And second, is it better to buy the company while it’s still struggling, or wait until it’s filed for Chapter 11?
Do Your Due Diligence
Due diligence is always important when you buy a business. But when you buy a business from a distressed seller, it’s more important than ever. You need to search the public records for UCC financing statements, tax liens, judgment liens, and lawsuits. Financing statements will tell you what liens and debts the seller had that are specific to the property, and will show you other hidden liabilities that are tied to that property. It will also help you determine the value of the assets you are purchasing and which creditors might come after you once the transaction closes. When you find these public records, ask yourself what they mean. If they’re old, what has happened since the public record was filed? Are they a liability that you are assuming with the purchase? Do your due diligence; don’t assume that the disclosure of a business’ liabilities in a legal document is comprehensive.
Structure It as an Asset Purchase
A distressed business is one that can’t pay, or is struggling to pay, its bills. And if you are looking to buy one of those, here’s the first lesson: Don’t buy the equity (stock). Structure it as an asset purchase instead. That way, you take only the assets you want, and you limit your exposure to the known and the unknown liabilities.
The biggest pitfall when buying the good assets of a sick company before bankruptcy is that the seller files for bankruptcy a month later and the creditors go after you for fraudulent transfer. The trustee can undo any transfer of value within two years of filing if the transfer was (1) made with actual intent to hinder, delay or defraud creditors, or (2) made for less than reasonably equivalent value when the seller was insolvent or the sale rendered it insolvent. You can protect yourself with a fairness opinion from an investment bank saying that you gave fair consideration for the assets.
When you’re buying a company, you should keep a large chunk of the purchase price in escrow. That way you can recoup whatever it takes to fix problems that crop up after the sale is finalized, and it also backs up the indemnification agreement that’s part of the deal. You should ask for an indemnification that includes breaches of the standard representations and warranties, and that includes the costs of fighting off any effort by creditors to undo the sale. If you don’t hold back a big chunk of the price, it’s tough to get your money back, since the owner’s leftover business will often be worth pennies on the dollar.
The Section 363 Sale
There’s a tradeoff between buying a business before or after bankruptcy. Buying a business out of Chapter 11 is a bit like a pre-bankruptcy deal. You buy underperforming assets at bargain prices that are ready for a turnaround. The most common mechanism for that is the Section 363 sale, which is usually done as an auction. The winner gets the assets free and clear of any liabilities, unless it has expressly assumed those. The sale must be approved by the court. In theory, because the creditors are identified and claims filed, due diligence is less of a concern. In practice, the assets are sold “as is, where is,” so if they’re damaged or less than stellar, there’s little recourse. Also, the fact that it’s an auction process may mean that you don’t have as much time to do your due diligence.
Anyone who buys from a bankruptcy sale is one of two types of buyer, either a stalking horse or a non-stalking horse. The stalking horse is the buyer who offers a baseline price for the assets and another buyer has to offer a higher bid to win. If the stalking horse’s bid is the highest bid, the sale goes through. If not, the stalking horse usually gets some sort of break-up fee, typically between one and three percent of the price of the sale. The stalking horse also gets the longest due diligence period.
As a competing bidder, there are two risks here. First, if you go too far to beat the stalking horse, you end up overpaying for the deal. Second, if you bid too cautiously, you end up losing the deal to someone else. The catch is that the due diligence window is much shorter. You have to move fast and be ready to expose the risks early. Whatever the role, you should always be open to negotiating with the seller, the creditors and the court, since they all can accept or reject the deal to some degree. Weigh their concerns, then get an experienced due diligence team in place for every scenario.
As a wrap-up, remember this: no matter if you’re buying before bankruptcy or from a 363 sale, you need to have an experienced due diligence team on standby to spot traps for the unwary. A bargain price is not a bargain if the seller’s debts will follow you after closing. Check the liens, structure the deal as an asset purchase, hold back some money in escrow, and know your role at auction.
