To say there are intricacies in financing a company in a turnaround situation or bankruptcy is an understatement. Companies in these situations have a myriad of different problems that can range from being out of compliance with an existing lender, to overdue trade payables, or missed sales opportunities. These problems are closely interconnected to each other and may prove difficult for a company to overcome.

Providing financing to a company in a turnaround or bankruptcy situation can prove even more difficult and requires “outside the box” thinking. First, the finance company must decide whether the client is viable on an ongoing basis. Management is a very key component. What steps has management taken to turn things around? Do they have experience in this arena, or are they the same management that led the company down the wrong path to begin with? Next, several key items such as security issues and key business relationships must be addressed, and the new finance company must be creative and nimble enough to implement a structure that will protect it from many of those legacy problems that exist. An alternative form of financing such as transactional-based purchase order financing is a viable option for companies in order to finance sales growth in a turnaround and/or bankruptcy situation.

Let’s first examine a company that is in a turnaround situation. We’ll call it ABC Company. ABC Company supplies seasonal gift items to big box retailers. Seasonal businesses are inherently risky since the cash flow of these companies fluctuates significantly and working capital can be unpredictable. ABC’s business over the past two years has been down due to the sluggish economy. However, this year, the company’s backlog of orders has grown significantly. Unfortunately, ABC’s balance sheet has taken a significant hit as previous years’ losses have affected its retained earnings and payables and other short-term debt has ballooned. ABC’s senior lender is already in an overadvance position, and the company’s critical suppliers won’t extend additional credit to ship product. Therefore, the company can’t finance its uptick in business through traditional means.

Next, let’s focus on a manufacturer of skin care products that recently filed for Chapter 11 bankruptcy protection. We will call it XYZ Company. Previous ownership spent significant money trying to grow different business segments at the expense of the core business line. Unfortunately, the new business segments didn’t work out. XYZ has tripped multiple financial covenants with its bank and the bank wants to exit the relationship. While the bankruptcy filing helped alleviate much of the pressure from the unsecured trade debt, the company is on COD payment terms with most of its critical suppliers. The company’s ownership is unable to put any more money into the company as they have tapped their personal resources funding general overhead just to keep the company alive. However, the company’s backlog has recently grown back to previous levels. If the company had access to capital, it could begin to fulfill new orders and turn things around.

There is a common theme that resonates in both of these situations. Neither company has access to traditional financing or supplier credit to fulfill the spike in business. Purchase order funding can provide an excellent solution to help turn both of these companies around. The key is to understand how purchase order financing can be implemented. In any turnaround or bankruptcy situation, the company must be able to demonstrate how it plans to be a viable concern going forward. It must have a backlog of business that it needs to fulfill in order to benefit from purchase order financing. A purchase order finance company must also address and solve the following key issues:

1. Do you believe in the company’s plan and the management’s ability to execute? Is the backlog growing? Does the company have firm, valid orders in hand from credit worthy end customers? Are the sales projections believable? How are the margins trending? Can management grow sales and focus on growing margins and profitability? How exactly are they going to do that? Remember, it’s not necessarily the top line that matters, but whether the company is cash flowing positive. Cash flow is the ingredient that keeps companies alive and adequately servicing its regular obligations.
2.  Dealing with the existing senior lender — Are you secured? Is the existing senior lender willing to carve out specific collateral and subordinate its security interest to that of the purchase order finance company? The subordination will need to address matters such as priority rights of assets, co-mingling of physical collateral, control of cash, rights under default, etc. A purchase order finance company must address how to segregate and monitor not only goods, but also cash payments. It’s paramount for the purchase order finance company to implement a plan to monitor collateral and cash constantly and move fast if something goes wrong.
3. Dealing with the bankruptcy court — Are you secured? Under many circumstances, providing debtor-in-possession (DIP) financing can be a very secure way to provide new financing. DIP financing has a super-priority administrative claim in the bankruptcy, which means the DIP lender is the first creditor repaid upon confirmation of a reorganization plan. When there are multiple lenders providing DIP financing, it can become a bit tricky. What happens if the bankruptcy court recognizes the senior lender’s pre-petition rights in the bankruptcy plan? If the existing senior lender is not willing to provide financing going forward but demands to have priority rights in bankruptcy, the purchase order finance company must be comfortable with its position on specific assets and the rights to repayment in a default situation. If the existing lender is not willing to lend any further, the purchase order financer should demand a priority right to all post-petition collateral in order to provide new financing to the company and be adequately protected.
4. Dealing with the trade payables. If the company has filed bankruptcy protection and the reorganization plan has been agreed to, then the unsecured vendors are not an issue unless they are critical vendors that the company needs to buy from in order to continue operations. Regardless of whether the company is in bankruptcy or not, the purchase order finance company must identify those critical vendors and verify under what terms those folks are willing to supply product. If the critical vendors aren’t willing to do business with the company anymore, who will the company buy from? If the company has not filed for bankruptcy protection, and the trade payables are significantly overdue, the purchase order finance company must confirm what the company is doing to address those issues. Are there payment plans in place? What judgments have been awarded?
5. Dealing with the customer base. In a turnaround and/or bankruptcy situation it is critical that the purchase order finance company make sure the client’s relationship with its existing customers is in good standing. Many customers rely on their suppliers to be able to handle warranty or ongoing service claims. If the customer base gets wind of financial troubles, outstanding payments can be withheld or significant deductions can be taken unilaterally by the end customers. Additionally, future business can be affected if the customers are concerned about the financial wherewithal of the client.

In both scenarios detailed above, each company must find an alternate source of capital to help fulfill profitable backlog that can help get the company back on the road to financial stability. Purchase order finance is an excellent solution to provide the needed capital to fulfill orders when traditional financing and/or supplier credit simply is not an option. However, a purchase order finance company must have the foresight to address many of the day-to-day issues that could ultimately affect its position. A purchase order finance company must identify the critical components of a specific business and watch it closely in order to react quickly to any problems that may arise.

Bryan Ballowe joined King Trade Capital in 1997, and oversees underwriting and portfolio management at King Trade Capital. He is a principal and member of King Trade Capital’s Investment Committee. Prior to joining King Trade Capital, Ballowe was a global financial analyst for Bank of America, underwriting senior debt and high-yield bonds for companies in the media and telecom industry. He holds a B.B.A. in Finance and a B.S. in Economics from Southern Methodist University as well as an M.B.A. from Southern Methodist University in Corporate Finance. Ballowe is a varsity letter winner and member of Southern Methodist University’s Men’s Southwest Conference Championship basketball team.