Recent bankruptcy announcements from Neiman Marcus, Garden Fresh Restaurants and J.C. Penney are the beginning of a cresting tidal wave. The retail and restaurant industries have been devastated by the COVID-19 pandemic and related quarantine orders, with many other businesses on the brink of bankruptcy.
However, bankruptcy isn’t always necessary, even when a business is in dire jeopardy. Planning, expeditious action and communication are essential — and make a difference even when bankruptcy is unavoidable. To be better prepared, consider the following:
CASH IS KING BUT THE KING IS BROKE
Everyone wants your cash. All creditors think businesses just received oodles of dollars from the federal government. But anyone who runs the math knows that at best it is enough money to pay some wages and maybe a little for the landlord and utilities.
Prioritize expenses. Businesses cannot operate under the usual reaction of paying the squeaky wheel. They have to make a budget and figure out what must be paid first to keep the doors open. Talk with the landlord and try to get concessions. While the Governor’s order prevents landlords from locking a business out today, if a business doesn’t have good communication with its landlord, the landlord will try to lock the business out as soon as the order is lifted. Make a payment proposal the business can keep. Do not over-promise to anyone. And plan for the worst until it gets better.
CUT EXPENSES
Trim as much as possible. Cut, cut, cut expenses. First, identify all business expenses. Start by looking at bank and credit card statements. Then cut all non-critical expenses. Even small savings can help in the long run, help in negotiations with creditors, and help show that the owner is a competent “captain” running a “tight ship” to potential customers, suppliers, lenders and investors. Experienced workout and turnaround specialists call this “stopping the bleeding” — and it is typically the first step taken in any turnaround.
Reduce payroll costs. Payroll is many businesses’ highest expense. The federal government can help businesses fund their payroll to keep employees on the job. A Payroll Protection Program (PPP) loan is an SBA small business loan to keep workers on the payroll. The SBA may forgive a certain amount of the PPP loans if all employees are kept on the payroll for eight weeks and the money is used for payroll, rent, mortgage interest or utilities. PPP loan qualification and repayment are complicated and changing quickly. Businesses should consult their bankers, lawyers and accountants now regarding these changing requirements.
Get help from the state. The Arizona Department of Economic Security instituted its Shared Work program to help employers and employees facing job cuts. This program allows employees to receive a portion of their unemployment benefits while working reduced hours. It has recently been supplemented by adding additional benefits to help ameliorate the effects of the COVID-19 pandemic. For more information, contact the Arizona Department of Economic Security by calling 877-600-2722 or going online at www.azui.com.
Ask for partial or temporary expense reductions. Cutting expenses does not always mean eliminating reliance on a product or service. Businesses often find that creditors, suppliers, employee and even customers would prefer temporary or partial reductions rather than being cut off entirely.
Try some of these questions on for size:
Mr. Creditor, would you agree to giving me a month or two of relief from payment if I will pay the full amount over the next twelve months?
Ms. Supplier, would you agree to a temporary price reduction of 15% for the next 18 months?
Valued Customer, would you agree to a temporary shortening of the free warranty period to thirty days instead of 90 days for the next 24 months?
Valued Employee, would you agree to a partial cut to three days a week until this crisis has passed?
Consider contingent expenses and deferred maintenance. Contingent expenses are expenses that might arise. For example, if a business could be called on to pay for a warranty claim, mistake or defect, that would be a contingent expense. Deferred maintenance is something a business should have been paying to maintain but either intentionally or unintentionally postponed. Businesses do not want to wait until the roof of their building collapses to learn that their leases require them to maintain and repair the roof. Renegotiate these items now before they become a problem and the business owner finds it has no leverage.
INCREASE INCOME
Sell assets to pay off debt. Consider selling unnecessary assets and using the proceeds to pay debt. Has the business developed software that can be licensed on an exclusive or non-exclusive basis? How about leasing the business premises off hours and using the proceeds?
Increase your pricing. Has this crisis resulted in increased demand or reduced competition that would allow the business to have more flexibility in its pricing?
Increase your offerings. Has this crisis resulted in additional needs, add-on products or services that the business can provide? Notice how quickly the ride sharing services pivoted to food and product delivery.
Partner with another business. Can the business to help another business with its undercapacity? How about large suppliers or large customers?
RESTRUCTURE CAPITAL
Raise investment capital. Can the business raise investment capital to pay debt down to a manageable level? Maybe half a pie is better than no pie.
Exchange debt for equity. Do not discount the possibility of turning a creditor, supplier, employee or customer into an equity source. Loyal customers and employees may be happy to purchase stock in the company. Suppliers looking to secure a customer may be willing to invest to lock you in as a customer — especially foreign customers or suppliers who are looking to break into the company’s geographical market or specific industry.
Consider PPP loans. A PPP loan can function like additional equity to the extent that loan repayment is forgivable.
Make sure to engage an attorney and CPA before beginning this process because there are serious legal, tax and business repercussions if a business makes even a small mistake in this highly technical area.
RESTRUCTURE DEBT
Streamline debt. Consider approaching creditors to restructure business debt. Do not be afraid to ask for concessions. What if the creditor says no? Do not be afraid to ask again by changing requested terms or providing some backup documentation. It may take several rounds of negotiation before the creditor takes the business seriously or concludes that it is better off making a concession rather than having to risk the alternative. Have financial statements for the last year ready because creditors like to see numbers when they are asked for debt relief.
Don’t forget leases. Leases are debt, too, and can also be restructured. Rent is the second-largest expense for many businesses just behind payroll or costs of goods sold. Why not approach the landlord for a lease concession before becoming so desperate that the business must accept whatever the landlord offers? In this environment, the business might find that the landlord will happily provide concessions if it is confident that the business will not abandon the lease. Landlords are losing tenants in today’s world, so explain the business does not want to be another lost. In other words, the landlord may gladly work with renters to avoid having the business go bankrupt.
Avoid forbearance agreements. Beware forbearance agreements that require a business to make unanticipated concessions. For example, some creditors will happily give a short-term forbearance agreement — provided that high-rate default interest continues to compound during the forbearance period. This can easily lead to an immediate default of a now mountain-sized amount of past-due principal and interest.
Restructuring debt is another area where businesses need competent legal advice before they start negotiating. Not only can they be tripped up by the fine print, but debt reduction can trigger income taxes on forgiven debt.
BUILD UP CASH RESERVES AND PROTECT PERSONAL ASSETS
What if business bankruptcy is unavoidable? Make sure the business has adequate cash reserves. Pay only for what it intends to keep. Reserves are needed to keep the business running at the beginning of a business reorganization bankruptcy (Chapter 11 bankruptcy) and to pay the attorneys and accountants who will be key to processing the bankruptcy. Do not plan on running up credit cards just before bankruptcy in lieu of preserving reserves.
How much reserves are needed? That depends on the size of the business and other circumstances, but small businesses should expect to pay their bankruptcy attorney at least $20,000 to $50,000 before filing a business bankruptcy.
How do business owners protect their personal assets from a business bankruptcy? Most businesses should be in corporations or “charging order protected entities” such as limited liability companies to protect personal assets from business debts. Be careful not to get behind in business debts that result in personal liability, such as failure to remit payroll withholding taxes to the IRS or transaction privilege taxes to Arizona Department of Revenue. Also, consider negotiating away any personal guaranties of business debts. Finally, business owners should avoid using home equity, personal savings, IRA savings or 401(k) savings in a failing attempt to save their businesses. Much — if not all — of these assets may be protected from creditors even in a bankruptcy. Using them to prop up a failing business may result in losing the business and unnecessarily losing the owner’s savings.
Bankruptcy avoidance and debt restructuring can be complex and have unintended consequences if not done correctly and thoughtfully. Consulting an experienced attorney not only helps business owners identify significant issues that should be resolved before they are locked into something they regret, but also helps them from being crushed by the coming wave of bankruptcies.
Lamar Hawkins
J. Phillip Glasscock
Lamar Hawkins and J. Phillip Glasscock are attorneys with Guidant Law Firm in Phoenix. Hawkins is also chair of the Arizona Board of Legal Specialization’s Bankruptcy Law Advisory Commission and one of Arizona’s foremost experts on bankruptcy law, debt restructuring, loans and loan workouts. Glasscock is a retired CPA with more than 35 years of experience in business transactions, real estate and litigation.
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