Every distressed company gets there differently. Maybe a big customer stopped paying, maybe a loan came due at the wrong moment, maybe all of the above. But however the distress came about, it means it is time for a slew of tough decisions that will determine the future of the company. The biggest is whether to restructure your debt privately, out of court, or to file under Chapter 11 of the Bankruptcy Code. Neither is right for every company, and several factors will point toward one option or the other. A consensual deal outside of court is usually the better result, if you can get one.
The first hurdle is liquidity. An out-of-court workout is faster and less expensive, which can be critical when cash is tight. But cash also determines whether there is time to lay out and propose a restructuring plan. If you can operate for several months without collapsing, then an out-of-court restructuring will be more feasible. If you do not have the necessary liquidity to develop an out-of-court deal, you most likely will have to commence a Chapter 11 case.
Another factor that can make an out-of-court workout much less feasible is the complexity of your company’s capital structure. Every time you add a creditor to your dealings, your chances of getting unanimous agreement go down. If you’ve got a complex capital structure and lots of creditors, it’s likely that at least one of them will be a holdout and torpedo your deal. An out-of-court workout makes more sense if your capital structure is simple and it’s easy to achieve unanimous agreement among your banks, vendors and trade suppliers. If you need to get 100% of your creditors to sign up, the total number of claim holders must be small.
Then there is the relationship itself. You need to come to agreement on the problem and its solution with all of your significant creditors - the lenders, the big suppliers and other third parties. And it’s much more likely to happen if the business has good relationships with those creditors. They all have to be satisfied, and they all have to stay at the table.
Advantages to an Out-of-court Workout
If you can clear those hurdles, the payoff is real. There are many advantages to an out-of-court workout, including significantly lower costs than a Chapter 11 case, plus far greater flexibility to negotiate with your lenders and to come up with different strategies to solve the problem. The time needed to complete a workout ranges between 6 and 9 months - or possibly less - whereas a Chapter 11 case might take 9 to 12 months on average. If you just call your creditors and start talking, no judge will insist that you assemble all your creditors together in court. And the months matter, since every delay costs growth and profits.
Workouts are also private. That means far fewer bureaucracies to deal with and far less financial reporting. And your financial statements never go into a public court filing. There is much less disruption to your business, both financially and otherwise. Workouts also protect employee morale, and they preserve relationships with trade creditors. This can be a very big deal if you are a small private company. The last thing you want is to leave traces all over the place that show how bad your business is doing.
A successful workout says something about you, too. If the creditors agree to go along with the company’s plan, that shows confidence in the management, as well as the conclusion that the problems are temporary and repairable. Creditors who lacked that confidence would have insisted on the protections of a formal Chapter 11 case.
Those protections are exactly what a private deal lacks. Outside of court, nothing stops a creditor from foreclosing, suing or taking other drastic steps while you negotiate. Also, creditors are under no obligation to negotiate with you. If you can’t get all the creditors on board, your restructuring agreement may be worthless.
In court, the picture changes. The automatic stay kicks in as soon as a bankruptcy petition is filed. It prohibits actions by creditors against the company, including lawsuits and foreclosures. You can be confident that no one will seize assets or pull you into litigation while you figure out what to do. You have breathing room.
Chapter 11 also hands you tools a workout cannot. The company can get out of executory contracts that it would otherwise be stuck with. Those include some leases, license agreements, franchise agreements and equipment rental contracts. Dollar amounts can be huge, especially in retail. By rejecting the agreements that don’t make sense for your business, you can stop paying for assets you don’t use. In addition, court approval of your plan sends a signal that the judge has reviewed the case and approves the reorganization. The court’s approval helps paint you as a viable company.
In some cases, the business isn’t viable, and creditors want it in Chapter 11 to have the court’s support. And the best outcome for the business and its creditors may be to sell the company. When that happens, buyers prefer to go through Chapter 11 because they can buy the company free and clear of all encumbrances and claims against its assets.
None of that comes cheap. Chapter 11 is slower and more cumbersome. It takes place in a US bankruptcy court, which means far more formalities, rules, and protocols. It’s less of a business transaction than a legal one. You will pay court costs, as well as legal and professional fees. All of that costs time as well as money, and that means it has to earn its keep.
And you give up the privacy a workout would have kept. You will also need to comply with many more reporting requirements. You have to turn in monthly financial statements and a budget. With new technology, this information is easier than ever for the general public and interested parties to access.
Not a Black-and-white Decision
The choice between a restructuring and Chapter 11 is not a black-and-white decision. It depends on many factors, including your current liquidity situation, how many creditors you have and your relationship with them. Both are intended to get the company back to a viable and profitable position. But the journey is quite different. Either way, a successful turnaround requires a series of deliberate, strategic decisions.
