As a savvy M&A professional or business broker, you come across difficult deals all the time. In the distressed space, those difficulties almost certainly center around the subordinate debt schedule. In some cases, there is too much debt on the balance sheet, which outweighs the core value of the operation to begin with. In others, the prospect of sunken time, money and opportunity cost involved with almost futile short sales make the proposition unattractive, while setting a very high bar on any potential buyer’s private valuation.
In this article, you will learn how a single, streamlined transaction can turn distressed, difficult situations into pristine ones in a matter of weeks. As a result, you will no longer be constrained to the “easy” deals and can change the way you assess the opportunities presented to you, either on the sell side or the strategic buy side.
The ability to turn “bad,” untransactable deals into great situations will add value to your model by scaling your potential deal flow. Additionally, this article will illustrate how the process of extracting value from a distressed business and eliminating subordinate debt will create incentives for all parties involved in the transaction.
A New Solution to a Common Problem
The inefficiencies involved with transacting in the distressed space can be understood in the context of the ultimate goal of any buyer, seller or intermediary: to extract and transfer the core value of the operation.
The bottlenecks to extracting this value are rooted in the highly inefficient yet most commonly understood method of liquidating business assets which is destructive to the core business value, as it preserves only the base asset value. Therefore, liquidation traditionally understood, is a non-starter as it offers no opportunity to retain core value or leverage a transaction.
This has left intermediaries in the position of seeing attractive core business value, but finding it untransactable at the same time. Alternately, if the transaction is to be facilitated, attempts at complex global settlements are very often the point of failure.
This no longer needs to be the case.
While many are familiar with Article 9 of the Uniform Commercial Code as a means of transacting on an asset base in a private sale, most are missing the big picture. Yes, Article 9 benefits 1st position secured creditors by allowing them to transact on their collateral with the assurance to third parties that assets will be unencumbered after the transaction. Yes, all subordinate creditors and liens are removed.
But here’s what many don’t know.
The assets liquidated via an Article 9 transaction can be sold into a new purchasing entity. The full continuity and core value of the business operation are preserved in the creation of a pristine, transactable enterprise.
The Article 9 short sale transaction is very different from traditional short sales because it requires only the consent of the 1st position secured creditor, who is incentivized to recover maximum value on their collateral. This means the transaction is frictionless because incentives are aligned.
Furthermore, the transaction is streamlined. After a 10-day notice period to subordinate creditors, the assets are transferred to the new purchasing entity, free and clear. The sale is seldom challenged by subordinate creditors because, by definition, the valuation of the assets will be less than the outstanding obligation to the 1st position. And since the appraisal is conducted by/with the 1st position creditor whose interest is in a maximum valuation, it is unlikely subordinate creditors would challenge the transaction based on consideration.
The strategic Article 9 short sale represents a rational means of liquidating business assets because it preserves ongoing concern value resulting in the creation of pristine transactable entities. That means “bad” or difficult deals can be assessed in a very different light.
Finding the “Bad” Deals
You know what these look like. These are the deals you dismiss because there’s not enough value to cover the seller’s needs, the creditor’s needs or your fees.
The most critical aspect of distinguishing a good transaction from a bad one is understanding how the value of an insolvent business is measured. For starters, it’s important to keep in mind value is not the same as revenue. Whether the company is losing money or underwater, when its debts are greater than its assets, the measure of value is determined by GAAP—Generally Accepted Accounting Practices—which are equal to the liquidated value of the collateral. Once this is determined, you are faced with one of the following two scenarios:
The business’ market value and or asset value is less than the debt owed.
These situations become short sales, and you’re likely to discard them.
The business’ cash flow does not support the debt service.
It’s these situations you should view as full of potential. By removing the debt service in a distress situation, the money allocated to repayment returns to the stream of operational cash flow. This has the effect of enriching the company and shifts the books from red to black. Unsecured vendors will likely take a loss (there’s a silver lining to this that we’ll describe below)—freeing up even more cash to support the business.
A Win/Win for All Parties
Because the ideal candidate for an Article 9 sale is a business that doesn’t have the asset base or income sufficient to pay debts in full, this method can’t simply be used by any business owner looking to get out of paying his subordinate creditors. In short, the proper use of the Article 9 strategic short sale is self-enforcing. Furthermore, in the face of insolvency, it creates a win for every party involved, including all creditors.
The 1st Position Creditor
This creditor is allowed to take the collateral base—that is, the assets of the business—and transact on them in a private sale to pay down their outstanding debts. This action eliminates the need for traditional foreclosure, liquidation and the uncertainty of auction.
For this to occur, a 10-day notice must be sent to subordinate creditors. After the ten days, the subordinate UCCs are terminated, and the assets transfer to the new purchasing entity. In as little as two weeks, the creditor gets their maximum value because they can deliver the assets to the buyer, free and clear. This couldn’t happen any other way, because with subordinate liens still attached to the assets there would be no interested buyers.
The business owner can close on the short sale and successfully exit instead of filing for Chapter 11 or being forced into Chapter 7—a feat they likely thought was impossible. And this is not the only benefit of this outcome. The owner also has the opportunity to settle his outstanding personal guarantees—which additionally benefits the other secured creditors, since those debts would likely have been discharged in bankruptcy. Not only that, the owner can possibly earn from the transaction since the new buyer will be entering a new ongoing concern at the attractive cost of the liquidated assets; and thus has a margin with which to create seller incentives.
The buyer wins because she gets to enter into a business she would not have been able to otherwise, and does so at a price that is highly attractive because it is based on the liquidation valuation of the assets.
The Subordinate Creditors
These creditors get a faster write-down of their toxic assets. They get to take the tax benefits quickly and don’t have to deal with lengthy collections and legal costs on top of the bad debt.
For vendors, the worst-case scenario is losing the debt owed to them as well as the future revenues they might have received from the business had it survived. Because this strategy preserves operations and converts the company into a healthier entity, those same vendors can continue to do business with the new entity, likely on even better terms.
The Article 9 short sale preserves the value of the business operation itself. The business reemerges even stronger and lives to see another day. The employees of the company keep their jobs, and the families reliant upon those jobs continue to thrive.
As an intermediary, you win because you have turned a bad deal into a great situation: the new debt-free entity is now a saleable commodity. Not only that, you have created a competitive advantage in the marketplace because you have the willingness and means to do something others can’t.
An Alliance That Works for You
Second Wind Consultants has conducted more Article 9 transactions than anyone else. A strategic alliance comes at no cost to the intermediary because transactional fees are absorbed by the value add created for the seller of the distressed assets.
Here are three scenarios in which bringing a distressed situation to Second Wind Consultants can create the incentives that bring the deal to the closing table.
Scenario 1: You have a struggling business and a potential buyer
Let’s look at an example: Larry Lancaster has a manufacturing business he wants you to list and sell. The company has $5MM of debt—$2.5MM to the 1st position creditor (we’ll call it an SBA loan) and $2.5MM to subordinate creditors (lines of credit, MCAs, etc.). You do a market valuation of the business and arrive at $3MM, while the underlying asset value is $2MM. Any way you slice it, this is a short sale.
You also already have a buyer in mind—a private equity group, for example. Second Wind will take the reigns at this stage, organizing the short sale directly to the buyer. So the private equity group buys the assets for $2MM under an Article 9 sale. At the same time, Larry gets a $1MM earn-out that’s variable, based on performance, over the course of the next two, three or five years. This results in a successful transaction for the bank ($2MM), a successful sale for Larry ($1MM), and the buyer gets an attractive purchase price ($3MM) with their downside risk minimized because Larry’s $1MM is performance-based and thus contingent. Furthermore, if Larry hits his performance benchmarks, the private equity group meets the ROI they anticipated on the deal.
Scenario 2: You have a struggling business you want to salvage and sell for top dollar
In this scenario, Second Wind takes Larry’s manufacturing business and reorganizes it into a new entity using the Article 9, strictly for the purpose of purchasing the assets. The new company transacts on the business using the asset value ($2MM) and turns that business back around to you with the long-term debt no longer on the balance sheet. Now you can take your time and sell the new company for maximum market value.
Scenario 3: You have a struggling business, and you need help finding a buyer
In this case, Second Wind oversees the process from both ends. You bring us the distressed business, and we conduct the Article 9. Simultaneously, Second Wind finds a buyer for the entity and facilitates the sale, and you get your commission.
The Bottom Line
As you can see, creating an alliance with Second Wind Consultants can vastly expand your deal flow. These pristinely reorganized enterprises are now available to you for M&A activity, strategic buy side representation and leveraged buyouts.
M&A / Brokerage Activity
By working with Second Wind to eliminate a business’ excess debt and transform it into a saleable entity, M&A professionals, brokers and other intermediaries can begin valuing potential listings or opportunities based on top-line performance, gross margins and asset value rather than viewing the business’ debt structure as an obstacle to closing. Whether its buy side or sell side representation, an intermediary working with Second Wind will be able to value a company’s revenue, margins and EBIDTA and allow the Article 9 sale to handle the complexity of multiple creditors and UCC filings so that the purchaser receives the assets free and clear of the debt.
Strategic Buy-Side Representation
By working with Second Wind to eliminate a business’ debt and transform it into a saleable entity, you can represent any purchaser. Whether it’s someone looking to buy their first business, a current business owner looking to expand through acquisition, or an institutional purchaser—such as a private equity group—you will be able to arrange the acquisition of a target business based on the value of its assets.
Any additional intangible value of the company may be considered via a consulting or earn-out agreement with the previous owner that requires that the business performs at a certain level. This mitigates the initial cost of entering into any acquisition for your buyer, and it hedges the downside risk since the transaction is partially based on performance, assuring him that he will get his initial ROI. Furthermore, the outcome of this partnership removes debt as an obstacle to closing for you.
Because Second Wind can leverage strategies such as the Article 9 to strip excess debt off the assets of businesses you’re trying to sell, they can then be used to finance the transaction. Article 9 remove the liens and encumbrances on assets allowing the purchaser to use accounts receivable, existing equipment and possibly inventory to raise money to buy out the previous owner.
No matter the type of deal, your unique ability to stretch your client’s funds out over a greater number of transactions means they’ll be able to take on more acquisitions. This means higher profits for you, and the ability to leverage your expertise as the broker who can turn bad deals into great situations.
Your Competitive Edge
Business intermediaries need to be better, smarter and more focused than ever before, as automation has facilitated a flood of competition for the “good” deals. While all eyes are on this low-hanging fruit, few are paying attention to the so-called “bad” deals. Start the conversation with Second Wind today and find out more about how a strategic alliance can expand your deal flow, increase your ROI, incentivize deals that would otherwise not close, and give you the competitive advantage you need.
It’s up to you to know how to turn these overlooked opportunities into gold.
Dominate Your Niche
Niche marketing allows you to carve out a share in a fiercely competitive marketplace. Leveraging specialized expertise lets you dominate a subsector before others even know it exists.
If you are the best and most sought-after broker for the complex sales, turning around and making the most of the very same deals others throw away, you will command higher pricing and larger profits, and create brand recognition and loyalty because you do what others can’t.
An alliance with a transactional expert in the Article 9 process means you can take a struggling business—albeit one with a strong top-line and good gross margins—and transform it into a saleable commodity in less than 60 days, regardless of how complex the company’s balance sheet is. Ask Second Wind about how reorganization can divorce assets from existing debt while preserving the value of the ongoing operations, resulting in a benefit for all parties involved.