Earlier in the pandemic, our team identified the economic crisis caused by COVID-19 as a growth opportunity for companies with the vision and the resources to take advantage of it. One of these opportunities is the ability to diversify or grow by acquiring struggling competitors, suppliers or customers.
States across America are starting to reopen and restart their economies. Sadly, not all businesses will have survived COVID-19 and its impact on the economy. Some companies were unable to generate revenue before the pandemic for nearly a year and may struggle to meet their fixed cost obligations. At the same time, federal loan programs, such as the Main Street Lending Program and the Paycheck Protection Program, have made large amounts of financing available at low interest rates. This creates an opportunity for businesses that have or have access to cash to buy distressed businesses at bargain prices.
There are a number of legal issues to consider when buying a struggling business, but two stand out. First and foremost, the buyer should perform thorough due diligence. Second, the buyer must decide to buy the assets of the business before it becomes insolvent or to wait to buy the business in Chapter 11 bankruptcy.
Due diligence is the cornerstone of any transaction, but it takes on added importance when buying a struggling or bankrupt business. Prospective buyers should search public records for UCC financing statements, tax or legal liens, or lawsuits. Financing statements reveal any liens or debts associated with the seller’s specific property and highlight hidden liabilities. Reviewing these documents will paint a more complete picture of the seller’s business and help the buyer assess the risks and value of the assets. It also helps identify potential creditors who could exercise recourse after closing.
Theoretically, buying assets in bankruptcy should reduce the burden of due diligence. Uncertainty is reduced as creditors have been identified and claims filed. However, due diligence remains paramount as the assets are sold “as is”, which may leave the buyer little recourse for damaged or substandard assets. In addition, the due diligence period may be reduced by the nature of the auction process.
Regardless of the type of sale, every buyer should have an experienced due diligence team on standby to help uncover the pitfalls for the unwary.
Buy the assets of a struggling business
A struggling business is a business that cannot or is struggling to pay its financial obligations. Rather than buying the equity of a struggling business, it is advisable to structure the transaction as an asset purchase. This allows the buyer to limit his exposure to the risks associated with known and unknown liabilities, while assuming only the desired assets.
The main concern when buying the performing assets of a struggling business is that the seller may then file for bankruptcy and creditors will try to avoid the sale as a fraudulent transfer. The trustee may avoid any transfer occurring within two years of filing for bankruptcy of the seller if there is (1) actual fraud or if (2) the transfer is less than the value of the assets when the seller was insolvent or has been made insolvent by the sale. Obtaining a fairness opinion from an investment bank demonstrating that the transaction was fair consideration can help a buyer avoid this pitfall.
Another way to reduce the risk of buying a struggling business is to require that a large portion of the purchase price remain in escrow. This makes it easier for the buyer to recover costs resulting from a post-closing issue and to cover indemnification agreements. The indemnity agreement should cover any breach of traditional representations and guarantees, as well as any costs incurred by creditors seeking to reverse the transfer. Without a large hold, it will be difficult to claim a refund as the entity holding the remaining assets may be worth only a few cents on the dollar.
Buy in a bankruptcy sale
A bankruptcy sale has its own advantages and disadvantages. Similar to a sale of distressed assets, buyers have the option of paying bargain prices for underperforming assets prepared for a turnaround.
The most common type of sale is the Internal Revenue Code Section 363 sale. The sale under section 363 usually involves an auction and the winning bidder receives assets free of any liabilities, unless expressly assumed. The sale is subject to court approval.
There are generally two types of buyers in a bankruptcy auction: the bidders and the stalking horse. The stalking horse makes a base bid, which is subject to higher bids. If the stalking horse’s bid is the highest bid, the trade continues from there. If a higher bid is accepted, the stalking horse typically receives a breakage fee of 1-3% of the purchase price. The stalking horse also enjoys the longest period of due diligence.
The bidders compete with the stalking horse and other bidders for the assets of the bankrupt company. This creates two risks: on the one hand, the risk of overpaying to win the auction and on the other hand, the risk of underbidding and losing the auction. The bidder may have a shorter due diligence period and must be prepared to act quickly to identify the risks associated with the purchase.
Whatever its role, buyers must be open to negotiations with the seller, the creditors and the court. Each of these three groups has varying degrees of authority in accepting or rejecting the agreement, so it’s important to take each other’s considerations into account.
Buying a business comes with risks and rewards. These same risks and rewards are magnified when buying a struggling business or buying a business in Chapter 11 bankruptcy. You will need an experienced team on your side to help you. assess and minimize the risks associated with the transaction.