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December
2004/
January 2005 |
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Is
This Business DOA?
Analyzing the Key Factors that Drive Small Business into
Distress
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Turnaround and restructuring
professionals (TRP) are brought into distressed situations because
of our knowledge of the legal framework, experience in similar
situations, management and leadership qualities, and ability to
rapidly assess and address the underlying causes of crisis (underperformance).
Parties-at-interest expect TRPs to efficiently determine the depth
of the problem and the likelihood of each outcome, whether (i)
a successful operational turnaround, (ii) sale of the enterprise
[often a §363 sale], (iii) forgiveness or exchange of debt,
(iv) Chapter 11 filing for purposes of rehabilitation, or (v)
liquidation [through various mechanisms]. This early evaluation
is often called a “feasibility analysis.”
In the opening weeks of an engagement,
TRPs not only work through a series of financial exercises to
best understand the company’s condition and opportunities
for profit enhancement, but also survey the standing, awareness
and attitudes of important constituencies. Absorbing this knowledge
regarding key relationships helps TRPs gauge the various degrees
of support and trust, which ultimately influences our assessment
of the viability of the enterprise.
Time is the Unforgiving
Driver
Each course of action has its own time requirement. This makes
an early assessment of cash flow the critical thermometer by which
the degree-of-distress of the company is measured.
Cash flow models are carefully
and honestly built (or rebuilt), and are typically a 13-week rolling
cash flow supported by a 12-month monthly cash flow. From this,
TRPs determine the number of weeks of cash still available to
operate the business. The survival time can vary from days (can’t
meet payroll this Friday) to 52 weeks or longer; for many distressed
situations, cash reserves are forecast to last from 3 to 30 weeks.
A short cash lifeline has enormous power: it can, among other
things, force liquidation, cause management to abandon plans to
seek out a strategic buyer, soften or repel a secured lender(s),
compel a fast-track §363 sale, and demand severe and immediate
cost cutbacks/personnel reduction.
Secured Lender as the
Driver
In many distressed situations, the borrower is in covenant default,
has exhausted its line of credit and available assets, and is
under lender pressure. Lenders are highly focused on reliable
financial statements and forecasts, which are both rare commodities
in the world of distress. So rare, in fact, that frequently the
credibility of the borrower has eroded. To this often emotionally
charged situation, TRPs bring not only added skills and resources,
but impartiality, integrity, leadership and the restoration of
credibility…all of which are essential to developing cooperation
from the lender.
Driving the Stakeholders
Most small businesses are owner-managed and privately held. They
typically lack any Board of Directors. If a board is present,
it’s normally populated with friends and “yes-men”
of the owner/manager. Management (ownership) has usually lost
credibility and stature with the lender, and surprisingly often,
credibility and stature with its principal constituencies, e.g.
employees, unions, vendors, customers and shareholders.
The beauty of our American process,
the most debtor-friendly in the world, is that TRPs are compelled
to leave the floundering business largely in the control of those
very people who have (i) lost credibility, (ii) squandered their
equity cushion and (iii) unequivocally proven their ability to
lead the business into crisis…and then expect them to (iv)
work in the best interest of creditors and (v) restore the business
to the full bloom of health.
Trade Creditors in the
Driver’s Seat
In the typical situation, trade credit has been stretched, sometime
unmercifully. In the later stages of distress, vendors have tightened
credit and/or terms and, in very late stages, reduced purchasing
to a COD or CIA basis. TRPs carefully review days of payables
on a historic basis to compare to the present, deteriorated state.
TRPs are concerned with the
level of vendor awareness, an empirical assessment of the degree
to which the distress within the company has become known to suppliers
—alternative suppliers may be difficult to obtain. A similar
measure of awareness at the customer and employee level is also
of importance. In smaller businesses in particular, owners have
often gone to great lengths to insulate the company’s problems
from employees, leaving them in blissful ignorance as the company
slides inexorably toward oblivion.
Where payables have not been
fully stretched, TRPs are often engaged in methodical programs
to carefully extend payables to provide added liquidity and survival
time.
Management Integrity
Driven into the Ground
In addition to the impaired credibility of owner/managers, TRPs
often find “burnout” amongst the management ranks.
Most prone are CFOs (then CEOs) who suffer the brunt of lender
and vendor pressure. Those who avoid burnout often accomplish
this through “denial”… a refusal to react to,
or even recognize, the depth-of-distress in which the business
is mired. Symptoms of this strange, amazing condition range from
optimism and wishful thinking to something like deer staring transfixed
in the headlights.
Also, in owner/operator businesses,
TRPs have come to expect a level of self-dealing regarding the
“perks” of ownership, which can include cars, company
payments for personal needs, incompetent relatives in meaningful
roles, overloaded and dead-wood payrolls or even cash diversion.
On occasion, these perks spill over into fraud and embezzlement,
which is often explained as “it began innocently as a short-term
remedy, that became addictive.”
Robert A. Morris, Managing Director for Morris-Anderson &
Associates, has extensive expertise in turnaround consulting,
systems development, business appraisal and acquisition strategy,
with more than 25 years of experience in analytic, financial
and line operating management. He can be reached at (847) 945-0767
or rmorris@morris-anderson.com.
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