Things to Consider Before You File for Bankruptcy

The current economy in the U.S. has put tremendous strain on many companies, particularly startups. Usually, our firm gets very few inquiries from companies that are facing bankruptcy and are looking for strategies, options and alternatives to bankruptcy. Lately, however, that seems to have changed.

With so many companies in financial trouble, the prudent executive has to ponder options that can best serve his company. Many executives feel that if their company is in extremis and is having difficulty paying bills, there is no acceptable alternative but bankruptcy. There are other alternatives.

Talking to Creditors

The very first thing that the head of a company must do is communicate with all major creditors and advise them in an honest and open fashion about the company’s situation. Most creditors would prefer to work something out with a debtor company rather than dealing with the bankruptcy court.

One very common agreement that comes to mind that can hold creditors at bay is a repayment agreement, either formal or informal (formal being in writing and signed by both parties; informal might be a face-to-face agreement addressing how the past due amount will be paid and over what period of time). With either of these agreements, the debtor company must be scrupulous in adhering to its terms. In the event that the company cannot meet a particular payment, the situation should be immediately disclosed and a remedy should be agreed upon.

Another common situation is where the creditor agrees to taking a certain percentage of the amount due as full payment. I have seen cases where a creditor company has taken 50 percent of the amount owed just to rid itself of the hassle and get needed cash quickly. Every situation is different and must be addressed uniquely.

The Risks to Filing for Bankruptcy

Before a company pulls the trigger and files for bankruptcy, the executives have to realize the risks to such a filing. The fact is, once a company is put into bankruptcy, much of its future will be determined by the creditors of the company with the oversight of the bankruptcy judge. This potentially puts control of the company out of the current management’s grasp.

The bottom line is that the company’s major creditors will have an inordinate amount to say about the future of the company, and it is not at all unlikely that they will also have a hand in actually running the company by virtue of the conversion of some of their debt to equity when the company emerges from bankruptcy. To avoid the situation where hostile creditors end up running a company, it is quite common for current management to look for outside sources of capital in order to become aligned with “friendlier” parties with whom they can manage the company in the future.

Therefore, it is obvious that much of the control of a company can leave the hands of current management in a bankruptcy filing. The executives of a company must fully address this fact before the final bankruptcy decision is made.

One alternative is to attempt to line up sources of capital as soon as possible. Then negotiate with these sources as to how much control you are willing to give up based upon how much new money is contributed to the corporation.

Creditors’ Committee

Under federal bankruptcy law, a creditors’ committee is established in order to give the creditors a common voice in the bankruptcy proceedings. With this common voice also comes control in that before a company is allowed to exit bankruptcy, the creditors’ committee has to approve the terms of the exit and has to convey such approval to the judge.

The fact is that if your company files for bankruptcy, it will be dealing with a committee that may be hostile and may want to wrest control of the company from current management.

That said, there certainly have been cases where management and the creditors’ committee have come to an equitable understanding whereby management keeps control of the company and the creditors are subject to minimal, if any, losses.

Prerequisites to a Filing

When all else fails and a bankruptcy filing is inevitable, there are certain prerequisites that must be met in order for the proceedings to unfold as smoothly as possible. The first obvious prerequisite is to hire a law firm with bankruptcy experience. Meet with the personnel from the law firm in order to fully explain to them what your current situation is and how you expect to extricate yourself from it.

Additionally, you must have a competent auditing firm that can produce current and accurate financial statements that fully disclose to the creditors and the court your current financial situation as well as projections about your future financial condition.

Finally, a cash-flow budget is essential. This budget is commonly prepared by management and projects where the company will be, from a cash standpoint, in the next year or two. This budget should be presented on a monthly basis so that the court and the creditors can monitor whether or not you are meeting your goals and retaining solvency.

A Difficult Choice

The choice of putting your company into bankruptcy can never be taken lightly. If there is any way to avoid such a filing, by all means do so.

If you absolutely must file, then total preparation is critical to the eventual successful exiting from bankruptcy as a stronger company. Good luck!

Theodore F. di Stefano is a founder and managing partner at Capital Source Partners, which provides a wide range of investment banking services to the small and medium-sized business. He is also a frequent speaker to business groups on financial and corporate governance matters. He can be contacted at [email protected].

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