Even during favorable economic conditions, certain companies will falter. While some of these companies may prove beyond repair, others can be turned around under proper leadership. But there is a process that needs to be followed for companies interested in purchasing these distressed companies, as outlined below.
What can drive a company into distress?
1. The company lost a very profitable big client. This could have been a first-party project or a traditional contingency client relationship that was a significant portion of the distressed company’s revenue, and the loss threw the business into a tailspin.
2. Legal or compliance issues. These issues can push a company into a tough position where it needs to do a deal quickly.
3. The company’s balance sheet could be upside down. A company can have been overleveraged for a variety of reasons. For example, the owners assumed significant debt when purchasing the business or when financing a capital improvement. As a result, an unexpected hiccup could have thrown the distressed company into a tough cash flow position.
How can you structure a deal to protect yourself when pursuing a distressed asset?
1. If the distressed company is having issues, it is likely there are other problems going on with the company from a compliance perspective. Companies buying a distressed situation should consider looking at an asset rather than a stock deal. This helps to avoid any “skeletons in the closet” the purchaser may be walking into or inheriting. While there may be a strategic reason for a stock purchase, all else being equal it is advisable to buy assets in distressed situations.
2. Make sure the distressed company is operating in trust and isn’t using client money to fund the business. This liability is an issue that will follow the purchaser after the business is sold. Make sure to assess at the front end whether the distressed asset is in trust or out of trust with any of its clients. If the answer is “yes,” hit the brakes. Avoid doing a deal because transferring the clients could pose a significant legal exposure to you as a buyer.
3. Figure out who “owns” the client relationships. That person or persons will be critical in transitioning the client base to the buyer. Make sure you are either locking into or assuming an employment agreement as part of the deal to make sure clients will move over to you as part of the transaction.
4. Look at the balance sheet, specifically the liabilities. Instead of paying cash up front as part of the deal, there may be a facility-lease assumption; some form of long-term debt that could be assumed by the buyer instead of paying cash up front.
5. Structure the deal in a favorable manner. Many distressed scenarios are deals where it will be “pay for performance” and making sure the client operation can stay in place, so the buyer can help to turn around the situation and make a good return.
In a distressed situation, a number of things could be at play – a client loss, a legal issue, key people have left, the balance sheet is upside down. The key is to determine as quickly as you can if you can solve the problems that led to the company’s distress in a timeline that will work for everybody.
Distressed situations come up quickly. When they do, the selling shareholders are looking to move as quickly as possible. As a result, the due diligence timeline and process is condensed. This is where things can get missed.
The more you can evaluate a distressed situation up front, the better off you are. Does the company have good financial controls in place? Are clients who continue to place business salvageable?
The more the purchaser can determine what the pain points are upfront and whether you can solve them, the better off the combined business will be after closing the deal.
Begin by establishing a trusting relationship with an M&A specialist, whatever your plans for purchasing a distressed company. Don’t let the fact you have to do something quickly prevent you from doing your due diligence on the situation and examining all the issues at hand. By remaining disciplined, distressed situations can be a win-win for both sides of the sale.
Michael Lamm is a managing partner at Corporate Advisory Solutions, a boutique merchant bank headquartered in Philadelphia. He can be reached at [email protected] or 202-904-7192.