19 Feb, 2018
How to Raise Capital For a Company in Financial Troubles
In recent years companies experiencing solvency or liquidity problems were able to raise new capital in the debt and equity capital markets with relative ease. In this challenging environment, a financially troubled company that is able to identify the source of its distress, formulate a strategy to raise new capital and execute quickly might be able to prevent further deterioration to its financial health.
In general, a financially troubled company might raise much-needed capital through various types of debt or equity financing. The cost of each of these types of capital depends primarily on the perceived risk of repayment, which is contingent not only on company and industry-specific risk, but also on priority of repayment if the company fails.
Debt financing A company might be able to raise debt capital if it can assure the lender that it will repay the new loan. A lender might seek assurances through the company’s pledging of some or all of its property as collateral. A lender might also insist that any financial covenants in the debt documents be tight so that it has sufficient warning of declines in the company’s operating performance.
A company without any unencumbered assets must explore other options, more expensive as the uncertainty of repayment increases. Depending on the severity of the financial distress, the company could also explore raising unsecured or subordinated debt, which is more difficult and expensive the more leverage the company already has.
If these options are not viable, the company might refinance its existing debt from new or existing investors.
Equity financing As a financially troubled company might be insolvent, it is usually very difficult to raise equity capital. An equity interest holder is entitled to distributions only after all creditors have been paid in full. So, the risk of an equity losing is relatively high.
Despite this risk, some lenders might provide rescue financing to a troubled company in the form of debt and equity financing. The debt/equity financing arrangement provides the lender with the greater certainty of repayment that debt offers and the potential upside and control of an equity investment. As a result, the total cost of these types of arrangement to the company is often very high.
Asset sales A company can also sell assets or monetize other property such as accounts receivable to raise capital. Selling accounts receivable at a discount to a factor that assumes receivables collection risk also might provide quick cash to the company, although the discount for non-recourse factoring is often quite high. Any assets transfer might be attacked as a constructively fraudulent transfer, which occurs if the company was insolvent at the time of the transfer or was rendered insolvent by the transfer and the company received less than reasonably equivalent value or fair consideration.
Identifying a capital source that is ready, willing and able to infuse new capital on acceptable terms and conditions is challenging. The company must consider all possible sources, including existing and new lenders and investors, its customers and any combination of these sources.
Existing investors A financially troubled company searching for new capital usually turns first to its existing investors. First of all, they should be familiar with the company, its business and its management, and should therefore require less time to conduct due diligence, which could be advantageous where the company faces an imminent liquidity crisis. Also they may have little choice but to provide additional capital for protection their investment, if the company’s survival is the best way to maximize recovery.
New investors Even if existing investors might have an advantage and an interest in providing new capital, the company should explore opportunities with new investors, who might be able to offer different or creative types of capital that could fit within the confines of the company’s existing capital structure.
Existing customers Existing customers may also serve as a source of capital. A customer might agree to accelerate payment on existing accounts receivable or to provide a lump-sum subsidy to provide much-needed liquidity to protect its supplier. These types of arrangement are more common in industries, where the failure of a single company in the supply chain as a result of financial troubles to provide parts just in time could cause a ripple effect, potentially shutting down manufacturing operations until an alternative supply is obtained. As a result, some companies have implemented vendor rescue programs to provide financial or operational assistance to a distressed supplier.
Raising capital poses special challenges for a financially troubled company because it is often a multilateral, complex negotiation involving the company’s most important constituencies, including existing and prospective investors, customers, suppliers and employees. During these negotiations the company must know its business objective and the legal means for accomplishing it.
Before a company begins discussions with existing or prospective investors, it must identify the cause of its financial distress varying widely among companies and industries. Regardless of the cause, a company must understand why its financial performance has deteriorated. It would indicate to existing investors, customers, suppliers, employees and prospective investors that management is in control and can address the problems. Maintaining these constituencies' confidence helps to prevent losing key customers and employees and the imposition of tougher credit terms by suppliers. Furthermore, where several financially troubled companies might be competing for capital, investor confidence in senior management can be crucial to a company’s efforts to distinguish itself.
A financially troubled company does not have an easy path to raising capital. It requires the cooperation of a diverse group of parties whose interests might not be aligned with those of the company or even each other. After a company has identified the source of distress, what its existing debt documents permit and whether existing investors will consent, it must weigh up the substantial costs, delay and risks associated with a law filing against the company’s ability to accomplish the same business objectives in an out- of-court restructuring. This task is not easy.
If market conditions continue to deteriorate, as has been predicted, it will not get any easier. There will likely be greater competition among many highly leveraged companies for what might be a diminishing amount of available capital. As a result, capital — whether obtained in a bankruptcy or in an out-of-court restructuring — might be more expensive and the terms and conditions on which it is provided might be more onerous.
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Some ideas about capital-raising strategies: Bringing Your Company Public, Exploring Alternative Capital-Raising Strategies, Refinancing and Minority Equity as Partial Exit Strategies, 5 Alternatives To IPOs, How to Raise Capital For a Company in Financial Troubles, 7 Private Equity Strategies