Corporations have been increasingly defaulting on debt, with many businesses are struggling to maintain revenues and liquidity. Sometimes businesses aren’t prepared for market changes or a slump stretches longer than it should have, causing them to fall further into debt as bills pile up. Banks can seize business assets and liquidate as a last resort to cut their losses.
There are only three ways for distressed companies to make ends meet when things get bad:
- Issue Equity
- Liquidate Inventory/Assets
- Corporate Debt Restructuring
Each has its pros and cons, and many distressed companies will find themselves needing to pursue all three in times of need. Debts can quickly cripple a business, and negotiating more favorable terms with creditors is usually the best way out.
Of course, it’s easier said than done. Businesses restructuring debt typically do so because they’re having trouble meeting obligations, and it goes both ways. A B2B company may be in financial trouble because it’s having trouble collecting on its own outstanding invoices. Many businesses are both debtors and creditors.
With net 90 contracts so common, one well-established business defaulting can create a domino effect. That’s why it behooves everyone to understand debt restructuring.
When done right, corporate debt restructuring can get a distressed business the cash flow needed to keep the doors open. Creditors can cut their losses, and everyone can come to an agreement on how to move forward with a deal that benefits everyone involved.
What Is Corporate Debt Restructuring?
Debt restructuring is a mechanism where a business’s creditors restore liquidity by reorganizing financial obligations. Some level of distressed debt can be forgiven, although that’s far from the only option. Refinancing typically lowers monthly payments and interest rates in exchange for lengthening the timeframe of the loan.
Some creditors will accept equity and/or other concessions in exchange for debt forgiveness.
Regardless of how it’s restructured, creditors often choose this route to protect their investments. A company with large debt payments may still have cash flow coming into the business. In this case, liquidation isn’t the most financially viable solution.
There are four signs that a business that’s earning revenue is in danger of defaulting on its obligations:
Missed Contract Payments
Businesses often maintain contracts with employees, suppliers, vendors, freelancers, and other third parties. These unsecured debts come in the form of payments for goods and services already received, royalties, commissions, or salaries.
When a business starts skipping payments for these basic operational debts, it’s a major red flag that it’s in financial trouble. Individual parties may take legal action, and things start to snowball from there.
Past-Due Secured Debt
Just like individuals, businesses often have mortgages, vehicle loans, and other secured loans. Debt can also be secured using intellectual property, equity, and other soft debt. Missing payments on secured debt causes the creditor to repossess the property as recourse. If collateral is seized, it often occurs in court, leaving a record for other partners and vendors to dig up.
Indenture Agreement Violations
Some creditors issue bonds, which demand principal and interest payments. Many of these bonds come with supplementary written promises, such as maintaining specific levels of equity or cash, monthly/quarterly performance goals, etc. Transgressions on these minimum requirements can be catastrophic to shareholders and other creditors.
A business insolvency places all assets in the hands of the court to determine equitable distribution. Businesses that file for Chapter 11 bankruptcy have all of their affairs (debts, assets, or otherwise) reorganized by a judge. It’s a last-ditch effort to avoid a Chapter 7 liquidation bankruptcy.
Some major retailers filed for Chapter 11 bankruptcy in 2019, including Beauty Brands, Innovative Mattress Solutions, Things Remembered, Z Gallerie, Kona Grill, Perkins & Marie Callender’s, Sugarfina, Forever 21, and Barneys New York. Retailers Gymboree, Charlotte Russe, Payless, Roberto Cavalli, and Diesel filed Chapter 7 bankruptcies in 2019.
Each of these bankruptcies represents potentially tens of millions of financial losses for somebody. The question is who?
How Businesses Restructure Debt
When a court liquidates a business, it’s done in a very systemic way. The payout order is set by Section 507 of the U.S. bankruptcy code for personal bankruptcies. This is a good guide for distressed businesses to use when negotiating debt obligations. Here is the typical payout order:
- Employee Salaries and Company Taxes
- Secured Creditors
- Unsecured Creditors
- Senior Stockholders
- Preferred Stockholders
- Junior Preferred Stockholders
- Common Stock
The lower a creditor is on the list, the less likely it is to receive a payout during liquidation. This means they’re more likely to negotiate more favorable payment terms.
It’s not just a simple financial negotiation either. Often, these debt restructuring deals restructure the entire business model from the ground up. Forever 21, for example, closed 350 of its 800 stores during its Chapter 11 restructuring. Payless Shoes spent the past two years in bankruptcy court, initially only closing 700 stores before shuttering nearly 12,000 stores in 2019.
Sometimes a distressed company will be sold to another company for the liquidity. Even in these cases, the corporate and debt restructuring will occur.
Is It a Good Idea to Restructure Corporate Debt?
Corporate debt restructuring has its advantages and disadvantages. It’s not the most ideal situation, but it’s the least invasive way to gain liquidity in a pinch.
Advantages of Debt Restructuring
The most obvious advantage of debt restructuring is gaining instant liquidity. With monthly obligations lower, the business gains breathing room to fund business operations and development. Getting ahead of the courts is a sign of good faith that makes negotiations easier.
Debt restructuring also keeps everyone’s credit intact. Instead of missed payments dragging down credit scores, more affordable options are created.
Disadvantages of Debt Restructuring
It’s not all good news though. Debt restructuring can have negative impacts on the business. Vendors and employees may be tempted to jump ship knowing the business is in trouble.
Also, if it’s not done fast enough (or mutual terms can’t be reached), the business may be sued by creditors. The court can seize all the business’s assets and liquidate everything.
Final Thoughts on Distressed Debt Restructuring
Debt restructuring can be a messy business with so many stakeholders involved. Tough economic times call for tough measures to stay in business though.
There were 45 major business bankruptcies filed in 2019, and a large portion were in retail. The 2020s are sure to be filled with even more debt restructuring as businesses try to stay lean and compete.