Expert Insight

What to Do if Your Business is in Financial Trouble

By Edmond P. Freiermuth, Vistage Speaker

While CEOs should devote their time and energy to growing the businesses they own or manage, they also have a responsibility to address financial difficulties before they turn into serious problems. Financial problems that go unresolved can rapidly escalate into a business-threatening crisis.

Given the current economic headwinds, all Vistage members should be aware of the devastating nature of bankruptcy and the ways it can be avoided. For most small and medium-sized businesses, the cost of bankruptcy (lawyers, professional services, etc.) is astronomical and success rate of bankruptcy is minuscule. Contingency planning for financial troubles is not an uplifting activity, but it is necessary--and a strong motivator--to head off problems before they become threatening. This article will focus on the best ways for financially ailing businesses to mitigate serious problems and get back on track as soon as possible.

Red Flags That Signal Impending Business Problems
Many early warning signs of financial troubles are common to virtually all businesses. When ignored, these warnings can lead to illiquidity (the inability to meet maturing obligations when due), or insolvency (the inability to remain a going concern without resorting to crisis management). If your business is experiencing the following early warning signs, the time to act is now.

Management time is increasingly used to resolve problems with impatient creditors; accordingly, efforts at maintaining sales volume are being diluted.
Accounts payable as a percent of cost of goods sold have increased, indicating that the business is "leaning on the trade."
Supplier demands for C.O.D. payments are sidestepped, and searches for new or additional sources of materials are initiated.
Accounts payable have been converted to notes payable.
Requests have been made for a "temporary" increase in an already too-tight line of credit.
The owners of the troubled business have begun to execute personal guarantees as a means of deflecting creditor demand for payment or threatened lawsuits.
The borrowing base, the most readily available source of cash from the bank, has been exceeded.
Accounts receivable have become progressively stretched, resulting in increasing ineligibles and the powerful temptation to pre-bill (that is, create an invoice for products or services not yet delivered).
Accounts receivable have been converted to notes receivable, weakening the working capital of the business.
The credit and collection function has been inadequately managed as indicated by a sharp rise in write-offs of uncollectible accounts receivable.
The customer base has become too concentrated, leaving the business vulnerable to the loss of a major account.
Inventory as a percent of cost of goods sold has risen, suggesting that staleness or obsolescence is now a potentially serious issue.
The discovery (after taking a physical count of the inventory) of missing items that require a write-down, producing a loss from operations.
Deficit cash flow from operations has unwittingly been "financed" by creditors.
Net working capital has actually turned negative which means a "cash flow crisis" is probably imminent.
Financial and operating data on the performance of the business have become irregular, untimely, or inaccurate, resulting in inconsistent or conflicting reports to its lenders.
A restatement and/or reclassification of prior period financial data as a result of changing auditors or altering the method of presentation (from a "compilation" or a "review" statement to an "audited" statement).
The company has become technically overdrawn at its bank and is "playing the float."
Payroll taxes and other funds held in a fiduciary capacity have been diverted to pressing business uses (like buying materials critical to filling an important order or meeting this week's payroll).
To reduce the cash burden, owners and/or officers begin taking advances (that is, "borrow") from the business in lieu of taking salaries, thus deferring income and FICA taxes.
As a result of operating losses, the debt-to-worth ratio of the business has declined to the point where it no longer "bankable," leading to further strains on cash flow.
Controls over purchasing and personnel have been in disarray.
Employee morale has dropped and the defection of one or more key sales or financial managers has begun to impair the normal flow of business.
Analysis of the problems is frequently focused upon external factors to the exclusion of relevant internal matters.
Management hasn't fully analyzed the profitability of each product line. Unit sales volume has shown a decline in recent years.
Selling, general, and administrative expenses as a percent of sales have grown.
Interest expense, including perhaps the imposition of a default rate, has been increasing at a faster rate than sales.
Sales forecasting has been continually optimistic, while actual sales and backlog indicate quite a different picture.
The relationship with the business's primary lender has weakened to the point that the business has been asked to find an alternative source of financing and no other lender wants to accept the risk, except at very steep interest rates.

If your business faces some or many of these situations, it’s time to start contingency planning for turnaround strategies or for out-of-court or bankruptcy reorganization.

Five Steps for Avoiding Bankruptcy
Step 1: Be personally involved in a detailed operational and financial review and analysis of your business. It’s all about the numbers. Creditors want to know the financial facts, not the reasons/excuses for not being paid.

To be involved is to:

Update the spreadsheet of fiscal year-end financial statements for the previous five years.
Be familiar with the most recent "management letter” on internal control structure from a CPA, if available.
Keep current on most recent interim financial statements.
Update the spreadsheet for the most recent accounts receivable aging and summary A/R agings for the last 24 months.
Update the spreadsheet for the most recent accounts payable aging and summary A/P agings for the last 24 months.
Know the details of the inventory report as of most recent month end.
Update list of major capital expenditures over the last 12 months and next 12 months.
Prepare a debt service schedule for the next three years.
Be familiar with the Borrowing Base Certificate provided to senior, secured lenders for the most recent month.
Check the calculations for the Loan Covenant Compliance Certificate as of the most recent month/quarter end.
Be familiar with all of the key terms and conditions of the Loan and Security Agreement with your primary lender.
Have an updated list of other secured creditors and collateral.
Know the key terms and conditions of your facility lease.
Be prepared to explain changes made in the senior management team over the last two years.

Step 2: Prepare a realistic and comprehensive 12-month cash flow forecast (see: Chapter 4 of Turnaround: Avoid Bankruptcy for more info on the process). Your forecast should be made with the assumption that all sources of new credit will be suspended until the business can again prove itself to be creditworthy. Think about what expenses the business can do without, and begin a scorecard to keep track of cost reductions. Multiple revisions of assumptions about sales, the driver of all variable costs and expenses, will be necessary. You should not rest until you and your management team have a "worst case scenario” that shows positive cash flow under the most dire circumstances. That may seem intuitive but getting there is a formidable process.

Step 3: Develop a new strategic plan based upon your firm’s precarious financial condition, but geared for resuming growth. This plan should review strengths, weaknesses, opportunities and threats (SWOT) and should create a profit enhancement planning (PEP) team.

Some goals of the strategic plan might include:

Make sure your organization is lean. Divide employees into three categories. "A" performers are motivated, highly skilled in their positions and indispensable under all but the most draconian scenarios. "B" performers are less experienced but "up-and-comers" able to handle new responsibilities. "C" performers are able to keep their jobs only during periods of strong economic growth. The split among these employees is roughly 10 percent, 80 percent and 10 percent, respectively. If you don’t know who the "C" performers are, you should find out.
Invest selectively in human resources, capital expenditures, new customers and new products until the business is clearly on the road to recovery.
Establish a system for rewarding employees with cash-based bonuses based on objective performance, not longevity or other subjective criteria. The starting point is an ambitious, but achievable, EBITDA target for the next 12 months. Bonuses should not be paid unless actual results are at least 80 percent of the plan. Achievement of higher levels of performance should be rewarded accordingly.
Prepare a marketing plan and motivate your sales force. Over the next year, the CEO should personally visit the company's top 20 customers and tell them how much their business is appreciated and how he/she intends to find more ways to be of service.
Train operating personnel so that customers’ orders are processed more timely and more accurately. Strive for order fill rates approaching 100 percent, so that customer satisfaction is as high as possible.

Step 4: Communicate with all creditors, simultaneously, in writing. Do not ignore, dodge or try to finesse them. Stop trying to negotiate individual debt settlement plans. Explain what happened, why it happened, and what changes are being made to solve the problems. All creditors are not the same. Those holding senior, secured claims (e.g., banks) and taxing authorities have rights and remedies that supersede those of unsecured general creditors. Over the years, I have written, and/or ghostwritten, scores of such documents. I can provide a sample to anyone having a need or interest but it is too long to include here.

Step 5: Present and negotiate a restructuring plan that includes specific payment proposals to the various classes of creditors, reflecting the ability of the business to make payments. Again, I have written many such documents and can provide a sample to anyone having an interest.

The preparation of an out-of-court plan to solve even severe financial problems, and then reorganize the business, is generally perceived to be the domain of attorneys and other professionals. However, financial turnaround consultants can help businesses find alternative, non-judicial means for resolving disputes, often in cases where the only solution seems to be bankruptcy. Although professional assistance is sometimes unavoidable, business owners/managers do not need to enlist the aid of a corps of attorneys, accountants, consultants and financial advisors. Make no mistake, however, self-managed business turnarounds do require extraordinary commitment and effort on the part of CEOs and other senior managers. When those qualities are coupled with action steps that make sense to all parties-in-interest, they can restore good relations with creditors and form the basis of a successful effort to turn the business around.

Using the Protection of Bankruptcy Court if All Else Fails
Using Chapter 11 of the Bankruptcy Code is the last resort that should be sought by a business in serious financial straits. The most compelling reason for addressing business problems in a pro-active manner is because most of the steps will be required of the owners and managers either in or out of Chapter 11. There is simply no way to avoid the hard work and anxieties associated with a business turnaround.

The steps needed to develop a plan of reorganization and a disclosure statement under the protection of the court are similar to the out-of-court process described in this article. Although some people who might argue differently, I believe the principal difference is the formal structure of the court-approved procedure and the need for attorneys to plead the company's case.

If you allow attorneys, et. al., to do the work for you, it will likely cost $100,000 to $250,000, assuming your business has an annual volume of about $5 million. Obviously, this will be proportionately higher or lower depending on the seriousness of the financial condition of the debtor, sales volume, number of creditors, relative strength of the secured and unsecured creditors and other factors.

In addition to the sizable (usually front-end) outlays for professional services, a number of other clerical and administrative headaches must be dealt with if your business enters a Chapter 11 proceeding. They include, but are not limited to:

Filing a list of the largest unsecured creditors at the time of the bankruptcy petition.
Filing a projected operating statement for the first 30 days of operation under Chapter 11.
Closing all existing bank accounts and opening new accounts immediately upon the filing of the petition. The new bank accounts must include general, payroll and tax accounts.
Closing the company's books and records as of the filing date and opening new books and records for subsequent operation of the business.
Procuring and filing a physical inventory.
Preparing and filing separate statements for each bank account for each day in which checks are drawn.
Filing weekly operating reports unless less frequent reporting is deemed warranted; however, the operating reports must be filed at least once a month.
Obtaining prior written authorization of the United States Trustee for the employment and compensation by the company of all officers, directors, shareholders or professionals. In other words, the business owners/managers face the possibility that they may be unable to remunerate themselves at the same level after filing the bankruptcy petition as before. And they may not have the ability to hire others at will. For privately owned businesses, which employ several family members, this can cause substantial financial hardship, as well as increased emotional and physical trauma.
Procuring the consent of the secured creditor(s) or court authorization to use "cash collateral." This effectively means the owners/managers may have to survive on even less net operating cash flow than was being generated prior to entering Chapter 11.

Failure to file the schedules and reports required in a bankruptcy case could result in the judge's dismissing the case— the assets of the business would then probably be foreclosed upon or liquidated. In essence, a company operating in a Chapter 11 bankruptcy proceeding is figuratively placed under a financial microscope. Every meaningful management decision is magnified and subjected to possible criticism by the court and creditors. An us-versus-them mentality can predominate meetings, and the margin for error is slim. Quite frankly, it is all too frequently a highly uncomfortable and stressful situation for everyone involved and, as oft-repeated in this article, should be avoided if at all possible.

I strongly believe that the arguments are compelling in favor of developing and implementing an out-of-court reorganization plan. However, there are several situations when Chapter 11 is the only way for a business to survive an all-out attack by creditors and successfully reorganize under the protection of the bankruptcy court. Such situations include:

Secured and/or unsecured creditors who are so skeptical of the incumbent managements’ turnaround competency that they insist that the business be sold or liquidated rather than reorganized as proposed by the debtor.

Secured and/or unsecured creditors may file lawsuits because they are not in favor of accepting an "unsupervised" (out-of-court) moratorium on debt repayment or a plan of reorganization. For example, a well-secured creditor might actually want to see the debtor operating under the watchful eye of the court to ensure that its security interests are not dissipated by further management errors.

Unsecured creditors holding substantial claims may independently seek writs of attachment, judgment liens or other legal forms of collecting debts owed them. Unless the debtor's principal secured creditor (usually its bank or finance company) files third party claims, the litigious creditors could have the court order successfully executed. Once one link in the fragile chain is broken, the debtor will have enormous difficulty resisting a bankruptcy filing.

In out-of-court reorganization plans, a majority of unsecured creditors cannot bind even a single dissident creditor to accept a debtor proposal. In a Chapter 11 proceeding, however, individual creditors or small groups of creditors who disagree with the majority can be compelled to accept the Chapter 11 plan if it provides them with a higher payout than would be received if the business were liquidated. Typically, a simple majority in number and two-thirds in dollar amount of all creditors can approve a Chapter 11 plan. This provision of the Bankruptcy Code is quite powerful in dealing with relatively small unsecured creditors who might attempt to hold large unsecured creditors "hostage" by threatening to prevent the debtor from consummating an out-of-court plan of reorganization.

It is virtually impossible for a small or medium-sized business with a sizable amount of debt to continue to operate without the court’s protection, if its primary secured lenders decide to stop advancing funds or opt to foreclose on collateral crucial to the operation of the business (i.e., accounts receivable, inventory and/or equipment). Under Chapter 11, an automatic injunction is created by the court prohibiting creditors from enforcing their claims against the debtor. While this stay, or moratorium, is in force, secured creditors cannot foreclose on their collateral. This gives the debtor time to develop a plan.

Chapter 11 allows the debtor to obtain “super-priority financing.” This allows a creditor advancing new funds on a post-petition basis with a security position that is senior to all previously incurred debt. Additionally, the ability to reject certain executory contracts (for example, burdensome leases and collective bargaining agreements) is also a powerful facet of the Bankruptcy Code.

It is, indeed, a great comfort to know that a business in grave financial difficulty can obtain temporary relief from dunning creditors by filing under Chapter 11. But let the petitioner beware: debtor-in-possession bankruptcy is not a panacea. Chapter 11 cannot solve even the most basic financial, marketing or operational problems of a business experiencing a continual flow of red ink. It is, however, an enormously powerful legal tool that affords a debtor a viable alternative to handing over the keys to the bank or finance company, or a liquidation of the business which causes great losses to employees, creditors and shareholders alike.

Preparing to File for Chapter 11 Protection
If it becomes necessary to seek court-provided relief under Chapter 11, do so vigorously. By definition, filing Chapter 11 means that a debtor has been unable to reach an out-of-court settlement or rearrangement with one or more classes of creditors. Filing also means that one or more potentially hostile adversary is bent upon preserving or protecting its own turf—usually to the detriment of the debtor or some other creditor class. There are several steps to consider taking before filing a bankruptcy petition.

Discreetly inquire about the best, most experienced insolvency lawyers in your area. Don't try to save a few hundred (or even a few thousand) dollars by retaining attorneys who are not specialized in bankruptcy litigation.
Provide these new counselors with all documentation relating to security agreements, loan agreements, stock purchase agreements, etc. It happens in almost every case—shoddy documentation on the part of creditors or their attorneys leads to vulnerabilities and willingness to negotiate.
With as much lead time as possible before filing, start building a war chest of cash. A business cannot have too much of this commodity.
Cancel all purchase orders and start developing a things-to-do list. In other words, circle the wagons and get ready for the attack.
Be prepared to make rapid decisions regarding the closure or suspension of business activities which are not being operated with positive net cash flows.
Prepare a current, detailed balance sheet, aging of accounts payable and a schedule of inventory and fixed assets.
Help your attorney prepare to argue strenuously for the use of cash collateral if your principal source of funds decides it no longer will support the company and intends to foreclose on its collateral, primarily accounts receivable. This requires a well-trained, highly experienced legal advisor. Don't lose your company because you sent an inexperienced attorney to do battle with the lender's legal counsel.
Look for legal ways to protect personal assets. This will be difficult because owners/managers of small and medium-sized businesses have probably used personally owned assets to shore up (collateralize loans for) the failing business.
Lastly, if none, or not all, of your personally owned assets have been used previously to secure loans, do not offer them in a time of crisis.

A comprehensive treatment of a Chapter 11 bankruptcy case is far beyond the scope of this article, and I defer to the professionals to dispense legal advice. Nevertheless, you should be made aware of a few additional legal factors. For example, who will run the company if Chapter 11 is filed? Will a "trustee" be appointed or does the debtor remain in charge? In the vast majority of bankruptcy cases, the courts will need to find good cause, including fraud, dishonesty, incompetence, or gross mismanagement by a debtor, before a trustee is appointed in place of existing management. Such causes are usually very difficult to prove without lengthy investigation. And, again, expert legal guidance and representation can protect debtors from vindictive creditors bent on seeing that the business fails.

The Chapter 11 Process
During the first 120 days of a Chapter 11 proceeding, the business, or debtor, has the exclusive right to file a plan of reorganization with the bankruptcy court. If the debtor does not file a plan in the specified period or, having done so, is unable within 180 days to obtain acceptance of the plan from each class of impaired claims, then any party-in-interest (the debtor, creditors, stockholders) may present a plan for consideration by the court. In certain cases the debtor can obtain a 180-day extension.

In the final analysis, a successful Chapter 11 plan of reorganization requires that a financially ailing business follow certain steps:

A creditors' committee must be formed.
Creditors must be classified and prioritized as to the types of claims.
Creditors whose claims are not impaired by the plan must be specified.
Creditors whose claims are impaired by the plan must be specified.
A repayment program must be put forth.
A method of payment must be determined.
The plan must be approved by all creditors whose claims are impaired (i.e., not proposed to be paid in full) by the plan.

If the worst case were to happen (the business fails and must be liquidated), would the owners lose everything? Almost, but not quite. The Bankruptcy Code exempts from creditor claims: a certain amount of equity in a debtor's residence (unless the asset was previously used to secure the repayment of a loan); a certain amount of equity in a debtor's motor vehicle; and a certain amount of the debtor's interest in household furnishings, clothing and appliances. Some states have higher dollar amount exemptions and debtors can choose such exemptions. In short, you can expect to end up poor but not penniless, and walk away with the shirt on your back.

The crucial question is: "Should the CEO and management lead the turnaround effort or should they allow their outside advisors to lead the way?" I clearly favor the former option and hope that after reading this article you concur.

Involuntary Bankruptcy Petitions
What is an involuntary bankruptcy petition? When dissenting creditors do not accept an out-of-court proposal for reorganizing a business, they can team up and attempt to force the debtor into a bankruptcy proceeding, either a Chapter 11 reorganization or Chapter 7 liquidation—and it's not very difficult. Three creditors with claims in the amount of $5,000 or more can initiate an involuntary bankruptcy case. This very rarely means that the business is being forced into a liquidation event. The probability is virtually 100 percent that the bankruptcy judge will allow the case to be converted to a Chapter 11 proceeding. It simply allows the debtor and creditors to have the ability to arrive at a court-directed reorganization plan.

If the bankruptcy court dismisses an involuntary petition, the court may make the filing creditors pay court costs and any damages. In instances of a bad faith filing, the court might grant compensatory or punitive damages. The potential liability for dismissed petitions may deter creditors from taking legal action without first determining the facts.

Chapter 7 Liquidation
If an owner comes to the conclusion that a business cannot be saved, he or she can figuratively “throw the keys on the table,” file for a Chapter 7 liquidation (at a relatively small cost), and walk away, provided that no personal guaranties have been executed to muddy up the water. Bankruptcy does not void guaranties.

There are other ways to wind down a dying business, including a general assignment for the benefit of creditors and allowing a senior, secured creditor to peacefully foreclose on its collateral. Readers can learn more about alternative ways and means of resolving difficult financial problems by reading my book, Life After Debt.

Filing Personal Bankruptcy
The failure of a business has an adverse impact on its owners, especially when alternative sources of employment or income are not immediately available. If this occurs, negotiations with creditors may also be required on a personal level. This can lead to the possibility of using the bankruptcy shield. As you probably know, the Bankruptcy Code was amended a few years ago.

I suspect that the most business owners that are members of Vistage would probably no longer qualify to file for Chapter 7. The new threshold for income and assets is so low that most individuals would need to file Chapter 13 and attempt to repay a portion of their debts over a multi-year period. If an individual had substantial assets but, regrettably, even greater liabilities, he or she might need to file under Chapter 11 to reorganize personal finances. This situation can arise if the business owner has personally guaranteed debts of the business.

Conclusion
With an increasingly risky economy ahead in 2008, Vistage members need to consider the tremendous benefits of addressing financial problems while they are still small. If unattended those small problems can turn into serious consequences.

Vistage Speaker Ed Freiermuth has more than 30 years' experience in financing and advising businesses of all sizes. He has worked directly with the CEOs and senior managers of more than 250 companies. As an independent business consultant, he works closely with lending officers, attorneys, accountants, venture capitalists, investment bankers and others seeking to resolve complex financial, marketing and operational challenges.

More Resources
In the mid-1980s, Edmond Freiermuth wrote two books on strategies and tactics for business owners/managers to maintain control of financially troubled businesses. While the books are more than 20 years old, the analyses, methodologies and recommendations presented in them remain relevant today. These books are offered as free downloads for those wanting more information.