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Key Idea: Avoid Bankruptcy

Sara Fortune, Chris' wife, runs human resources and serves on the leadership team.  She and Chris agreed that while bankruptcy was a legal option for them early on, it would not be good for their souls or for their talented employees.  More...

Key Question:

A: 

Think long-range.  Bankruptcy might be the easy way out of big problems but for Chris and Sara it was not the right way.

Bankruptcy is a word that strikes fear in the hearts of all of us. Yet sometimes bankruptcy is the only viable route to ensure a company's long term survival. Consider the following hypothetical situations:

  • A barge company has long term fixed price contracts to haul flour from the mills down the Mississippi river. Tugboats are used to haul the barges into and out of the open river. There is a world wide oil shortage and the price of fuel sky rockets. The barge company's contracts do not include fuel escalation clauses.
  • A service company operates out of 10,000 square feet of leased office space. The lease is non-cancelable and has 7 years remaining. A number of major tenants in the area move out and there is an excess of commercial space available. The cost per square foot decreases dramatically. The service company finds that it can no longer compete effectively in its market due to its higher occupancy costs.
  • The employees of a successful manufacturer are unionized. The union contract is up for renegotiation at the same time that the manufacturer loses 2 of its 3 largest customers. Union negotiators are demanding increased wages and benefits for their membership.

In each of these cases, the bankruptcy is not a "way out" but a "way back," perhaps the only way back to profitable operations and financial stability. What about the vendors or, in bankruptcy language, the unsecured creditors? As difficult as it is to write-off the accounts receivable of a customer, once that hurdle is over, would a creditor be better off with a financially revived customer or no customer at all?

The word bankruptcy comes from the Italian "banca rotta" or "broken bench". According to legend, in medieval times, when a tradesman of Florence's Ponte Vecchio bridge was unable to meet his financial obligations, soldiers would break his bench to prevent him from selling additional wares. Today's creditors sometimes, sadly, take the same view. But most are sophisticated enough to realize that what's lost is lost, and looking forward, perhaps more carefully, is in their best interest.

Q:
  What does the law say about bankruptcy?

A:   Article 1, Section 8, of the U.S. Constitution enumerates the powers of Congress which include establishing "uniform laws on the subject of bankruptcies throughout the United States". Congress met this obligation with the passage of U.S.C. United States Code, Title 11, Bankruptcy. Chapter 7 of the Code, Liquidation, and Chapter 13, Adjustment of Debts of an Individual with Regular Income, provide the governing legislation for the permanent discharge of debt by a corporation and individual, respectively. Chapter 11, Reorganization, provides the opportunity for a restructuring of debt and a fresh start.

Although Chapter 11 is the applicable law for both businesses and individuals, in practice it is used almost exclusively by businesses. Bankruptcy filings and subsequent proceedings are under the jurisdiction of the Federal District courts. Although the law is the law, each District has considerable latitude in establishing rules. The information provided here is general and should not be relied upon as legal advice. Businesses contemplating bankruptcy should seek legal counsel from an attorney experienced in such matters in their respective geographical area before proceeding.

Q:
What is the banruptcy process?

A: A business seeks protection under the courts by filing a petition for voluntary bankruptcy. Voluntary bankruptcy is when the debtor seeks the relief of the court. Involuntary bankruptcy is when a group of creditors ask the court to declare the debtor bankrupt. Bankruptcy in general is expensive and time consuming; involuntary bankruptcies are rare.

When the petition is filed by the debtor, creditors are prohibited from making collection efforts on amounts owed and are barred from filing litigation against the debtor and from foreclosing on any assets. Leases and contracts are generally voided; and any current litigation is stayed. The debtor has the right to some breathing room, to sort things out, to regroup, and to turn the business around. He may continue to pay the ordinary ongoing expenses of the business, but he may not pay any liabilities incurred as of the date of filing. Sounds great, doesn't it? But the price is high.

As soon as the petition is filed, the debtor assumes a second identity of debtor-in-possession or DIP. The debtor is in possession of his assets, but since his liabilities to 3rd parties exceed his assets, he is assumed to be safeguarding those assets for the creditors benefit during this period of "reorganization". Rarely does the court appoint a trustee in the case of a small business bankruptcy, the trustee's responsibilities rest with the DIP. Bankruptcy has been compared to living in a fishbowl. The reporting and disclosure requirements are onerous as the DIP reviews all creditors' claims, makes monthly operating reports to the court, accounts for all property, and provides whatever information is requested. The real victim in bankruptcy, they say, is trees. Small businesses have 100 days to submit their plan for reorganization to the court. Past that deadline, the creditors may submit a plan. Most often in the case of a small business, the Chapter 11 filing culminates in a Chapter 7 liquidation of the business.

If the business is liquidated and the assets sold, secured creditors, those with liens on company assets, get paid first. Remaining funds are distributed to creditors with a priority claim, such as taxing authorities and employee benefit plans. Unsecured creditors are last in line, and share in any remaining proceeds on a "cents on the dollar" basis. Rarely is there anything remaining for distribution to stockholders. According to a study performed by Dr. Stuart Gilson of Harvard Business School, 80%-90% of the Chapter 11 filings of companies with assets of $100 million or more result in successful reorganizations. Continental Airlines, which has filed for protection from its creditors under Chapter 11 of the U.S. Bankruptcy Code not once but twice, in 1983 and 1990. The vast majority of filings by companies with assets of $20 million or less result in Chapter 7 liquidations. Clearly, the eye of the needle for a successful business restructuring is very small. How does a small business owner navigate through it?

Q:  How does a business stay alive through the process?

A:  A Chapter 11 filing is financially, emotionally, and even physically draining. Before proceeding, the small business owner(s) must ask himself and/or herself the following questions and carefully consider the answers:

  • Is my fundamental business plan sound, i.e., are the current difficulties due to nonrecurring events? If I can get through this, do I have a viable company or am I just postponing the inevitable?
  • What would a willing buyer pay for my business? How much value lies in the company's reputation, customer lists, trade secrets, and other intangibles? (Although there may be no interest in selling the business, an honest answer to this question will be a strong indication of whether or not it makes sense to proceed with a restructuring.)
  • What is my relationship with my bank? This is particularly important if your bank is also a secured creditor. You will most likely be required to maintain a "cash collateral" account where the bank will approve the release of every individual disbursement.
  • What is my relationship with my vendors? The largest vendors will form the creditors' committee. Will they want to continue to do business with the debtor after the filing? Am I an important and/or longstanding customer? How important is it to them that I survive? (These questions make it clear why most of the successful Chapter 11 filings are those of the large companies).
  • Do I have the right attorney and CPA to advise me through this process? Do I know how much they will charge?
  • How much cash can be stockpiled before the filing? How does this compare to the amounts my attorney and my CPA will charge me?
  • What will be the effect on my employees? Will they support me through this time or will they immediately start looking for other positions? Will I have to terminate some of them? If so, whom? What will be the effect on the others? Can we take care of our customers if we reduce our workforce?
  • How will I communicate the fact that I have filed for bankruptcy to my employees, my customers, and my vendors? How will I continue to communicate with them as I develop my plan for reorganization? What level of support can I expect both initially, and thereafter?
  • What are my chances for survival and at what cost? Is it worth it?

These are tough questions and a small business owner's attorney and CPA can be invaluable in providing dispassionate expertise in what is a very emotional time for the decision maker. Few small businesses emerge successfully from a Chapter 11 filing but some do. A careful consideration of the likelihood of a positive outcome to the challenges of corporate bankruptcy can only enhance the likelihood that a business will emerge healed.

Questions for this clip: 1 | 2

Think about it

What do you think you would do if you  were adviced to file for bankruptcy protection?

Clip from: Saris Cycling Group aka Graber

Madison, Wisconsin: Sara and Chris Fortune bought Graber Products in 1989 when it had 24 employees and $3.3 million in sales. When we taped this story there were up to 60 employees and with revenues over $10 million. They continue to grow, changed the name of the company to Saris Cycling Group, and are very committed to keeping their manufacturing in the USA.

Actually, manufacturing is on its way back to the USA!

That is not prophetic verse but the reality of our advancing technologies where highly educated workers can do it better, often faster, and sometimes cheaper than anywhere in the world.

This episode is a case in point: And, this story comes from the heartlands of America. These are the kind of people who love this country and all those basic freedoms to do the right thing in the face of adversity. They have done it right and now they ship their products around the world.

When Chris and Sara bought Graber Products, they bought a solid business with a good reputation, but the sales were flat. The employees were dedicated, but the company needed fresh energy to start growing again. To dump the stodgy image of the company that he bought, Chris found an Italian fashion designer who came up with improved form and function for his bike racks. Chris believed that the market was ready, willing and waiting for new ideas and he was right. Customers have flocked to the new products and employees love to come to work.

They are their industry leaders. They have kept manufacturing in America. And, their industry recognizes them for their generosity of spirit, moral courage, and ethical leadership. These people are quiet heroes,  new pioneers making the world a better place.

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Saris Cycling Group (once known as Graber Products)

Chris Fortune, CEO

Visit our web site: http://saris.com

Business Classification:
Manufacturing, Sports (Biking), wholesale

Year Founded:

Avoid Bankruptcy

HATTIE: What do you think it takes internally to be able to shoulder the risk of business?

CHRIS: I think a lot of it is attitude, a "never-give-up" attitude. And it's just keeping your head down and driving through the hard times, because if you look up, you may lose your head. As a business owner, for you to be successful, the biggest thing is to never give up -- never, ever give up.

 SARA: When we bought the business, we were hit with a patent infringement. Chris went to the previous owners and said, `We got this. It's not settled. We feel like it came before the purchase.' And they settled easily. It was all calm. We thought it was gone. Business thrived, we developed. We added a new product to get our name back out into the market, and it did very well. And then, about 18 months later, we got another letter saying we were infringing. And we thought it had all been settled, because it was on the existing patent.

And what I've learned in that short time--well, it ended up being about four months--I learned that this bigger company knew exactly what they were doing. We went to trial in March. It was a simple, tiny part of a patent. We went to a jury trial. Everything that we said--what we were told wouldn't happen, did happen. In the end, we lost 10 times more than we thought and had to cease to produce in the spring. I really believe the big company wanted us out. They saw us at that time as a challenge to them, and they thought, `Let's snuff these guys out now so we don't have to deal with them in the future.' And the bankruptcy issue was brought up.

HATTIE: So you lost $1 million in that scenario.

SARA: Right.

HATTIE: And when you lost $1 million and also had to shut production down, you said to yourselves, `All right, what are our choices?'

SARA: Right.

HATTIE: And bankruptcy was a legitimate choice.

SARA: And probably the number one choice for the people around us, saying, `This is the way you'll survive.' But that's also the relationship with the bank we had.

Chris--once again, it's the value in Chris. He's a survivor, end of the story.

Chris and I sat down and talked, and bankruptcy just wasn't an option. I mean, there's something that grates wrong in it.

CHRIS: We looked at bankruptcy, but we didn't feel that was morally or ethically the way to do it.

SARA: And the bank also supported us and said, `OK, this is what we can do to help, this is what we're going to require of you.' So we've been carefully watched. It was a bad time for us not only in the money issues, but it was the moral issues. For me especially, I was just dumfounded. I believed in people so strongly, and what they were saying.

CHRIS: We've been through the valley of death, and the way we've come through is our commitment to get through it and our determination to get through it.

HATTIE: Were you ever scared when you were in the valley? CHRIS: Sure. HATTIE: Did you ever think, `Well, we may not have the wherewithal to pay...'

CHRIS: It was never an option. We had to find a way to be successful and make this thing work. 

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