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Bankruptcies Can Give Businesses a Fresh Start

Proactive bankruptcy can help a firm restructure its business and allow it to return to profitability sooner than it might otherwise be possible. Here’s how it works.

To a business owner or CEO, filing for bankruptcy may sound like the worst type of failure. But given the current economic climate, proactive bankruptcy can give business owners and CEOs a fighting chance to reduce debt and become profitable again—without giving away control.

A bankruptcy can achieve company-wide savings almost immediately, if done correctly. Filing for bankruptcy gives executives the leverage to renegotiate contracts, automatically stays business obligations and grants the organization the ability to repay its obligations either over time or at a reduced rate.

Cost Structure Forces Continued Bankruptcies

In the last few years, sales for most companies have declined and are finally beginning to stabilize and trend up. However, the new growth may be artificial, since sales are typically based on lower receipts overall due to the decline experienced during the depths of the recession.

Businesses that have not yet restructured may find themselves competing in a market in which they are unable to offer as favorable of terms to their customers as those businesses that have become more competitive by their restructured obligations and strengthened balance sheets.

Another crippling factor is the increase in the cost structure underlying most businesses, including the annual costs associated with maintaining brick-and-mortar locations, which may be locked into long-term leases for operations that are earning less with each passing year, dragging the entire company down in the process.

Overall, expense increases have outpaced revenues. With the increase in pressure from online rivals and shrinking profit margins, most companies’ ability to service debt and maintain their obligations has been drastically impaired.

An Unusual Solution: Proactive Bankruptcy

Many businesses that negotiated their debt and original lease obligations during the height of the market made commitments that are not feasible today. Rather than face dissolution of their organization and liquidation of their vital business assets and remaining cash, owners should consider proactively pursuing bankruptcy and restructuring their obligations.

Businesses often wait too long and, as a result, enter bankruptcy with a tarnished brand and a lack of cash resources to finance a Chapter 11. This unfortunate set of circumstances will limit the options available to a business owner or CEO facing bankruptcy.

As part of reorganization under Chapter 11 bankruptcy, companies have the opportunity to restructure while continuing to operate—often without having to hand over control of their business. Their financial obligations are automatically frozen while the optimal method of repayment is determined. Repayment plans are negotiated, usually providing businesses a debt reduction or lengthened repayment structure.

While it is relatively straightforward to renegotiate vendor contracts, multi-unit operators face more complex decisions when it comes to maintaining or streamlining their operations. Consolidating locations can be the best way to increase profitability. The transfer of sales from closed locations to those remaining, and the elimination of overhead as a result of those closures, can result in an increase in top-line unit sales and improved margins.

Round Table Pizza (Round Table), a company with more than 450 restaurants in the western United States, Asia and the Middle East, is a great example of how proactive bankruptcy can protect a business while it gets back on its feet. Faced with declining sales and profit margins at the same time its debt was coming due, Round Table filed Chapter 11 in February 2011.

This gave the company time to restructure its debt of $37million and close 22 unprofitable locations. Round Table also modified its real estate leases, reducing annual obligations by 22% and positioning the company to receive more favorable lease terms in the future.

Because Round Table filed while the company still had resources, marketing efforts continued throughout the Chapter 11 period. So even while going through the restructuring process, the company actually achieved same-store sales increases of 5% in company operations.

Round Table’s proactive bankruptcy proved to be a very wise choice. In less than a year, the company accomplished its restructure with a plan that paid back 100 percent of what it owed its creditors. Consequently, Round Table’s ownership was able to maintain its equity interest in the business.

Debt reorganization typically presents two options for debtors. The first is to secure exit financing from an outside lender to pay off the debt owed to the existing lender under more favorable terms or at an acceptable discount. The second option is to modify the terms of the debt with the existing lender. Either way, the debtor has to demonstrate to the court that the plan provides more favorable terms than liquidation.

About Dave Spargo

Dave Spargois a founding principal with Huntley, Mullaney, Spargo & Sullivan, a financial restructuring firm.