Commerce Partners- Business Reorganization & Expert Witnessing

Published in: Los Angeles Bankruptcy Formk Website and Commercial Lending Review, Volume 5, Number 1, Winter 1989-90. A Publication of: Institutional Investor, Inc., New York, NY.

OWNERS OF TROUBLED BUSINESSES usually must choose between two alternatives: to reorganize for the benefit of present owners or to reorganize and make additional changes in order to sell the business. When commercial lenders become involved in the workout of a troubled borrower, they may be asked to judge the troubled business's reorganization or sale plans.

This article will describe the physical and administrative problems of troubled businesses and some practical methods of reorganizing or selling them.

Typically, the commercial lender's involvement with a troubled borrower begins with a telephone call. The founder asks for a meeting to discuss good news and bad news. The good news is that the founder has decided to have a candid discussion with the lender about the business problems that the founder had been working hard to hide. The bad news is that the company is in trouble and unable to pay its debts. More good news is that the people responsible for the problems have been fired. The founder is requesting a loan payment moratorium combined with increased funding to allow him or her to continue business as usual—but to work out all of the problems. While rarely surprised at the extent of the problems, the commercial lender is usually dismayed at the business owner's simplistic view of their solutions. The lender must determine the viability of the founder's plans to reorganize or to sell the business.

If the founder, attorneys, and creditors have committed themselves to a change, critical choices must be made. If the founder has lost all desire to risk and to work hard, the business should be sold. If the founder, though discouraged, wants to make the business work, the business should be reorganized. Either choice requires that the business will not continue to operate as usual. The founder will have to adjust his or her personal and professional lifestyle.

To reorganize, every aspect of the company's physical, financial, and interpersonal activities must be analyzed without placing blame for past failures. The most difficult task is dealing with fears and egos.

A vital beginning to business reorganization is interviewing each employee. In larger companies, new senior management should interview all senior employees and a sample of clerical and production employees. Supervisors rarely understand or reveal all the production problems or know attainable production levels. Production employees can contribute procedures to improve product quality. Frequently, the best general information sources are the telephone receptionist and the janitor.

Outside suppliers should be interviewed. Sales representatives, computer consultants, bookkeepers, maintenance services, accountants, and attorneys will be able to provide realistic evaluations of employees, perspective on the company's history, and recommendations for reorganization.

Troubled companies use available people to fill positions regardless of their ability or other work responsibilities. Employees rarely work in the area of their greatest expertise. Company procedures discourage them from giving information to management. Theft, discrimination, and petty disputes are common, resulting in resentment against the company.

Personal interviews should be used to determine employees' capabilities and to learn ways to redefine jobs to use their skills best. Interviews should be in employees' offices. They should begin with assurances that no one is to be fired and that you would like to know about four topics:

Most employees have-never been asked to evaluate the company, to make suggestions for solving its problems, to name other employees who are productive, or to describe their own career goals.

The five most important suppliers and customers should be interviewed immediately. They can tell you about the company's problems and analyze employees and products. They want to protect the advantageous prices they have achieved because of the company's lack of organization, negotiating power, and financial sophistication. However, they will be able to suggest new products and ways to raise immediate cash through sale of unnecessary raw materials or machinery and discontinued inventory. Because you have assured them that they are advantaged insiders, they will reveal industry, competitive, and product information. They may begin to pay bills more promptly or to supply credit, once they believe that they are an integral part of the company's reorganization.

Most companies' early products are well conceived and successful. However, the company may have drifted away from its profitable basic products.

Each product line should be analyzed separately and a 90-day rehabilitation period established. If the product has not become profitable in that time and it is not a component of a profitable product, it should be eliminated. Sales representatives, customers, and suppliers may have suggestions for salvaging the product or information about its effect on cross-sales. If customers and suppliers are involved in the decision to eliminate a product, resentment and industry gossip about the longevity of the company itself will be reduced. All production and marketing groups should be included in these discussions to ensure that no reasons for keeping an unprofitable product have been overlooked.

Since the company needs cash, it must decide what can be sold immediately. Troubled companies have aged inventory and excess machinery, equipment, tools, boxes, and trucks. Like outdated clothing, these items have little future value. After reserving items that will be used in 60 days,

A production analysis (which analyzes how products are produced, raw materials used, and personnel and machines allocated) will reveal which workers and machines are idle occasionally and which raw materials are wasted. It is probable that sales are not sufficient to keep the machines consistently working without creating excess inventory and incurring raw materials costs. A company with excess capacity may contract with industry competitors to perform contract labor. Although fabricating products for others does not build the company's name recognition, it raises cash, employs workers, and opens a new source for supply of raw materials, through purchases directly from the competitor or from its suppliers at quantity discounts. In addition, it acquaints a potential acquirer with the company's capabilities.

The physical plant should be examined to determine other uses for it. Renting buildings, unused machines, or even parking spaces all are possibilities. Space may be converted to retail stores or subleased for storage. Any benign short-term use of facilities should be explored. Immediate income, exposure to new products and ideas, and revival of on-site enthusiasm result. The reorganization manager's motto should be: What doesn't sell as steak, convert to hamburger—even sausage.

Most troubled companies have inadequate financial controls. Often, the controller is the first to leave a troubled business. Without a cost accounting system or reliable information, the company is unaware of the actual cost of its products. Many companies will pay creditors only after many demands and have no method for organizing payables. An elaborate computer system may be unused because the one employee who knew how to work it has left. Systems for accounts receivable collection, customer credit analysis, accounts payable, overtime and comparative salary analysis, and raw material costs comparison must be reestablished.

Pinpointing financial issues is critical. The accounting systems should be analyzed by new accountants or financial personnel to suggest changes and improvements. The computer software may not be used to its fullest, so a computer expert should describe to management all of its capabilities. Raw material, labor and overhead costs should be calculated for each product and cost accounting systems established. Financial personnel should be given specific tasks so it is clear what capabilities and competence each person has. Accounting personnel should meet with management, production and sales personnel to explain uses of financial statements and realistic sources of information. Both management, and creditors from whom management seeks cooperation, must be kept accurately informed of the company's financial progress.

Typically, the production, marketing, sales, and accounting departments and corporate staff of troubled companies do not cooperate. Committees including representatives of each of these functions should be set up to oversee production, marketing, and credit. No customer's order should be taken before it is agreed that corporate can buy the raw materials, production can fabricate in time, sales accepts the price, and credit approves the purchaser. Production supervisors should meet every day to ensure they are working together and supporting the needs of customers as (realistically) defined by the sales department. Damaged raw materials should be recycled if the cost of repairs does not exceed the cost of new materials.

Employees from each function should be represented on a reorganization committee. Janitors, machine operators, and drivers are as important as managers and executives. All can provide valuable advice about goals and timing. In addition, production workers who are consulted become convinced that the company will listen to them, cares about them, and will survive. The reorganization committee should meet every few days or whenever a crisis occurs. A crisis team headed by a senior executive should establish specific procedures for dealing with crises or angry customers immediately.

Senior managers should visit every department at least twice a day. Talking in a friendly way with everyone provides new information and an opportunity to observe and is reassuring to employees. Immediate supervisors should be the only ones who correct workers, but everyone pays extra attention when executives are walking by. Workers have a greater interest in helping the company when they have access to managers. Creditors or potential company acquirers who tour the plant will be impressed when senior managers know where things are and show they can achieve the friendly cooperation of workers.

The survival and growth or sale of a troubled company depends on inspiring confidence. Unless reorganization activities quickly produce both positive results and positive perceptions, the company will not survive. Employees who understand operational changes and believe that they will be effective develop confidence in the company and their roles. This confidence makes the changes work more successfully and is observed by creditors, customers, and the industry. Managers should not share their personal doubts about the company's future with employees. A successful reorganization converts hope to confidence and confidence to performance.

All the reorganization activities listed above aim to improve short-term income. The reorganization manager is fighting for the company's survival. Both secured and trade creditors must see immediate improvement in the company's income, or they will be unwilling to support reorganization activities or even the company's continuation in business. The company should give customers discounts for immediate payments and use available cash to obtain discounts from suppliers who offer them. Customers who pay slowly should be served last. Creditors who provide no early payment discounts should be paid last.

Employees must be encouraged to work without salary increases and excess overtime. Managers should have the same restrictions placed upon their salaries and fringe benefits. Expense accounts should be analyzed carefully. Incentives should be given for increased production and cost savings. All personnel should be assured that they will be compensated for their sacrifices after the company has survived and grown. Suppliers and customers should receive the same assurances. New customers should be solicited, particularly from the company's largest competitors, to provide income and to give competitors a reason to contemplate purchasing the company rather than waiting for it to die. The company should establish phased long-term material purchases to obtain immediate quantity discounts. At least one major long-term customer should be acquired. This builds employee morale, industry reputation, and creditor confidence.

Once a company's troubles are publicized, suppliers demand to be paid in advance or at delivery. Customers begin to seek other sources. Rarely do customers or suppliers believe that the company is a better credit risk after a Chapter 11 filing. Suppliers must be convinced that they are important to the debtor, that the debtor is stronger because prior creditors are not being paid, and that they are most likely to get paid and to continue to benefit from the debtor's business if it is not liquidated. Unless the secured creditor has an all-inclusive priority lien, these arguments are true.

Beginning with small amounts of credit and short payment periods, credit must be reestablished. Suppliers often can be influenced by the Chapter 11 requirement that a debtor-in-possession's checks must always be good when written.

It is essential to have immediate, candid, and optimistic discussions with important customers, distributors, and salespersons to convince them that the workout plan will succeed. They must be assured that management will become more responsive. Customers who make suggestions for change will have an emotional stake in the workout.

Customers will want to maintain the low prices and advantageous payment terms they have obtained because of the company's previous problems. They must be assured that they will not lose those advantages (even if they are slowly decreased) and that they will receive special treatment because of their value to the reorganizing company. Potential acquirers demand a strong customer base. Customers who have remained loyal through difficult times have great value to a potential acquirer.

Competitors have been criticizing the company for years. A change in management as part of any reorganization gives credibility to rumors of decline.

The industry must be shown that creditors, customers, and employees are optimistic about the company's future. The fastest way to communicate this positive message is to mail a candid, but optimistic, letter to the company's entire mailing list. It must be truthful, acknowledge past problems, and indicate cautious optimism about future prospects. It should mention and analyze the reasons behind competitors' negative statements. Using any newsworthy event, announcements should be frequent. The company should attempt to acquire new customers from major competitors to convince the industry of future viability.

Acquirers will begin serious negotiations to buy the troubled company when survival or a potential sale to a competitor become possibilities.

An appropriate mix of long-term and new employees combines company knowledge and loyalty with new ideas and methods.

Industry buyers will bring their own senior management. Investors require that virtually all senior management be in place. Present employees should have their jobs redefined to use their greatest capacities. Missing management positions should be filled with experienced persons. Although recruiting for a troubled company is difficult,

experienced industry personnel are always available. It is more important to have someone good in place immediately than to wait to hire someone great.

Experienced industry persons lend significant credibility to the image of the company's continuation. They bring personal knowledge of the personalities of competitors, potential acquirers, and the future directions of the industry. Present personnel know how to get things done but may not be able to initiate new ideas. New employees may not recognize the company's limitations but they provide new methods, products, and customers. They are more willing to be more optimistic to a potential acquirer because they are not afraid of changes in policies or activities.

Industry acquirers will be familiar with both present and new employees and will observe the company's improvements. Industry acquirers want to expand their product and customer base and need most of the troubled company's key personnel. Investors need the company to be fully staffed, since they do not intend to be involved in daily operations.

Most troubled companies can consolidate operations, use assets in a more productive way, and produce significant returns. These activities, however, require working capital that lenders will not lend and the company cannot generate. A company that creates a specific plan for reorganization, supported by independent experts, enhances its sale value. The potential acquirer is shown the potential profits from a capital infusion, improved management expertise and organization, and efficient and creative use of assets. The more definite and professional the reorganization plan, the easier it is for the acquirer to visualize success.

A reorganization plan must be based on analyses of manufacturing, marketing, machinery and equipment, and real estate. An industry expert can show how to consolidate operations and can discover excess plant, equipment, and real estate. Hiring a recognized expert is worthwhile, even when the company cannot afford to execute the consultant's recommendations. The consultant can offer objective and cost-effective analysis that is credible to potential acquirers.

Excess land and buildings may be analyzed by a real estate broker and architect. Alternative preliminary land plans can be inexpensively developed. This demonstrates how the company has both manufacturing and real estate assets and attracts a new group of buyers. Many real estate investors are also seeking non-real-estate businesses for diversification. Business investors are similarly interested in the economic allure of real estate development. Preliminary land planning combined with free real estate broker marketing analysis, yields creative, but inexpensive, real estate projections.

The recent case of a manufacturing and distribution company (Western Company) illustrates these principles of successful workouts. Based in Los Angeles, the company ships products throughout the United States and Canada. It was founded about 25 years ago by a creative, sensitive, and brilliant expert in product development and manufacturing who remained the chief operating officer and sole shareholder. The company had four products. One was a monopoly product; one was the highest quality product for its price; two were overpriced in a highly competitive market (these were the company's original two products).

Western Company operated on a 15-acre site with nine buildings. There were four unassociated investment properties. In its heyday, the company employed more than 350 employees and operated three eight-hour shifts six days each week. Secured debt exceeded $21 million, unsecured debt, more than $3 million. The founder had guaranteed and cross-collateralized all the secured debt and part of the unsecured debt. After filing for bankruptcy under Chapter 11, the founder retired. I assumed responsibility for operations, and the company was represented by insolvency counsel and the financial restructuring division of an investment banking firm.

The physical consolidation would cost approximately $500,000 and take as long as 90 days. However, because of the tremendous amount of excess machinery, no production function would be completely down if the machinery were moved in stages. Consolidation also would reduce production employees by approximately 40%, create effective physical controls and manufacturing flow, and make available for other uses six empty buildings on nine acres of land

An architect/land planner and a real estate broker also analyzed the Western Company. They created plans to use six acres and three buildings for company offices and production facilities. Three uses were proposed for the excess nine acres: industrial park, mini-warehouse and open storage facility, or apartment project for low-and moderate-income individuals aided by federal and state subsidies. The cost for subdividing the land and obtaining zoning approvals was approximately $500,000. It would require about 18 months to complete the planning, approval, and subdivision process; then, the land could be sold in a ready-to-develop condition. Building construction was expected to require approximately 14 months for the apartments, 6 months for the industrial park, and 4 months for the warehouse. Several developers began negotiating to become the real estate joint venture partner.

Analyses like these show the buyer that profits can be attained with a minimum injection of capital and management. These ideas help the acquirer to visualize reorganization plans and opportunities for profits. They make clear the downside risk of loss. The potential acquirer sees how he or she could use the company's assets and personnel in innovative and profitable ways.

Troubled businesses create unanticipated partnerships between debtor and creditors. In bad times, the debtor wants the creditor to be a partner; in good times, the debtor wants to ignore the creditor's ideas. Creditors must recognize that their economic interests are tightly bound to the debtor's ability to work out its problems. Both debtor and creditor must reevaluate every day whether it is in their interest to allow the company to reorganize or to force its liquidation.

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