In this article, learn why a traditional sale/exit of an overleveraged business is unlikely to create a successful exit for owners - and how the alternative of a "reorganizational exit" offers far more benefit for sellers.
Understanding seller “reorganizational exits.”
Understanding the difference between a traditional sale/exit and a sell-side “reorganizational exit" can make all the difference in the world for an overleveraged business owner.
It will determine whether a buyer captures most or all of the enterprise value of a business, or whether a seller will meaningfully recoup value on the company they built.
Reorganization: For the benefit of the seller or buyer?
The core principle is simple: When a business is overleveraged, it is going to be reorganized in order to resolve liabilities, and relaunched to capture its underlying value.
The important question for a seller is whether the business will be reorganized by the buy-side (to the exclusive benefit of the buyer), or by the sell-side before going to market - creating benefit for the seller.
Regardless of distress, consider that an investor is targeting a business because it has underlying enterprise value; a distressed investor seeks to capture that value, without the debt, through their own reorganization.
In these scenarios, the buyer controls the reorganization and therefore has the leverage to capture most or all of the transactional benefit of relaunching your business. Typically, sellers have almost no leverage and are left on the sidelines, hoping only to reduce their personally guarantied deficiency exposure.
Alternatively, sellers can take control of the reorganizational process on the sell-side before going to market. In doing so, sellers gain leverage to capture value that the buy-side would otherwise monopolize.
For a seller, this is the key to meaningfully sharing in and benefiting from underlying business value – and to making a truly successful exit.
Path 1: The traditional "sale/exit:" Buyer captures the full value of your business.
In distressed situations, sellers are looking to exit in order to satisfy debts and/or avoid bankruptcy. The buyer typically inherits all of the value, with the seller simply hoping to mitigate as much personal financial damage as possible.
Because an upside-down business has no equity value, a distressed investor can capture control of the business for a nominal cash injection or by taking out the first position lender. Typically, their strategy will be to take the company into chapter 11 and acquire full control and ownership through a 363 sale (often at the cost of simply taking themselves out of the first position debt.) The buyer has inherited all of the enterprise value of the business, along with the full benefit of cramming down and resolving sub-debt while relaunching the business.
In short, distressed businesses are sold in a buyer’s market, which is why a traditional "sale/exit" will generally not result in a positive exit for the seller.
Path 2: The "reorganizational exit:" Seller captures more value and exits successfully.
In this alternative form of exit, a seller (rather than the buyer) initiates the reorganization of the business to strip off the debt and capture underlying value in the business - before going to market. In this way, sellers create leverage to participate in value otherwise monopolized by the buy-side.
Example: A (5MM) liability or a positive 4MM exit?
In a recent transaction involving a co-packing business in Southern California with historical revenue of 15MM annually, the business was upside down and unfinanceable, with 10MM in sub-debt, 5MM of which was personally guarantied.
· Path 1: Sale/Exit?
In a traditional sale exit model, a distressed investor would have reorganized the business by taking out the senior lender for 3.5MM (1st position note), entering a Chapter 11, and ultimately obtaining the company at the cost of taking themselves out of the 3.5MM 1st position note.
The original owner would be left with an employment agreement, but facing 5MM in personally guarantied debt and a personal bankruptcy.
· Path 2: Reorganizational Exit
Instead, the owner took control through a reorganizational exit. The business was brought to market as a reorganization by which all the debt would be stripped off the business.
In this process, the owner identified a reorganization partner who would step in to acquire the business operation, with no debt, through the bank’s sale of assets into the new operating entity.
The understood near-term enterprise value of the business was 13.5MM. Because the reorganization partner would inherit this value by satisfying the first position creditor for 3.5MM (as the distressed investor otherwise would have in the 363 example above), a 10MM value-delta would be created by the seller in the transaction.
However, unlike in the 363 version, the owner took control of the reorganization process from the outset. By controlling the reorganization and leveraging the ability to deliver value to their reorganization partner, the seller negotiated a consulting contract that allowed them to share in the upside potential of the relaunched business.
The reorganized business was then brought to market without distress, and with the original owner capturing a net benefit of 4MM.
In the traditional sale/exit model illustrated above, the buyer receives essentially all benefit, leaving the seller with a 5MM liability. In the reorganizational exit, the buyer also receives benefit, but the seller negotiates on an even, fair market footing, resulting in a net positive seller benefit of 4MM.
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