Bankruptcy in the U.S is permitted by the United States Constitution, which authorizes Congress to enact uniform laws on the subject of bankruptcies throughout the United States. Bankruptcies are initiated with a petition filed by the debtor or on behalf of creditors (involuntary bankruptcy) in an attempt to recoup a portion of the debt or force a restructuring. Although some law relevant to bankruptcies can be found in other parts of the United States code, the Bankruptcy Reform Act of 1978 is the most recent addition to the United States Code, Reform Act of 1978 is commonly referred to as “Bankruptcy Code”.
Depending on the circumstances, private companies under the Bankruptcy code may file a petition for relief under different chapters of the code. Title 11 is comprised of nine chapters, of which six chapters are designated for filing petition. The remaining three chapters provide rules to govern those petitions.
Bankruptcy filing specifications differ widely among various countries, leading to higher and lower filing rates, depending on how easily a private company or a person can complete the process.
Chapter 7: Liquidation
Chapter 7 is one of the two primary options available to private companies in distress. Chapter 7 is also referred to as Liquidation. A Chapter 7 proceeding is one in which a business or firm is terminated or stops operating. The business assets are sold and proceeds of the sale are distributed to creditors.
As does a public company, a private company qualifies for filing a Chapter 7 bankruptcy. The portion of the debt that cannot be repaid through liquidation is absolved. Private companies generally try to avoid Chapter 7 bankruptcy, because it terminates all business operations with no opportunity to reinstate at a later date. Income generated after the bankruptcy filing is considered in the proceedings.
Example: Secured creditors take less risk because the credit that they extend is usually backed by collateral, such as revenue or other assets of the private company. After all debts with secured creditors have been settled, the subordinated levels of debt, such as unsecured creditors, can claim repayment. After all the private company’s debt is settled, equity investors are able to stake a claim on assets.
Chapter 11: Reorganization
Chapter 11 is a complex form of bankruptcy and is generally filed by private and other corporations who aim to restructure their capital allocation to operate more efficiently and effectively, primarily by eliminating debts and contracts (such as office leases or union contracts) that they can no longer afford. Chapter 11 involves the reorganization of a debtor private company’s business affairs, assets and liabilities. The bankruptcy gives the debtor a fresh start, subject to the debtor’s fulfillment of its obligations under its plan of reorganization (like public companies, a private company must file a Plan of Reorganization for the Bankruptcy Court’s approval demonstrating it will be viable after exiting bankruptcy.) Chapter 11 bankruptcy can also be used to liquidate some of the assets of a private company and pay the creditors from the proceeds of the sale (these are referred to as “Section 363 sales transactions; PrivCo tags M&A transactions resulting from a bankruptcy order as a Section 363 sale).
Chapter 11 is available to companies (corporations, partnerships or sole proprietorships) that are plagued by severe financial distress. Permission for filing Chapter 11 bankruptcy is given, if debt repayments can be abated or postponed. The private company is protected by an automatic stay that is initiated upon approved filing of the petition. As a result, creditors cannot take any action against the debtor. The stay eases the financial burden of the debtor, during which negotiations can also take place to try to resolve the difficulties in the debtor’s financial situation.
After filing for bankruptcy, the debtor is relieved of payments for 120 days, during which, the debtor must formulate and file a plan of reorganization with the court of bankruptcy. If the debtor fails to submit a plan during the 120 day period, or if creditors fail to adhere to the debtor’s plan during the first 180 days, creditors are allowed to submit a plan of reorganization. Sometimes compromises must be made on behalf of the debtor and associated creditors when the bankruptcy court is faced with conflicting plans of reorganization. Often creditors of the companies such as banks and lenders take some or all of the stock of the private company upon exit from Chapter 11 and essentially become the new owners of the company. In some cases the private company and its creditors agree in advance on what the outcome will be and will file what is referred to informally as a “prepackaged bankruptcy”, which also will tend to be completed much faster than an ordinary bankruptcy since the private company and its creditors agree in advance and don’t need to “duke it out” in court over what a fair outcome will be.
Example: Private company Merisant Worlwide, Inc. and its affiliates filed for protection under Chapter 11 bankruptcy in the U.S Bankruptcy Court for the District of Delaware. This move was intended to restructure the private company’s balance sheet and improve its long-term growth and financial well-being. The private company’s operations in the US and worldwide proceeded without interruption after the bankruptcy filing. Merisant Worlwide, Inc. felt that restructuring its balance sheet was the ideal way to increase the success of its products in the market.
Corporate restructurings can also take place without the involvement of a bankruptcy court, saving the significant legal costs to both the private company and to the creditors of a formal court process.
Corporate restructurings all aim to create shareholder value. A restructuring is a adjustment of ownership, operations, assets, or capital structure of a private company in order to improve operating performance, optimize capital structure and enhance public perception. Before known as a simple balance sheet reconfiguration, restructurings now include a variety of financial transactions from mergers, asset sales and special dividends to share repurchases. Restructurings have been used to lever and de-lever the balance sheet, concentrate equity ownership, or realize value of a subsidiary.
Over the past 20 years, corporate restructurings have been on the rise as institutional investors become more active and vocal. Institutional investors have begun to make demands of management and the board of directors. In some cases, institutional investors wage proxy battles in order to enhance shareholder value.
Given the prevailing market conditions over the past three decades, hostile take over activity such as leveraged buyouts and hostile acquisitions have been on the rise. Nevertheless the value of acquired private companies is not always reflected in the stock price of the acquirer. Therefore, private companies have been focusing on improving core businesses, divesting poor performing assets and highlighting strong performers.
Corporate restructuring comes in many flavors, including financial and transactional methods. Corporate restructuring can include a reconfiguration of the balance sheet via issuing a special dividend, share repurchases, or recapitalizations. Financial restructurings are designed to make the capital structure more efficient or can be used to defend against a takeover effort. Transactional restructurings include a reconfiguration of assets or operations. Such methods are typically divestitures, spin-offs, split-offs, and equity carve-outs. Other less common transactions are tacking stock, leveraged buyouts, leveraged ESOPs, or complete liquidations.
Creating Value in Restructuring
A private company evaluates its internal process, capital structure, and strategic priorities. The private company then refocuses its attention and resources on areas that will maximize operating performance. This can include reallocating capital to grow key assets or entering new markets.
A Special Dividend is a capital distribution to shareholders. Even if private companies do or do not pay regular dividends, a special dividend can be issued to reconfigure the private company’s balance sheet or alter the private company’s leverage ratio. This can be done from existing cash deposits or from newly issued liabilities.
Recapitalization requires that the private company take on additional debt or reduce their equity by repurchasing shares. Recapitalizations are usually done to alter the ownership of the private company. The main goal of initiating a recapitalization is to keep the private company’s capital structure more stable and in some cases boost the stock prices of private companies. Recapitalizations are done by cash-rich public companies that are threatened by a takeover.
Although uncommon, Leveraged Employee Stock Ownership Plans are typically used to concentrate the ownership of a private company in the employees’ hands. This is another method to defend against a possible takeover. An ESOP is an employee stock ownership plan where employees own a piece of equity in the private company. Leveraged ESOPs are initiated by borrowing capital to capture a majority of the equity at one time. This equity can then be vested over a period of time to the employees. Leveraged ESOPs drastically alter both the capital structure of a private company, by increasing the liabilities, and the ownership concentration from the original owners/management to the employees.
In this case, Sale represents a direct divestiture of a division or subsidiary of a larger private company through a private sale of its assets or its equity. This sale represents a taxable transaction. Proceeds of the sale can be used to pay down debt, reinvest in core growth, or can be paid out as a special dividend to shareholders.
A Split-Off is the separation of a subsidiary from the parent by splitting the shareholders of the parent private company’s stock from the shareholders of the subsidiary’s stock. Most split-offs are tax-free transactions and used to downsize a private company or defend against a hostile takeover.
In a Spin-Off transaction, the private parent company separates the shares of a subsidiary from the original private company shares and distributes those shares, on a pro-rata basis to its shareholders. Shareholders may in turn sell the shares on the open market. In essence, two separate entities are formed in which the stockholders are issued the shares in the legal subsidiary proportional to their original holdings in the parent private company. Both the entities have their own management and run individually after the spin-off. The distribution of the subsidiary’s stock to shareholders is in the form of a dividend. This is typically a tax-free transaction for both the shareholders and the parent.
An Equity Carve-Out is a sale of a portion of equity in a subsidiary to the public via a public offering. The private parent company retains the majority stake in the now public subsidiary, usually greater than 80%. With ownership of over 80%, the private parent company still retains the right to undertake spin-offs and split-offs on a tax free basis.
Tracking Stock is a special class of stock with earnings or dividends that are attributed to a specific division or subsidiary of a private company. Tracking stock is a way for a private parent company to separate certain divisions of its private company and allow shareholders to benefit from earnings and capital appreciation without having to give up control of the assets associated with the particular division.
While characteristically a take-private transaction, leveraged buyouts are acquisitions with a highly leveraged capital structure where the majority of the cash flow from the acquired company, division, or subsidiary is used to service and repay the loan. Leveraged buyouts may be used to enhance shareholder value, counter takeover threats or realize the value of undervalued assets.
The overarching goal of a restructuring is to increase shareholder value but there are many reasons behind restructuring.
There are two basic forms of restructuring: financial and transactional. A financial restructuring usually takes place when the operating performance of a private company is doing well but the capital structure needs improvement. Transactional restructuring takes place when there is a need to reconfigure both the operating effectiveness and the capital structure of a private company. Many times financial and transactional restructurings can occur simultaneously.
There are many different types of financial analysis that must be preformed prior to a restructuring transaction. Valuations must be preformed of the targeted and acquiring private company with analysis of divested divisions or business units and their impact on shareholder value.
Break-Up Valuation Analysis
Break-up valuation is the central technique used in all types of transactional restructurings, specifically all transactions that involve any types of divestitures. A typical break-up valuation has four steps.
Capital Structure Analysis
Leverage is an important factor when considering restructurings. Leverage can be increased to defend against takeovers, pay out special dividends, repurchase shares, or optimize capital structures. During a divestiture transaction, leverage of the parent private company and the intended divestiture target needs to be taken into account.
Each industry and sector will have specific leverage ratios that are acceptable for private companies across that industry. When analyzing a restructuring transaction it is important to obtain comparable ratios for private companies within that industry since capital requirements, growth opportunities and cash flow trends change.
With the comparable valuations completed, one now has a framework by which they may determine the impact of the proposed restructuring. In divestitures, the capital structures of the parent and the divested private company must be analyzed. It is important to make sure that the capital structure of the divested business is appropriate for its place in the business cycle.
Accretion/dilution analysis is the assessment of the impact of a transaction on the earnings per share of a private company. In order to do an accretion/dilution analyst, one must first project the financial statements of the parent private company prior to the restructuring and then post restructuring. The results of earnings per share pre and post transactions must be compared. If earnings per share have increased, the transaction is accretive while if the earnings per share have decreased after the transaction, the transaction is dilutive. The restructuring transaction must be viewed from the standpoint of shareholder value.
Certain types of restructuring transactions such as share repurchases, concentrate ownership among the remaining shareholders. This change in ownership will increase the earnings per-share of a private company and can imply that earnings will grow at a faster pace if a divested private company was not growing as fast as the other subsidiaries, businesses or divisions of the parent private company.
The Role of Taxes in Determining a Divestiture Approach
The tax basis to the parent private company of a potential divestiture target is an important consideration in the restructuring procedure. The higher the tax basis the more likely the asset will be divested in a direct taxable sale while a lower tax basis will be more incentives towards a tax-free alternative such as a spin-off, split-off, or equity carve-out.
A spin-off is a distribution of the stock of a subsidiary or business division to shareholders of a parent private company in proportion to their original holdings. Spin-offs are tax free transaction if they meet certain requirements with the IRS. The stock of the subordinated private company is distributed to shareholders so that the initial ownership of the spun-off private company and the parent private company is the same. However, the goal of the spin-off is to relieve the parent management from the operating and controlling responsibilities of the spun-off subsidiary.
Spin-offs have been used extensively as a method for increasing shareholder value. After extensive academic and practical research, spin-off transactions have determined to create considerable shareholder value. Specifically, returns to shareholders of private companies that spun-off unrelated businesses were higher than those of shareholders of private companies that spun of businesses related to their core. Conducted studies have reinforced the precept that the market rewards private companies for focusing on their core businesses. In addition to immediate shareholder benefits upon announcement, spin-offs provide considerable and sustainable long term benefits.
Creating Value with Spin-Offs
According to the Internal Revenue Service (IRS), creating shareholder value through spin-offs is not a valid business purpose. Even though “creating shareholder value” is not explicitly stated in spin-off agreements, spin-offs nevertheless create shareholder value indirectly for both parties. In order to visualize how a spin-off adds value to shareholders, compare the total market capitalization of the two private companies pre-spin-off and post spin-off. A small, high growth subsidiary hidden within the folds of a larger conglomerate will greatly expand in market capitalization once it is spun-off and able to secure funding for its specific needs.
A spin-off transaction deconsolidates the financial statements of the parent private company and the spun-off subsidiary. The stand alone performance of the parent and the subsidiary allows the market to value each private company individually based on operating performance and individual growth rates. Poorly performing subsidiaries that are spun-off will help the overall performance of the parent private company stock since they are not dragging down the financial statements of the parent while strongly performing subsidiaries will be valued positively by the market and shareholders will realize gains from the distribution of equity.
Balance sheets of the subsidiary and the parent will also be deconsolidated. This allows the market to asses the capital structure of each private company individually. The subsidiary will be able to finance itself using its own cost of capital. This in effect creates a more efficient use of capital for the private company’s particular needs. In addition a dividend may be paid by the spun-off private company to the parent private company. This dividend, if the spin-off meets the tax free requirements of the IRS, is also a tax free distribution to shareholders who are typically taxed on capital gains from dividends.
From the perspective of the private company’s balance sheet, a spin-off, can alter leverage ratios, earnings per share, and ownership. From the perspective of the parent private company’s income statements, spin-offs can alter the private company’s revenue growth rate, earnings per share and the multiples applied to them. In the case where a parent private company spins off a faster growing subsidiary, different multiples are applied to the spin-off and the parent private company to offset the differences in growth rates. It is also important to understand that increased shareholder value may not be realized until the market prices-in all changes within the private company.
Announcements of spin-offs signal that the parent company is focusing more on its core businesses by getting rid of poor performer or acknowledging a strong performer. The break-up of a larger private company allows for easier valuation of its parts.
To be considered a tax-free dividend to shareholders, spin-offs have to meet the criteria set by Section 355 of the Internal Revenue Code:
Many of the sections and requirements for obtaining a tax-free spin off status through Section 355 and 368 are highly subjective and interpretations may differ. It is therefore prudent for the private company to obtain a ruling from the IRS prior to proceeding with the distribution.
Management and Governance
Although a spin-off provides incentives to management and employees, management teams, prior to the spin-off, reported to the parent private company and have no prior experience in managing the financing of a private company or managing a “new” private company as a publicly traded entity. Having no prior contact with Wall Street, the newly chosen management should not only know their business but also be trained in the differences between managing a subsidiary and a public company. The initial board of directors will be mostly compromised of the board of directors of the parent private company as they vet management, and overseeing the complete divestiture of the two private companies.
Separation of Assets
There may be significant issues in deconsolidating the assets of the parent private company and the subsidiary especially if they use the same inventory, office space or resources.
As the date of the distribution approaches, there may be debate over how much debt the parent private company and the subsidiary take on. It is important to understand that in large enterprises, funding and financing is allocated and obtained on the corporate level and is not always delaminated per subsidiary and operating unit. As a result, the spun-off subsidiary sometimes pays a dividend to the parent private company prior to the distribution in order to de-lever the parent and lever up the subsidiary.
Contingent and Other Liabilities
Certain liabilities of both private companies may have been intermingled in order to take advantage of economies of scale such as 401(k) plans and health benefits. Each of the items will have to be evaluated individually so as each private company accounts for their liabilities based on underlying resources. All contingent liabilities must be resolved prior to the spin-off in order to retain the maximum benefits from the transaction.
Relations with Customers, Supplies, and Shareholders
In order to minimize investor turnover, it is important to maintain good investor relations. It is very common that after a spin-off many investors sell out of their holdings since the new spin-off or the parent private company no longer fit their investment criteria.
With similar applications to customers and suppliers, many customers and suppliers have done business with the parent or the subsidiary as a result of the other. It is important to maintain good relations throughout and post the spin-off process so as to retain all customers and suppliers.
If a spun-off subsidiary is questionably able to compete on the open market as a stand alone entity, the IRS mandates that in order for the spin-off transaction to remain tax-free, neither the parent nor the spun-off subsidiary can be acquired within a set amount of time (usually two years). This is to ensure that shareholders for the company remain the same both before and after the spin-off transaction.
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