As a continuation of our previous article, the sheer complexity and extensiveness of this topic makes it challenging to explain and it’s best to narrow it down to financial restructuring only for otherwise viable businesses.
Here we will focus on capital structure—commonly made up of both debt and equity. The capital structure is determined by the objectives of management and shareholders, and to a large degree any party who has financial stake in the business, lenders in particular.
There are numerous moving parts when undertaking financial restructuring. This process is not completely remote from other functions. All the moving parts need to come together to achieve the goals of financial restructuring.
Whether the financial restructuring process involves conversions of debt into equity or vice versa, or addition of a quasi-equity component (subordinated or mezzanine debt is a hybrid of debt and equity), the main objective is to achieve the most cost efficient and strategic capital structure relevant to the size of the business.
Financial restructuring can either be proactive or defensive. Proactive restructuring is initiated by management. It is carried out when the balance sheet is relatively healthy and increasing debt and share buy backs are performed to maximize the capital structure.
Another advantage of proactive restructuring is that the company can propose revised payment terms to lenders that is conducive to its own ability to generate cash flow. If the management anticipates future cash flow disruption, they act long before covenant breaches take place.
Defensive restructuring is implemented in response to bank threats, as in the case of Hot Fab Metal Inc. in our previous article. The motive is to appease lenders during financial hardship or imminent bankruptcy. When early warning signs of financial distress emerge, the bank’s response is to “shore up” its loan exposure. If management waits until too late, banks will have the upper hand in terms negotiation.
Whether the motive is defensive or offensive, companies with cash flow challenges should attempt to negotiate favourable terms as follows: (1) reorganization of repayment terms including deferral of principal for six months to 1 year. (2) If conversion from a short term (line of credit) into long term debt is necessary, ask to refinance over a longer term period (five years vs. two years) to lock in the lowest interest rate possible.
Debt vs. Equity
Debt restructuring is undertaken to strengthen the company’s balance sheet while freeing up cash flow to keep the business viable. Debts are efficient sources of capital because they are non-dilutive, meaning shareholders can maintain their existing level of ownership in the business. In most cases, debts are cheaper since interest rates are typically at Prime + 1% or 2% for relatively stable companies. Actual cost of borrowing are even lower if tax considerations are deducted from interest payments. Capital leases and present value of operating leases are considered debts when lenders assess the strength of a company’s balance sheet.
Equity restructuring is implemented for various reasons. For private companies, it provides owners with a tax efficient exit mechanism, especially if the intent is to pass the business on to the next generation of family owners. Restructuring may be carried out to write off accumulated losses for the purpose of achieving an ideal Leverage Ratio.
Equity is a more expensive source of capital since investors seek an internal rate of return (IRR) ranging from 15 to 20% for similarly healthy businesses. This type of financing is ideal when the company does not fit into banks’ lending criteria. It is further beneficial if equity investors have more to offer than just capital. For example, private equity firms provide operational expertise and strategic buyers deliver synergies as a component of the partnership. Both have higher tolerance for weaker balance sheets and are more inclined to inject capital based solely on the company’s ability to generate cash flow.
When negotiating with lenders or investors during the financial restructuring process, it is crucial to keep in mind the following: (1) Be clear about strategies and goals within one-year, two-year and five-year time frames – new products, new geographic markets, new customers; (2) Lay out other resources needed such as human capital, equipment and larger production facility; (3) Make sure that financial forecasts support strategies and vice versa.
Hire a CFO or Financial Advisor who will assist in developing liquidity forecasts, improving cash flow management, navigating the complexities of financial restructuring and negotiating with lenders and investors.