Buying a Distressed Business

A distressed business is worth buying only when the cause of its trouble is something the buyer can correct and the liabilities of the past can be left behind. The low price is the easy part. The work lies in diagnosing why the business is failing, structuring the purchase so that old obligations do not follow the assets, and arranging enough capital to operate while the repair takes hold.

What distressed means

The term covers a range of conditions: declining revenue, operating losses, an inability to pay debts as they come due, a loan in default, or an owner who can no longer manage the company because of health, age or exhaustion. Some distressed businesses are fundamentally sound and badly run. Others are well run in a market that no longer exists.

The first question: fixable or structural?

Every evaluation begins with the cause.

Problems that are often fixable:

• An owner who is absent, ill or disengaged
• Too much debt on an otherwise profitable operation
• Weak financial controls, pricing or collections
• Neglected marketing or sales effort
• A dispute among partners
• Costs that have not been adjusted to current revenue

Problems that are usually structural:

• Declining demand for the product or service
• Loss of the one customer, contract or location the business depended on
• A competitor with a lasting cost or technology advantage
• Regulatory change that removes the basis of the business

A useful test is to ask what the business earned when it was healthy, and what specifically changed. If the answer is internal and recent, there may be something to recover. If the answer is that the market moved, a new owner faces the same market.

What a buyer is paying for

A business without earnings cannot be valued on a multiple of earnings. The price is based on what remains of value.

• Tangible assets. Equipment, vehicles and inventory at realistic liquidation or replacement value.
• Customer relationships and contracts that are likely to transfer.
• The workforce, where skilled employees are difficult to hire.
• Location, licenses and permits.
• The name and reputation, if they are still assets and not liabilities.

The buyer should also estimate what the business could earn once stabilized, and what it will cost to get there. The price should leave the buyer, who is doing the work and taking the risk, with most of the benefit of the recovery.

Structure: leaving liabilities behind

In distressed acquisitions, structure matters more than price. Buying the stock or membership interests of a troubled company means acquiring every debt, claim and tax obligation it has, known and unknown. For this reason nearly all distressed purchases are asset purchases.

An asset purchase does not provide complete protection. Several risks require specific attention.

Liens. Lenders, equipment lessors and tax authorities may hold security interests in the assets. A lien search identifies them. Assets must be released from liens at closing, which usually means the purchase price goes to the secured creditors.

Tax obligations. Many states can pursue a buyer for the seller's unpaid sales, withholding or unemployment taxes unless a clearance certificate is obtained before closing. Requirements differ by state.

Successor liability. Courts in some circumstances hold a buyer responsible for a seller's obligations, particularly where the new business is a mere continuation of the old, or in matters of employment, benefits, product liability and environmental contamination.

Fraudulent transfer. If an insolvent company sells its assets for less than reasonably equivalent value, creditors may later challenge the sale. A fair price, supported by an appraisal or evidence of a marketing process, and proper notice to creditors reduce this risk.

Contracts. Leases and customer agreements may require consent to assign, and counterparties who are owed money may demand payment as a condition.

Experienced legal counsel is necessary in these transactions.

Purchase paths

A distressed business may be acquired in several ways.

• A negotiated purchase from the owner, with the lender's consent where its collateral is involved.
• A purchase from the secured lender following default, through a sale of collateral under the Uniform Commercial Code.
• A sale in bankruptcy, in which a court can approve the transfer of assets free and clear of liens and most claims. This offers the strongest protection and involves more time, cost and competing bids.
• A receivership or an assignment for the benefit of creditors, state-law procedures in which a fiduciary sells the assets.

Each has different timing, cost and degree of protection. The appropriate path depends on how many creditors there are and how urgently the business needs new ownership.

Financing

Conventional acquisition financing is seldom available. SBA lenders must now demonstrate debt service coverage of 1.25 times on historical earnings, and a company with losses cannot meet that test. Buyers typically rely on other sources.

• The buyer's own capital.
• Seller financing, often on flexible terms because the seller has few alternatives.
• The existing lender, which may prefer to finance a capable buyer over liquidating collateral at a loss.
• Asset-based lending against equipment, receivables or inventory.
• Real estate, where the property can be financed separately.

Whatever the source, the buyer must also fund operating losses and working capital during the turnaround. Undercapitalization is the most common reason these acquisitions fail. A plan should assume that recovery takes longer and costs more than projected.

Diligence under time pressure

Distressed businesses deteriorate quickly, and sellers or lenders often want to close in weeks. Records may be incomplete. A buyer should concentrate on what cannot be fixed later.

1. Lien, judgment and tax searches.
2. The condition and ownership of the key assets.
3. The status of the lease and essential licenses.
4. Direct conversations with the most important customers and employees, as early as confidentiality permits.
5. A list of creditors and vendors whose continued cooperation is necessary.

After closing

The early weeks set the course. Stabilize cash by controlling disbursements and collecting receivables. Speak with customers and suppliers, many of whom have been treated poorly and will need a reason to stay. Tell employees plainly what has changed. Then address the specific cause identified in the diagnosis, since that is what the buyer paid for the opportunity to correct.

Who should attempt it

Distressed acquisitions suit buyers who have operating experience in the industry or an existing business to combine with the target, adequate capital, and a tolerance for uncertainty. They are a poor choice for a first-time buyer relying on the business for immediate income. For those equipped to do the work, they offer a way to acquire customers, people and assets at a cost well below what it would take to build them.

Twelve31 Advisors has particular experience advising acquirers of underperforming and distressed small businesses on evaluation, structure and financing.