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Hello,
Buying a business can be complicated. Buying a
distressed
business, while often a low-cost way to expand, only ratchets the degree of complication up further.
Distressed businesses can present opportunities to grow your business, just make sure you understand the additional elements involved.
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Charlie Goodrich
Founder and Principal
Goodrich & Associates
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So You Want to Buy a Distressed Company? Look Before You Leap!
Heard On The Street
About Us
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So You Want to Buy a Distressed Company? Make Sure You Look Before You Leap!
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When it comes to distressed companies, there are three kinds of buyers:
- Serial Distressed Investors
- New Distressed Investors
- Profitable businesses that have come across an opportunity to grow and expand, hopefully on the cheap
I haven't had many clients of the first two kinds. Serial distressed investors know what they are doing and need little help. Newbie distressed investors don't usually know what they are doing… but they also don't know they need my help.
So, this newsletter is intended for people who run a profitable business and have come across an opportunity to expand cheaply.
What do we mean by a distressed company?
Essentially, a distressed company is a business where liabilities exceeds the the value of a company's assets. Equity is toast and the business is (usually) insolvent, meaning it lacks the cash or liquidity to pay bills as they come due.
On the smaller side of things in particular, distressed businesses are insolvent because the company and creditors have waited too long. Yes, these companies often have other problems, such as poor management, products that are behind the competition, and equipment in need of upgrades or repairs. But, "regular" business can have these problems too.
Why buy a distressed company?
In most cases, it's an opportunity to add products, markets, geography and, perhaps, a sales force… all on the cheap.
For example, I had a construction staffing company client that looked at a company in bankruptcy because it could be a low cost way to expand its geographic territory. In a different example, a real estate developer wanted to buy land inexpensively to build condos. His plan was to buy a company in bankruptcy whose factory was on prime land. Then he would outsource manufacturing to China, bulldoze the factory and build condos on the bulldozed land.
How to buy a distressed company
Buying a distressed company is a lot like buying any business, so don't ignore the M&A basics. There are, however, several key differences:
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Due to a lack of funds in the company, there is typically not enough time to support a full blown due diligence process — or full blown sale process.
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Representations and warranties mean little because there will be nothing to back them.
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Unless certain legal protections are taken, the "stiffed" creditors will find ways to squeeze money out of you, the new owner.
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Often, a senior secured lender has the final say and not the business management or ownership.
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With those caveats in mind, follow these steps…
First, decide if you really need to buy the business to get what you want.
Can you just steal customers, the sales force, key employees, etc., directly? Remember, a distressed business often has already spooked its customers and employees. Always consider this option before signing any confidentiality agreement with the company or otherwise having the business let you look under their hood. Once you do that, your options for poaching staff, customers, etc., become limited.
Second , determine whether a transaction when you buy the business as a business is feasible.
Look for these problems:
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The business is burning cash so fast it will be shut down before you can buy it, or the employees and customers will be gone. If so, then what is left is a bunch of "parts." An ongoing business, even if performing poorly, is typically worth more than its parts.
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Is a fight likely regarding who gets the sale proceeds, or the ability to agree to a deal? This happens when multiple parties have claims they each think is senior to the same collateral. In the real estate investor example above, there was a collateral dispute between the working capital lender and the term loan lender on some shared collateral. And, much worse, the Pension Benefit Guaranty Corporation quietly filed liens that weren't noticed by the other lenders and that effectively trumped the other lenders' liens. I advised my client that he would spend a lot of money treading water until the lien mess was resolved.
On the ability to agree to a deal question, I advised the construction staffing company of such an issue. In this case, there were multiple state liens for unpaid taxes. Spending money to try and reach a deal with three state governments simultaneously would have been a long, expensive hill to climb.
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Is there no secured party to drive the process? If not, there may be no one willing to facilitate the process with money. This is rare, however.
To get answers to the previous two questions, always have a lien search done. Not doing so can be expensive. Sometimes you will find other problems too.
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Are key contracts you need realistically assignable? Can the other party say no and are they likely to do so? These are issues in "regular" M&A too. But in distressed M&A there may be large unpaid bills to pay, performance defaults, and the likelihood that the other party will want to make sure you are sufficiently capitalized and staffed to deliver your end of the contract.
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Third, get good legal counsel and a financial advisor.
Perhaps an investment banker too. The key here is to use those advisors who do this kind of thing for a living. Distressed M&A is not the same as regular M&A from both a legal and financial perspective. For the legal help, consider retaining counsel that practices in the state where the business is located or has most of its assets, particularly for smaller transactions. Why? The state law mechanisms and legal issues to buy distressed businesses can vary substantially by location.
Fourth, determine who really calls the shots.
Typically, this is what is known as the "fulcrum creditor:" The one who won't get paid in full from the sale proceeds, but who will get something. The senior lender
above
the fulcrum creditor will get paid no matter what, so is ambivalent. The creditors
below
the fulcrum creditor will get nothing, or at best squeeze a few crumbs from the fulcrum creditor, so they don't count. In smaller companies, the fulcrum creditor is often the senior secured lender. In more complicated capital sources, this can be a junior secured lender.
Fifth, determine the legal mechanism to buy the company.
Here is where local distressed counsel and the right financial advisor can really help. It's also where the way in which the fulcrum creditor wants the sale done really matters. The lender can put in a receiver with particular Court appointed powers, or the lender can do what is called a secured party or Article 9 sale. And there is always bankruptcy as an option. There are other ways too. But here, the fulcrum creditor doesn't want the stiffed creditors coming after them and neither do you. That is what this decision is really all about.
Sixth, consider increasing your control over the process.
How? Either become the senior secured or secured fulcrum creditor by buying their loan or, lend the company money in a way that makes you senior to other creditors. This is hard to do safely outside of bankruptcy. (Inside of bankruptcy it is called a DIP loan, a topic too complex for even an entire newsletter!)
Conclusion
Buying any business can be complicated. Buying a distressed business, while often a low-cost way to expand, only ratchets the degree of complication up further.
So be careful. There are lots of pitfalls for those who haven't done it before. You'll need to consider all the basics of any M&A transaction, along with these additional considerations.
That said, lowering the cost of investment always increases the return on investment.
Don't ignore distressed opportunities to grow your business.
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Please share with your colleagues
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Economists
Brian Reinbold
and
Yi Wen
with the Federal Reserve Bank of St. Louis explain why the US has a balance of trade deficit and why there has been a decline in U.S. Manufacturing employment.
The reasons for each are not the same. Read why
here
.
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Goodrich & Associates is a management consulting firm. We specialize in helping our business clients solve urgent liquidity problems. Our Founder and Principal, Charlie Goodrich, holds an MBA in Finance from the University of Chicago and a Bachelor's Degree in Economics from the University of Virginia, and has over 30 years experience in this area.
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