Bankruptcy
Richard D’Aveni
A corporation is technically bankrupt under two conditions: insolvency or negative net worth. Insolvency occurs when a firm does not have the liquid assets to pay its currently due liabilities. Negative net worth is when the firm’s total debts exceed the value of its total assets. While technically bankrupt, firms are not ‘‘in bankruptcy’’ unless either the firm’s management or its creditors file a petition with the US Bankruptcy Court to place the firm in bankruptcy.
When placed in bankruptcy, the corporation’s management is replaced by or placed under the supervision of a trustee in bankruptcy. Trustees are typical when the bankrupt is a large firm or management fraud is suspected. The bank ruptcy judge may supervise the bankrupt firm directly without a trustee in smaller, more man ageable cases and cases not involving manage ment fraud. Unlike normal circumstances where the management has a duty to run a firm for the benefit of stockholders, once in bankruptcy, the firm is managed for the benefit of the creditors. The goal is to maximize the amount repaid to creditors, even at the expense of stockholders’ interests.
In some cases, entrepreneurs establish their businesses as sole proprietorships or partner ships, rather than as corporations or corporate like limited liability partnerships, because in vestors require the entrepreneurs to ‘‘put up’’ all their savings to show commitment to the success of the business. In the case of failed proprietorships and partnerships, the individual entrepreneurs may declare bankruptcy. They lose all their assets, except their ‘‘homestead’’ (their house and personal belongings up to a limited amount in value), but they gain a fresh start in life without any debts to repay.
In general, it is better to create a corporation or limited liability partnership to limit the entre preneur’s losses to only those assets invested in the business if a bankruptcy occurs. However, creditors and other investors may still ask for personal guarantees from the entrepreneurs, ef fectively extending an entrepreneur’s losses to some of his or her personal assets if a bankruptcy occurs. In an attempt to protect assets from such potential losses, entrepreneurs may place some of their personal assets in the names of relatives, in trusts, or in foreign bank accounts that are hard to reach before there is any hint of bank ruptcy. However, care must be taken to avoid fraud if such methods are used, especially if done to hide assets or deny their real ownership during a bankruptcy proceeding.
Types of Corporate Bankruptcy
Two types of petitions may be filed in the case of corporate bankruptcies: liquidation or reorgan ization. A liquidation petition asks the court to cease business operations and sell all assets, dis tributing the proceeds to the highest priority creditors first, typically secured creditors. The remaining proceeds go to lower priority, un secured creditors, and then to equity holders, if any funds are left over. Creditors rarely recover all their money in liquidation – otherwise, the firm would not be technically bankrupt.
A reorganization petition asks the court to continue some or all of the business operations of the bankrupt and to reorganize its debt and equity structure. In the reorganization, some debt holders may become stockholders. Some debt may be written off, or its interest rate or duration adjusted to make it easier to pay the debt after the firm emerges from bankruptcy. New investors may be sought and some assets may be sold, so some debtors may be paid out of these proceeds. Many possible reorganization plans could be adopted by the court. So inter ested creditors – and often management – sug gest different plans and a vote is taken among the creditors to advise the court. The vote is taken by class of debtors. That is, each group of se cured, subordinated secured, and unsecured debtors votes separately. More fine grained classes may be created by the court if the inter ests of the creditors within a class differ substan tially.
If all classes accept the plan, the judge gener ally accepts the plan. But this is rare, especially if the highest priority creditors get all the funds. So complex negotiations go on among the cred itors, and plans are formulated to entice the lower priority creditors to vote for them by offering some funds to them that they would not receive under the normal priorities assigned to them. It is rare that agreement can be reached among all creditors, even after negotiations occur. In this case, the court looks at the plans which gathered the support of at least one class of creditors. That class of creditors then at tempts to persuade the judge (based on the merits of the plan) to do what is called a ‘‘cram down,’’ which is exactly what it sounds like – the plan is crammed down the throats of the other creditors and shareholders. The judge has some guidelines for selecting among plans if more than one gains the approval of at least one class of creditors, but these guidelines essentially give the judge a lot of discretion to cram any plan down on the parties that he or she wants.
Smaller and entrepreneurial firms are typic ally liquidated because there are few tangible assets left to be used in reorganization. Liquid ation is especially likely if key managers, sales people, or scientists have departed before or during the bankruptcy process. But complete liquidation is often wasteful because substantial intangible assets often reside in the heads of the entrepreneurial team. Thus, if a reorganization is to take place, special provisions must be made to secure the loyalty of key personnel. In larger scale bankruptcies, intangible assets often reside in systems and groups that are not so dependent upon any one individual, making reorganization and emergence as an ongoing concern easier.
Involuntary and Voluntary Bankruptcy
When the creditors file a bankruptcy petition, it is called an ‘‘involuntary’’ bankruptcy because the bankrupt has no choice in the matter. In practice, management can sometimes influence whether a bankruptcy petition is filed, and in most situations management can influence the timing of a filing. As a firm’s financial condition deteriorates, management often attempts to ‘‘work out’’ its problems with the creditors by reorganizing its debts, much the way the bankruptcy court would, but without the restrictive supervision of a court and the technical rules of bankruptcy law applying. Management can also try to turn around its operations and strategy while reassuring its employees and customers that everything will be all right after a few changes are made.
Impression management becomes very im portant for avoiding entering into a downward spiral that causes the firm’s legitimacy and sup port to dry up. If management projects a credible impression that they can save the company, it often becomes a self fulfilling prophecy, redu cing the probability of failure and attracting new investors and allies that contribute to pulling the firm out of trouble. This is, of course, preferable to bankruptcy proceedings because it avoids the stigma and administrative costs of bankruptcy, as well as any potential decline in customer confi dence that may be caused by even the hint of bankruptcy.
However, management can get into trouble during the process of managing impressions be cause management typically gives contradictory messages to different stakeholders – telling em ployees and customers to stick with the firm because things are improving, while telling unions and creditors that things are getting worse to convince them that they must make concessions to reorganize the firm’s financial or cost structure. In the process, fraud or its ap pearance may be committed. This problem is especially acute for publicly traded firms, where SEC disclosure rules apply and securities fraud is easy to commit.
In smaller bankruptcies, creditors are often quicker to file an involuntary petition due to fears that entrepreneurs may strip assets illicitly from the firm, or because the entrepreneurs’ bankruptcy 9 impression management techniques are trans parent or not credible given the small size of the firm and its lack of reserve resources. In the end, creditors must make a judgment about the ‘‘dependability’’ of the debtor’s management – that is, its ability to turn around the company and the trustworthiness of the management’s statements. Studies have shown that when cred itors make judgments, it is not always a rational process based solely on the numbers. Creditors also base their decisions about whether and when to file bankruptcy on their personal relationships with management and the prestige of the debtor’s management team. Teams filled with people with important memberships in or connections to elite aspects of society (such as military, social, or economic elites) are often given more time to work out their financial and strategic problems. Prestige provides a halo effect that makes impression management more effective.
When management files the petition, it is called ‘‘voluntary’’ bankruptcy. In practice, many so called ‘‘voluntary’’ bankruptcies are not really voluntary at all. Many result from a race to the court house when management gets wind that creditors are going to file. Management may prefer a voluntary bankruptcy because if it files first it can determine if liquidation or reorganization will be pursued, and management may want to influence whether a trustee is chosen and if the management itself is replaced by the court or the trustee.
Some bankruptcies are truly voluntary and used in a strategic manner. ‘‘Strategic’’ bankruptcy has been used to void onerous union contracts, unneeded real estate leases for closed facilities, overwhelming pension liabilities, excessive legal judgments resulting from major product liability cases, as well as to reorganize the finances of firms with good operating cash flow but poor financial structures. Congress has put many restrictions on the use of the bankruptcy laws for strategic purposes, but strategic bankruptcies are still possible under certain circumstances.
Bankruptcy Avoidance in Entrepreneurial Firms
Entrepreneurial firms often live on the edge of bankruptcy during their start up period. In fact, the vast majority of start ups don’t last two years. ‘‘Liabilities of newness’’ abound. As with most things new, customers, employees, and investors are often skeptical about whether the business model, the product or service, or the management, are legitimate, questioning whether they will succeed in the long run. The usual worries about cash flows, the ability to get that all important first customer, the risks of major customer defections, key employee departures and other factors affecting the survival of the firm all encourage fears that might drive creditors to file an involuntary bankruptcy petition prematurely.
To get by this period, entrepreneurs either need substantial funds of their own to assure everyone that the firm will survive or they must have extensive networks in the local community or industry. Studies have shown that the survival of entrepreneurial firms often depends upon their access to resources, relation ships, and customer or technical knowledge. Entrepreneurs with wider networks of friends and colleagues – even non elite connections within those communities – significantly de crease the chances of bankruptcy during the start up phase because their centrality in the network provides them with options that they could not generate if they were isolated individuals.
Several other strategies for overcoming the liabilities of newness that cause most bankruptcies among entrepreneurial firms exist. For example, seeking a ‘‘strategic investor,’’ an investor who promises to be the first customer, can reduce the worries about bankruptcy. Distribution alliances with potentially dangerous competitors, such as imitators who might become fast followers, can also reduce the risk of bankruptcy. In addition, affiliation with a particularly prestigious institution (such as a university) or a highly regarded venture capital firm are used to counter problems associated with illegitimacy, because the affiliate’s implied endorsement extends their brand or reputation to the entrepreneurial firm.
Bankruptcy Stigma
Bankruptcy carries a large stigma effect with it. The mere hint of a pending bankruptcy 10 bankruptcy can cause the defection of key managers or customers. And managers who were in charge at the time of a bankruptcy often find it difficult to find another good job because they are tainted by their association with a bankrupt firm. At one time, failure to repay debts was a criminal offense, treated like theft.
In modern times, this stigma has lessened. In fact, in some entrepreneurial societies (such as Silicon Valley), entrepreneurs with histories of multiple failures are common. Working for a failed firm hurts, but does not destroy, an entrepreneur’s resume or ability to raise capital. Two factors are important in avoiding the stigma effect of bankruptcy. First, don’t go down with the ship. People who are in charge at the time of failure are stigmatized more than those who leave a year or two before the failure, even when the early leavers were responsible for the failure. If it happens on one’s watch, the failure will be attributed by others to that person. Bailing out early also gives the entrepreneur deniability – the ability to say it’s not my fault, subsequent actions and strategies of others could always have been better. Be cause this provides incentives to leave when the going gets tough, savvy investors often seek to lock up entrepreneurs with tough non competition agreements and draconian employment contracts.
The second factor lessening the stigma effect associated with bankruptcy is the learning effect. Serial entrepreneurs can present what they have learned about why the venture failed, how they would do things differently this time around, and who they would get to join their team to avoid the previous problems. In addition, often a technology or product fails because the business model was wrong, or the business model fails because the technology or product was wrong. Or a technology could have been used for an other purpose that other customers would have adopted faster. In such cases the value of the learning from the previous experience may over come the stigma of being associated with bank ruptcy. Nevertheless, it is still better to be successful the first time, rather than to have to argue why the stigma of bankruptcy shouldn’t be attached to you.
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