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BUYING A DISTRESSED BUSINESS: TEN TIPS FOR ENTREPRENEURS
By Scott Edward WalkerWalker Corporate Law Group, PLLCNow that the “easy-credit” party has ended, there will likely be extraordinaryopportunities for entrepreneurs to buy distressed (i.e., financially-troubled) businesses atbargain prices. Buying a distressed business, however, is tricky stuff and raises a host of significant risks and potential problems that are not typically found in the acquisition of ahealthy, solvent business. Below are ten tips for entrepreneurs who are looking to getinto the distressed M&A game, which relate to two different contexts: (i) prior to (orabsent) a distressed target’s Chapter 11 filing -- i.e., the non-bankruptcy context; and (ii)after a distressed target’s Chapter 11 filing -- i.e., the bankruptcy context. As discussedbelow, it is generally advisable to purchase a distressed business after the target’s Chapter11 filing pursuant to Section 363 of the Bankruptcy Code (a “Section 363 Sale”) due toits speed, benefits and flexibility.
Non-Bankruptcy Context
1.
 Do Your Diligence
. A comprehensive due-diligence investigation is afundamental buy-side component of any acquisition, but it is particularly important inconnection with the acquisition of a distressed business due to, among other things, thelikelihood of limited (or a lack of) recourse post-closing. Needless to say, a rigorousanalysis of why the business is distressed is critical -- e.g., Is the business over-burdenedwith debt? Are there any significant liabilities such as an adverse judgment or productliability claims? Has the business lost key management? Are the target’s problemsmerely related to poor execution? Only after such an analysis has been completed canthe entrepreneur and his/her transaction team strategize to develop an effective game planin connection with the acquisition. Indeed, it may very well be the case that the buyer’sonly practical course of action is an acquisition in the bankruptcy context.2.
 Buy Assets, Not Stock (Equity)
. Generally speaking, it is usuallyadvantageous for an acquiror of a private company to purchase assets, not equity, of thetarget for two principal reasons: (i) it will obtain a stepped-up tax basis in the acquiredassets; and (ii) it will minimize the assumption of any unwanted liabilities. If the privatecompany is severely distressed, however, there may not be tax benefits to an asset deal; itis nevertheless clearly the most prudent structure from a liability/risk perspective due tothe greater likelihood of undisclosed/unknown liabilities of the target relating to thestresses of the circumstances, including potential tax liabilities, claims/lawsuits accruingpre-closing and perhaps fraudulent activities. (The target, of course, will often push back and insist that the buyer take the entire company -- warts and all.) The bottom line is thatevery deal is different and must be structured and negotiated with the assistance of competent counsel, including tax counsel.
 
3.
Take Steps To Protect Against a Fraudulent Transfer Challenge
. If assetsfrom a distressed target are purchased prior to a Chapter 11 filing, a significant risk theentrepreneur buyer faces is a subsequent fraudulent transfer challenge. Under federallaw, state law and/or the Bankruptcy Code, the sale can be avoided (i.e., set aside) upon ashowing by dissatisfied creditors or by a bankruptcy trustee subsequent to a bankruptcyfiling that there was “actual” fraud (i.e., the sale was actually intended to hinder, delay ordefraud creditors) or, more likely, “constructive” fraud (i.e., the sale was made for lessthan fair consideration or reasonably equivalent value and the target was insolvent at thetime of, or rendered insolvent by, the sale). Indeed, Section 544 of the Bankruptcy Codepermits a bankruptcy trustee to utilize applicable state law to avoid such transfers for“reach-back” periods of six years or more. To minimize this risk, a buyer must do twothings: (i) build the best possible record that “fair consideration” or “reasonablyequivalent value” was paid (e.g., by obtaining a fairness opinion from a reputableinvestment bank); and (ii) require that (A) the sale proceeds stay with (or be used for thebenefit of) the target and not be distributed to the target’s stockholders and/or (B)adequate arrangements are made to pay-off the target’s creditors.4.
Sign and Close Simultaneously
. Another significant risk the entrepreneurbuyer faces when acquiring a distressed business in the non-bankruptcy context is thepossibility of the target’s Chapter 11 filing after the purchase agreement has beenexecuted, but prior to closing. In such event, the target would have the right to “reject”the purchase agreement, and the buyer would merely have an unsecured, pre-petitionclaim against the target for its damages (often worth pennies on the dollar). Conversely,the target would also have the right to “assume” the purchase agreement thereby lockingthe buyer into a deal that, perhaps, may not look so good after weeks/months of thedeterioration of the target’s business. (Not to mention the possibility of a significant timedelay in waiting for the target’s decision of rejection/assumption.) The best way toeliminate this risk is to sign and close the acquisition simultaneously.5.
“Hold-back” or Escrow a Significant Portion of the Purchase Price
. If thedistressed target files for bankruptcy after the closing of the acquisition of its assets, thebuyer’s claim for a purchase price adjustment and/or indemnification under the purchaseagreement will be treated as an unsecured, pre-petition claim (again, often worth pennieson the dollar). Indeed, certain indemnification claims may be disallowed if they arecontingent at the end of the Chapter 11 case. Absent a guarantee from a creditworthyaffiliate or stockholder of the target (which will obviously be difficult to obtain), the bestway a buyer can protect against this risk is to hold-back or escrow a significant portion of the purchase price. An escrow/holdback is often used in connection with the acquisitionof a healthy private company (typically 10-15% of the purchase price); however, if thecompany is distressed, the buyer should consider a greater amount.
Bankruptcy Context
6.
 A Section 363 Sale is Usually the Way to Go
. The purchase of assets of aChapter 11 debtor may be consummated either as a Section 363 Sale or as part of thedebtor’s overall plan of reorganization. A Section 363 Sale is the more common method- 2 -
 
because it is faster and cheaper (i.e., it avoids the plan confirmation process - with itscomplex disclosure and voting procedures) and therefore minimizes the risk of a declinein enterprise value and/or a shortage of working capital. From the buyer’s perspective, aSection 363 Sale is often more attractive than a non-bankruptcy acquisition for a numberof significant reasons, including: (i) in most cases, the bankruptcy court will approve thesale of the assets “free and clear” of all liens and liabilities (other than those liabilitiesthat the buyer expressly agrees to assume and, arguably, certain “successor” liabilitiessuch as environmental and product liabilities claims); (ii) the approval of the bankruptcycourt should bar any subsequent fraudulent conveyance challenge (as discussed above);(iii) the buyer will be able to cherry-pick assets and contracts (e.g., through the debtor’sassumption/rejection rights discussed above) in ways not possible in the non-bankruptcycontext and assumed contracts will be “cleansed” of non-assignability or change-of-control provisions (except for certain contracts such as personal-services contracts andcertain intellectual-property licenses); and (iv) State shareholder-approval laws and bulk-transfer laws generally do not apply to a Section 363 Sale.7.
 It May Pay To Be the Stalking Horse
. A Section 363 Sale is subject tobankruptcy court approval after notice to interested parties and a hearing. To ensure thatthe debtor has obtained the “highest and best” price for its assets, an auction will usuallybe conducted under the supervision of the bankruptcy court. Accordingly, the thresholdquestion for a prospective buyer is whether it should play the role of the “stalking horse”bidder (i.e., be the initial party to execute a purchase agreement with the debtor) -- or justwait to see the final sale terms approved by the bankruptcy court and then decide whetherto make a higher bid (assuming it has such an opportunity). There are a number of advantages to being the stalking horse, including: (i) more opportunity to conduct anadequate due-diligence investigation; (ii) the ability to set the threshold price and termsof the sale; and (iii) the ability to negotiate certain deal protections and bid procedures, asdiscussed below. The major risk to being the stalking horse, of course, is bidding toohigh -- i.e., locking into a deal that may not look so good at the time of the auction.8.
 Negotiate With All of the Relevant Constituencies
. In the non-bankruptcycontext, a buyer generally negotiates solely with the distressed target’s management andneed not deal with its creditors (except where the buyer is seeking amendments to debtdocuments or waivers, etc.). In a Section 363 Sale context, however, there are a numberof different constituencies -- often with disparate interests -- with which the buyer mustdeal, including perhaps secured creditors (e.g., first-lien and second-lien holders),unsecured creditors, equity holders (e.g., preferred and common stockholders),bondholders, landlords, indenture trustees, etc. Indeed, it is imperative that the buyerunderstand the debtor’s capital structure and the dynamics of the various pieces and thenkeep all of the relevant constituencies “on board” throughout the negotiation process. Tobe sure, a Section 363 Sale will generally require the support of secured creditors unlessthe sale proceeds are adequate to pay them in full. If there are first-lien holders andsecond-lien holders, and the first-lien holders will be paid in full, but the second-lienholders will not, the second-lien holders may be able to block the sale. Moreover, equityholders and/or unsecured creditors will often oppose a Section 363 Sale if their interestshave not been adequately addressed (e.g., if only secured creditors are being made whole- 3 -
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