A traditional sale/exit of an overleveraged business is unlikely to create a successful exit for owners, but a sell-side ‘reorganizational exit’ can create far more benefit for sellers, as well as business development opportunities for secured financiers.

When a business is overleveraged, i.e., when the value of the company’s assets is less than its aggregate liabilities, by definition, no equity value remains. In such a scenario, it is unlikely that buyer and seller incentives will align for a traditional sale transaction because the market value of the business does not align with a sale price required to resolve seller liabilities.

In such instances, outside of a wind-down and liquidation, preserving the underlying business value will involve a reorganization, such as the resolution and relaunch of distressed assets out of a 363 sale as part of a Chapter 11 bankruptcy process. The historic problem for sellers is that in such a process, it is typically the buyer who captures most or all of the upside of relaunching the business, with the seller benefiting only marginally.

However, if the seller leads the reorganization and relaunch of the business, it provides the seller with a path to meaningfully participate in the relaunched business, post-distress, and to exit successfully when the time is right, something that wouldn’t be possible otherwise.

For The Benefit of the Seller or Buyer?

Regardless of a businesses’ level of distress, investors target businesses because they have underlying enterprise value, with distressed investors seeking to capture that value without the debt through their own buy-side reorganizations.

In the context of this type of reorganization, the buyer controls the reorganization and therefore has the leverage to capture most or all of the transactional benefit of relaunching the business. Typically, in this scenario, sellers have almost no leverage and are left on the sidelines, hoping to mitigate personally guaranteed deficiency exposure.

Taking a deeper look at a buy-side reorganization, in such instances, because an upside-down business has no equity value, a distressed investor can capture control of the business with a cash injection equal to just the first position debt. Typically, the distressed investor’s strategy will be to take the company into Chapter 11 bankruptcy and acquire full control and ownership through a 363 sale (often at the cost of simply taking itself out of the first position debt). The buyer then captures the full “delta” between the discounted cost of inheriting the business on the one hand and its underlying enterprise value on the other hand. The previous owner is often left as distressed as before, facing personally guaranteed deficiencies and, likely, a personal bankruptcy.

In short, distressed businesses are sold in a buyer’s market, which is why a traditional ‘sale/exit’ will generally not result in a positive exit for the seller. However, the historic imbalance between buyer and seller in distressed/ special situations investing can be rebalanced to create successful exits for owners, as well as an opportunity for buyers through sell-side reorganizations.

The Sell-Side Reorganization

A seller-led reorganization hinges on a first position creditor’s UCC Article 9 sale of business assets, which resolves the assets of all liabilities below a bank’s asset valuation through the sale transaction. The Article 9 sale provides for a buyer’s ability to purchase the going-concern assets unencumbered from all previously existing liabilities. However, unlike in a 363 sale, for example, the seller has leverage in the Article 9 asset sale transaction, with that leverage deriving from the fact that the senior creditor’s Article 9 sale requires borrower consent. Therefore, in consideration of such consent, whereby the enterprise value of business assets will pass to the new purchaser unencumbered, the seller is able to negotiate incentives (as a non-owner participant) in the relaunched business.

In this type of sale transaction, the delta created between the cost of the assets and the enterprise value inherited by the buyer is the space within which the seller can negotiate participation as a path to deriving enough value to resolve personally guaranteed deficiency balances on the previous operating entity. In turn, the seller may also be able to negotiate re-entry into equity in the new operating entity, based on performance, such as achieving determined EBITDA targets. When the business is later brought to market as a non-distressed listing, the original owner can participate in the fair market value exit through vested equity or stock options.

By reorganizing and relaunching a distressed business on the sell-side, sellers can actively contribute to its revival as an alternative to a conventional exit. This seller-led reorganizational exit provides the leverage needed to obtain incentives that genuinely involve the seller in the business’ relaunch. This approach offers a seller an exit path to fully address liabilities and derive meaningful benefit from future success.

In this alternative form of an exit, a seller (rather than the buyer) initiates the reorganization of the business to resolve debt and capture underlying value in the business before going to market. In this way, sellers can create leverage to participate in the value that is otherwise monopolized by the buy-side. In addition, when a reorganization is initiated through the seller, a business can be brought to market at fair market valuations. As a result, the value and benefit created by the reorganization and relaunch are not exclusively the buyer’s, as the seller now has leverage to meaningfully participate and exit successfully.

A Real World Example

In a recent transaction involving a co-packing business in Southern California with historical revenues of $15 million annually, the business went upside down and became unfinanceable, with $10 million in sub-debt, $5 million of which was personally guaranteed. Here’s how things would have played out if the businesses took the buy-side reorganization path:

In this traditional sale exit model, a distressed investor would have reorganized the business by taking out the senior lender for the first position note ($3.5 million in this case), entering the business into Chapter 11 bankruptcy and ultimately obtaining the company at the cost of taking itself out of the $3.5 million first position note. The original owner then would be left with an employment agreement while facing $5 million in personally guaranteed debt and a potential personal bankruptcy.

Instead of following the buy-side reorganization, the owner took control through a reorganizational sell-side exit. The business was brought to market as a reorganizational opportunity, with all the debt to be resolved from the business operation through an Article 9 process rather than a judicial process. The owner identified a reorganization partner that would step in to acquire the business operation with no debt through the company’s bank’s UCC Article 9 sale of assets into the new operating entity.

In consideration of the opportunity brought to the buyer, the seller was incentivized with both a consulting compensation package (which provided the seller a path to resolve personal guaranties) and a stock option schedule tied to performance, providing for re-entry into equity within the relaunched business.

Prior to the reorganization process, the understood near-term enterprise value of the business was $13.5 million. Because the reorganization partner would inherit this value by satisfying the first position creditor for $3.5 million (as the distressed investor otherwise would have in the 363 example earlier in this article), a $10 million value-delta would be created by the seller in the transaction. However, unlike in the 363 version, the owner took control of the reorganization process from the outset. By initiating the reorganization and leveraging the ability to deliver value to the reorganization partner, the seller was able to negotiate an incentive package that allowed it to share in the upside potential of the relaunched business.

With 12 months of new financials established, the business was brought to market as a non-distressed co-packing facility and sold at a fair market valuation. The sale triggered both a buy-out of the remaining consulting contract and an exercise of the original owner’s stock options.

By result of the sale, the original owner captured a net benefit of $4 million, a truly successful exit particularly when measured against what would otherwise have been a $5 million liability through a buy-side distressed investment.

From a secured finance perspective, this reorganizational exit represented a two-fold opportunity. First, there was an opportunity in the reorganization itself, whereby a senior lender (bank) was taken out by an asset-based lender that financed the purchaser’s going-concern Article 9 asset sale/ purchase. Secondly, there was an opportunity for the asset-based lender in the form of a growing relationship with a healthy new business, along with the opportunity to finance additional equipment and accounts receivable lines moving forward.

Rebalancing The Scales

The sell-side reorganizational exit offers a rebalancing of the scales in the distressed space. When a traditional sale/exit is not possible because distress precludes the alignment of buyer and seller incentives, a seller-led reorganization may bridge this traditional impasse. By staking the seller more meaningfully in the relaunch of the underlying value of the business, more M&A transactions are possible, more judicial processes are avoided, more collateral value is preserved and further opportunity is presented for the role of secured financiers in the restructuring ecosystem.

ABOUT THE AUTHOR: Robert Dinozzi is chief growth officer and partner at Second Wind Consultants, where he is responsible for near and long-term corporate strategy, as well as industry-specific alliances for the value-added application of Article 9 restructuring in banking, alternative lending, private equity, investment banking and M&A.