by Joe Pimbley, Columnist & Featured Contributor[message type=”custom” width=”100%” start_color=”#F0F0F0 ” end_color=”#F0F0F0 ” border=”#BBBBBB” color=”#333333″]Editor’s Note: This is the second in a new Series of Articles by Joe, as excerpted from his Book; “Banking on Failure” co-authored by Laurel McDevitt. [/message]
[su_dropcap style=”flat”]A[/su_dropcap]LL BUSINESSES – no matter how successful in the present – will fail eventually unless the owners wind down the operation voluntarily. Far from being a problem, in the big picture sense at least, failure is actually an ingenious component of capitalism. It is the ever present threat of failure that prods companies to keep costs low, product quality high, and customers happy. Even for a company that nominally succeeds with cost and quality, competitors may be better, more effective, and more innovative in winning customers’ business.
Discussion of
business failure has threads of virtually infinite length in many directions. We shall focus narrowly here on the financial description of failure. This chapter provides background and context for the book’s larger themes of risk in the banking system and on how banks should run their businesses to avoid failure. But the content here applies to businesses broadly and not to banks specifically. We do not yet bring in the roles of bank regulators and government bailouts. Let’s think of banks as “just like any business” for now.
Role and Diversity of the “Investors”
Failure strikes a business when it cannot honor a contract of some sort. Such contracts impact four types of investors: equity holders; debt holders; employees; and suppliers. The word “investors” is unusual here in its application to employees and suppliers, but it’s appropriate given their investment of time and resources into the business.
Equity holders, also known as stockholders, are the owners of the business. They are entitled to all profits – which are revenues remaining after paying employees, suppliers, debt holders, and taxes. As owners, the equity holders also decide company strategy. If the business performs poorly, the employees, suppliers, and debt holders have first claim on revenues and assets in order to pay wages, invoices, and interest and principal on debt.
Debt holders are people or entities that own bonds or loans of the company or have some other right to receive future payment (such as a government taxing authority for taxes already incurred). For such debt, the business has a documented legal obligation to make payments on specified dates. Failing to make one of these specified payments is known as “default.” A typical feature of the debt agreement, called “acceleration,” stipulates that such a default renders all other future payments of every bond and loan of the business immediately due and payable. Hence, even if total repayment is not originally due for twenty years, the required repayment date becomes “today” when the business misses a current payment. Acceleration is punitive! It’s a disaster scenario for the business.
Employees provide services to the business in exchange for salary, benefits, and any other agreed compensation. Suppliers, also known as vendors, provide goods and services in exchange for payment. Suppliers do not typically receive payment as soon as they deliver products or render services. Rather, they invoice the business and expect payment within an agreed time such as 30-60 days.
Point of Failure
The point of failure of a business is simply that point in time at which it cannot pay one or more obligations. If the company fails to make a debt payment, then the acceleration feature will amplify the payment shortfall. When a supplier goes unpaid, it will stop providing services or demand immediate cash to continue services. Other suppliers will behave similarly when they learn of this failure to pay. A business that manages to continue paying debt holders and suppliers by asking its employees to forego salary for some period is obviously courting trouble. Employees expect to be paid!
Healthy businesses pay their employees, suppliers, and debt holders every month as these contractual obligations become due. A good measure of ability to make all these payments is the company’s pre-tax net income which is simply the business revenue minus the contractual payments and other expenses. More precisely, we need to distinguish debt principal from interest for this reference to net income, but the larger point remains that healthy profit (a synonym for “net income”) is a strong indicator that a business is not near the point of failure.
Yet a company with significant ongoing losses may not necessarily be at the brink of failure. If there are ample assets to continue making necessary payments even while the business loses money, then the business may survive. Profitability must return at some point, of course. This period of business losses being covered by existing reserves is known as “cash burn.” The equity of the business deteriorates during this timeframe by the same amount. As one might expect, it is the equity holders who are most unnerved and unhappy during this phase. If they cannot determine a change in strategy that will return the company to profitability, these equity investors will sell or unwind the business. A great example of this cash-burn quandary is the Canadian firm BlackBerry in late 2013.[1]
Consequences of Failure
When a business cannot make contractual payments to a debt holder or other creditor (such as a supplier or employee), the affected creditor will likely sue the business to get a court to compel payment. A court judgment in favor of the creditor could attach business assets, hinder the firm’s normal activity, and foster lawsuits from other creditors. Hence, a business in this situation will typically file for bankruptcy protection. This filing prevents creditors from seizing assets, permits the business to break other contracts and commitments, and institutes a large negotiation between the debtor (i.e., the business) and all creditors under the supervision of a bankruptcy judge.
As a rule, equity investors lose everything in bankruptcy. They had been owners of a firm that could not pay its debts. Their consequence is that they lose ownership of the firm and any money they’d invested in the past.
For the creditors, the goal of the bankruptcy exercise is to maximize the value of the firm’s assets in order to give each creditor the highest possible “recovery” in this default event. One possibility is to liquidate the firm by selling any and all assets that can be sold. A competing company, for example, may be willing to buy a production facility of the defunct business. The easiest assets to sell are financial assets (i.e., stocks, bonds, loans, et cetera). Business assets may include marketable intellectual property such as patents or a valued trade name. (The company Hostess Brands, Inc. owned the valuable trade names Hostess and Dolly Madison when it liquidated in a bankruptcy proceeding. The court sold these trade names to private investors.[2]) If, after selling all conceivable assets down to the desks and office chairs, the creditors receive 70 cents for every dollar the business owed them, that’s reasonably good recovery as bankruptcies go. Employees generally have the highest priority of all creditors to receive past wages, but they will all lose their jobs upon a liquidation.
Another possibility is that the failed business will “emerge from bankruptcy” to continue its business. The U.S. airlines have the habit of going into and emerging from bankruptcy on a frequent basis. (Recent major airlines that filed bankruptcy proceedings are American Airlines in 2011,[3] Delta Air Lines in 2005,[4] Northwest Airlines in 2005,[5] US Airways in 2004,[6] and United Airlines in 2002.[7]) In such cases, the creditors and the bankruptcy court have decided that ultimate recovery is higher if the business continues. The original equity investors still lose everything. The original debt investors often receive equity in the new, post-bankruptcy entity in exchange for taking losses on the earlier debt. Hence, a reason the business may survive after emerging from bankruptcy is simply that it will have less debt. In effect, the debt holders exchanged some debt for equity.
Are these debt holders “happy” because they now own the company? Not really. Their ownership is simply a mechanism with which they hope to recoup the original loan amount. The vast majority of lenders would regret their earlier decisions to lend to the business. There exists a minority, though, of “distressed lenders” who buy bonds and loans of the failing business before bankruptcy at a discount to face value. The goal of these distressed buyers, both through negotiation during bankruptcy and from the low purchase price, is to realize value post-bankruptcy in excess of their invested amount.
Broadly speaking, these are good and “fair” outcomes. The owners of a business will lose their investments if the business cannot repay its debt. The lenders to this business will lose the amounts they lent to the extent the assets of the business are worth less than the loans. When there is failure, there will be losses. The investors should take the losses that accrue to their positions.
When a business fails, there are reasons. It may be that management made poor decisions or that they paid themselves too much or that they could not build their products at sufficiently low cost or that customers simply did not wish to buy what the company offered. The natural consequence of any of these problems is that the Board of Directors – which represents shareholders – should fire management and get another team to correct the shortcomings. Either the change in management will work or the company will fail.
It is market discipline that leads to business failure. A company that makes poor choices (e.g., with debt or expenses) or that otherwise cannot find a profitable strategy should cease to exist. Consumers and the market do not need the failing company – otherwise the company would not be failing.
Individually and collectively as employees, we all wish to avoid failure. It is the certainty of market discipline that motivates all of us in the private sector to make good business choices, keep expenses low, and provide services that customers value. When we do fail, we lose our jobs and need to move quickly to find or form new businesses with new methods or new products.
[1] See, for example, “BlackBerry Comeback Hampered by Vanishing Cash,” Bloomberg, November 5, 2013.
[2] See, for example, “Hostess Sells Twinkies Brand to Investment Firms,” New York Times, DealBook, March 12, 2013.
[3] See, for example, “American Airlines files for bankruptcy,” Reuters, November 29, 2011.
[4] See, for example, “Delta, Northwest File for Chapter 11 Bankruptcy,” Fox News, September 14, 2005.
[5] Id.
[6] See, for example, “U.S. Airways Files for Bankruptcy for Second Time in Two Years,” PBS NewsHour, September 13, 2004.
[7] See, for example, “United hits turbulence of bankruptcy,” CNNMoney, December 9, 2002.
The next excerpts for Chapter 2 will discuss “Likelihood of Failure” and “Lessons for Running the Business.”
