Bankruptcy and Restructuring
Bankruptcy occurs when a business becomes unable to produce the cash necessary to pay its debts. Once in bankruptcy, a company reorganizes their assets, equity, and debt in order to meet the needs of its creditors and minimize the losses of its shareholders. Several parties are involved; Courts, lawyers, and investment banking firms are all brought in to negotiate and come to an agreement on a bankruptcy plan. Plans can play out in several different ways, depending on the situation of the company and the type of bankruptcy. Two of the most common types of bankruptcies are Chapter 7 (liquidation) and Chapter 11 (reorganization/restructuring) bankruptcy.
When most people hear the word bankruptcy, the idea that comes to mind most closely resembles Chapter 7. Otherwise known as liquidation, a Chapter 7 bankruptcy involves a company’s assets being liquidated in order to raise the cash necessary to pay off its creditors. Investment bankers are brought on to head the valuation process, and they help the bankrupt company sell its assets during the liquidation. Chapter 7 allows a company to sell everything it owns and then walk away from the debts they are unable to resolve. Because this is unfair to creditors, filing for Chapter 7 bankruptcy is more difficult to accomplish than filing for other types of bankruptcies.
When a company doesn’t meet the requirements for Chapter 7, It may choose to file for Chapter 11 (reorganization) bankruptcy. In this case, allowing the company to continue operating would be more beneficial to creditors than liquidating the company’s assets because the company could continue to make sales to help pay off debt. As a general rule of thumb, Chapter 11 occurs when a company still has the ability to make money but has let its debt get out of control; Chapter 7 occurs when a non-viable company goes under.
The Restructuring Process
When a company files for Chapter 11 bankruptcy, it undergoes a restructuring process that will enable it to more quickly repay its debts and get back on its feet. In this situation, an investment banker’s job is more complicated than simply selling off assets. First, the bankers will help the bankrupt company with Debtor in Possession (DIP) Financing. DIP Financing involves a loan that becomes the most senior (first paid) debt, and it allows the company to secure cash to continue to pay the bills necessary for operation.
Next, investment bankers need to restructure the company in order to maximize efficiency and make paying off debt more manageable. There are two sides to the restructuring process; financial restructuring and operational restructuring. Financial restructuring involves negotiating with creditors to refinance loans and extend payment periods. Operational restructuring involves making changes to the company’s business model and management structure to make the business more efficient and profitable as a whole. The industry knowledge and expertise of the investment bankers are extremely valuable in the operational restructuring process, and the changes made in this stage have a great impact on how well a company is able to recover from a Chapter 11 bankruptcy. In any case, the restructuring process helps bankrupt companies by alleviating pressure from loan payments.
As a part of the Chapter 11 bankruptcy process, the company is re-evaluated and its makeup is changed. For example, A company originally has assets totaling $10 million, debt of $6 million, and $4 million in equity. After filing for bankruptcy, a plan is agreed upon that values the company’s assets at $5 million. Investment bankers determine that the business can only handle $2 million of its original debt, so $2 million becomes debt and the remaining $3 million exists as equity.
The company originally had $6 million dollars in debt and $4 million dollars in equity, and now has a combined value of $5 million for both. Since any business’ first responsibility in a bankruptcy is its creditors, the original stockholders lose their entire stake in the company, and the $5 million remaining debt and equity is distributed among the creditors. First, the debts owed to the most senior creditors are paid off; this allows them to receive fair compensation and cut ties with the company. Now, $4 million of the original $6 million worth of debt is left to be paid. To accomplish this, the company distributes its current $3 million worth of equity to its less-senior creditors, who can expect the company’s stock to rise as it recovers from its bankruptcy. The end result of a Chapter 11 Bankruptcy is that the creditors receive fair (or close to it) compensation, while stakeholders lose big.
The most difficult part of putting together a bankruptcy plan is the debtors and creditors coming to an agreement when re-evaluating the company. As a debtor, the company will fight for a higher valuation so that there might be some equity left over for the original stakeholders. As a non-senior creditor, a lower valuation means that the equity they will receive has the potential to increase by a greater amount as the company recovers.
Bankruptcy is a complicated process that involves several parties with obligations and goals. Courts, lawyers, and investment bankers act as intermediaries between debtors and creditors and work to find a viable solution. In Chapter 11 bankruptcy, a restructuring process allows the company to continue operating to fulfill its obligations to its creditors first. The experience and expertise of investment bankers play a large role in shaping a bankruptcy plan, and it has a great impact on how the company is able to re-establish itself to operate in the years to come.
(Credit to Khan Academy for Chapter 11 Bankruptcy Example)