Key Business Recovery Considerations and the SBRA
The financial impacts of COVID-19 have forced companies of all sizes to make incredibly difficult choices. This includes companies that have historically been quite successful and, by all accounts, were in solid shape coming into the crisis. Arguably the most difficult choices many are facing is how to maintain solvency and whether they need to reorganize to survive. The Small Business Reorganization Act of 2019 (SBRA) is making reorganization much easier and less expensive as an option. A provision of the CARES act has increased the amount of debt that can be handled in these cases making it a viable option for many more companies. Company leadership should look at all available options and understand the advantages and disadvantages of each in determining whether SBRA is the right path for them.
Reorganization is a Powerful Tool for Post-COVID Business Recovery
Prior to the SBRA, Chapter 7 or traditional Chapter 11 bankruptcy were essentially the only paths that companies experiencing overwhelming financial distress could take. The addition of Subchapter V to the Chapter 11 Bankruptcy Code now provides a new alternative process for business owners to restructure and ultimately retain ownership of their business. The CARES Act increased the debt limit that can be handled this way to $7.5 Million, greatly increasing the number of eligible debtors.
Subchapter V is faster than traditional bankruptcy, approved in 90 days or less, much less expensive, no creditor’s committee is involved, and, to say it again for emphasis – the current ownership can retain ownership if the plan is followed and the judge approves. The CARES Act expanded the amount of debt that can be addressed to $7.5 million for filings through March 31, 2021 to enable more businesses to take advantage of this path.
If you need to be thinking about making a reorganization decision, evaluate your alternative scenarios and pay special attention to Subchapter V provisions if you qualify under the debt guidelines. Seek the advice of external bankruptcy experts. It is important to examine each reorganization scenario to make the best decision. Below is an example of one such assessment.
SBRA for Retailers
Great Products Company (GPC) is a well-known, five-location clothing retailer that caters to young women. It is a closely held corporation with a strong management team and annualized revenue of $18M. Their profits for 2017-2019 averaged $1.5M.
The company’s pre-COVID cash flow was sufficient to cover mortgage payments and operating costs. Revenue comes into the company via cash and credit cards with a three-day turn. They do not offer company-backed credit cards and hold no receivables other than the three-day credit card float.
GPC has a strong relationship with a local bank, including long-term loans secured by all assets and a revolving line of credit secured by inventory. There are no personal guarantees and all property (including administrative offices) are on long term leases. GPC secured a PPP loan for $1.7M and is expecting a 70% forgiveness.
Current Financial Situation
Supply chain impacts have put next season’s merchandise 60 days behind in production. Additionally, much of the current season’s merchandise remains unsold due to forced store closures and curtailed consumer spending. Deep discounts are now being offered which will shrink the revolving line of credit to unacceptable levels.
While the business is now again operating at pre-COVID hours, revenue is still down 25% from revised expectations and gross margin has been adversely affected by additional markdowns. Without a dramatic increase in overall business, the company stands to lose $1M. This would cause them to default on their revolving line of credit and likely mean a default on their long-term loan. Their anticipated debt by October 2020 is comprised of the following:
- Long-term bank note – $1.8M
- Revolver – $1M (fully used)
- Residual on PPP loan – $500K
- Lease Obligations in Arrears – $200k
- Vendor Obligations – $3.5M
- Total Debt = ~$7M
Other factors are also influencing the company’s choices. GPC’s owners do not want to sell the company and do not believe they could find a buyer that would satisfy their requirements. The owners believe strongly that they can rebuild the business over the next three years. Most of their vendor obligations rest with one overseas manufacturer. The bank is willing to work with the company but wants a turnaround plan in place that they can support and closely monitor.
Assessment of Available Actions
Given the current situation, GPC should prepare an operational forecast to determine what amount of excess cash flow may be available from operations to fund repayment of their current debt. This should be a three-to-five-year plan with enough detail to enable leaders to manage the business in accordance with the plan.
Based upon the operational forecast, GPC should then determine the amount of debt forgiveness that will be required to achieve the plan and assess whether the plan appears objectively fair and reasonable. External finance and law professionals who have successfully guided organizations through reorganization and deeply understand SBRA, and Subchapter V in particular, can help GPC (and companies in similar circumstances) determine the best course of action for achieving their objective of retaining and rebuilding the business. In this instance, there are three options:
Option 1: Restructuring Outside of Bankruptcy
This option is only available if cash flow indicates that repayment of the restructured debt is highly likely (90% probability) and the management team is capable of handling complex negotiations. It requires:
- Cooperation of lenders to release assets or accept a reduced amount of note repayment
- Vendor agreement to reduce outstanding balances or freeze current balances to be paid out over time
- Renegotiation of lease obligations, and
- Preparation of a retention plan for key members of management
Option 2: Bankruptcy Protection Request via Subchapter V of Chapter 11
This allows a plan to be pulled together that is likely to succeed based upon a reduced debt level and proposed repayment plan. It prohibits further collection activity from vendors while operating under bankruptcy rules. It requires:
- A business plan that is “fair and reasonable” and in sufficient detail for monitoring by the trustee
- A substantial repayment of debt over an extended period of time to retain ownership
- Less time and expense than traditional bankruptcy, (does require quarterly monitoring), and
- Acceptance that failure to meet plan parameters may move a judge to liquidate.
Option 3: Liquidation
Often the secured lender (e.g. bank) will push for liquidation if the debt reduction approximates the value of inventory liquidation as this would accelerate their receipt of cash. This path requires:
- Notification to vendors of liquidation scenario and intent.
- Preparation for a liquidation sale.
- Filing for Chapter 7 bankruptcy protection.
The Chosen Path
This company should choose Option 2. Their debt is less than $7.5M. The business is viable if they can get relief on repayment terms of their current obligations (which built up because of the current COVID-19 crisis impact), and Subchapter V will support the owner’s goal of retaining ownership and rebuilding.
Make an Informed SBRA Decision
The current financial climate has been especially hard to take for businesses that were in great shape before its onset. It has understandably jarred owners and leaders of these businesses and, in some cases, has led to decisions made in the pursuit of solvency that were not fully informed. Under the right conditions and with the right guidance, the SBRA provisions can be a very welcome path for companies needing to alleviate the unforeseen financial burdens that 2020 has delivered and survive to rebuild and reap the future benefit of their efforts.
Need assistance in determining the best path to reorganize and rebuild? Request a free consultation from a vcfo expert who can help you determine whether provisions of the SBRA or another option is right for you.