BUYING A DISTRESSED BUSINESS: TEN TIPS FOR ENTREPRENEURS

By Scott Edward Walker

Walker Corporate Law Group, PLLC

Now that the “easy-credit” party has ended, there will likely be extraordinary
opportunities for entrepreneurs to buy distressed (i.e., financially-troubled) businesses at
bargain 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 a
healthy, solvent business. Below are ten tips for entrepreneurs who are looking to get
into the distressed M&A game, which relate to two different contexts: (i) prior to (or
absent) 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 discussed
below, it is generally advisable to purchase a distressed business after the target’s Chapter
11 filing pursuant to Section 363 of the Bankruptcy Code (a “Section 363 Sale”) due to
its speed, benefits and flexibility.

Non-Bankruptcy Context

1. Do Your Diligence. A comprehensive due-diligence investigation is a

fundamental buy-side component of any acquisition, but it is particularly important in
connection with the acquisition of a distressed business due to, among other things, the
likelihood of limited (or a lack of) recourse post-closing. Needless to say, a rigorous
analysis of why the business is distressed is critical -- e.g., Is the business over-burdened
with debt? Are there any significant liabilities such as an adverse judgment or product
liability claims? Has the business lost key management? Are the target’s problems
merely related to poor execution? Only after such an analysis has been completed can
the entrepreneur and his/her transaction team strategize to develop an effective game plan
in connection with the acquisition. Indeed, it may very well be the case that the buyer’s
only practical course of action is an acquisition in the bankruptcy context.

2. Buy Assets, Not Stock (Equity). Generally speaking, it is usually

advantageous for an acquiror of a private company to purchase assets, not equity, of the
target for two principal reasons: (i) it will obtain a stepped-up tax basis in the acquired
assets; and (ii) it will minimize the assumption of any unwanted liabilities. If the private
company is severely distressed, however, there may not be tax benefits to an asset deal; it
is nevertheless clearly the most prudent structure from a liability/risk perspective due to
the greater likelihood of undisclosed/unknown liabilities of the target relating to the
stresses of the circumstances, including potential tax liabilities, claims/lawsuits accruing
pre-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 that
every 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 assets
from a distressed target are purchased prior to a Chapter 11 filing, a significant risk the
entrepreneur buyer faces is a subsequent fraudulent transfer challenge. Under federal
law, state law and/or the Bankruptcy Code, the sale can be avoided (i.e., set aside) upon a
showing by dissatisfied creditors or by a bankruptcy trustee subsequent to a bankruptcy
filing that there was “actual” fraud (i.e., the sale was actually intended to hinder, delay or
defraud creditors) or, more likely, “constructive” fraud (i.e., the sale was made for less
than fair consideration or reasonably equivalent value and the target was insolvent at the
time of, or rendered insolvent by, the sale). Indeed, Section 544 of the Bankruptcy Code
permits 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 two
things: (i) build the best possible record that “fair consideration” or “reasonably
equivalent value” was paid (e.g., by obtaining a fairness opinion from a reputable
investment bank); and (ii) require that (A) the sale proceeds stay with (or be used for the
benefit 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 entrepreneur

buyer faces when acquiring a distressed business in the non-bankruptcy context is the
possibility of the target’s Chapter 11 filing after the purchase agreement has been
executed, 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-petition
claim 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 locking
the buyer into a deal that, perhaps, may not look so good after weeks/months of the
deterioration of the target’s business. (Not to mention the possibility of a significant time
delay in waiting for the target’s decision of rejection/assumption.) The best way to
eliminate this risk is to sign and close the acquisition simultaneously.

5. “Hold-back” or Escrow a Significant Portion of the Purchase Price. If the

distressed target files for bankruptcy after the closing of the acquisition of its assets, the
buyer’s claim for a purchase price adjustment and/or indemnification under the purchase
agreement will be treated as an unsecured, pre-petition claim (again, often worth pennies
on the dollar). Indeed, certain indemnification claims may be disallowed if they are
contingent at the end of the Chapter 11 case. Absent a guarantee from a creditworthy
affiliate or stockholder of the target (which will obviously be difficult to obtain), the best
way 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 acquisition
of a healthy private company (typically 10-15% of the purchase price); however, if the
company 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 a
Chapter 11 debtor may be consummated either as a Section 363 Sale or as part of the
debtor’s overall plan of reorganization. A Section 363 Sale is the more common method

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because it is faster and cheaper (i.e., it avoids the plan confirmation process - with its
complex disclosure and voting procedures) and therefore minimizes the risk of a decline
in enterprise value and/or a shortage of working capital. From the buyer’s perspective, a
Section 363 Sale is often more attractive than a non-bankruptcy acquisition for a number
of significant reasons, including: (i) in most cases, the bankruptcy court will approve the
sale of the assets “free and clear” of all liens and liabilities (other than those liabilities
that the buyer expressly agrees to assume and, arguably, certain “successor” liabilities
such as environmental and product liabilities claims); (ii) the approval of the bankruptcy
court 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’s
assumption/rejection rights discussed above) in ways not possible in the non-bankruptcy
context and assumed contracts will be “cleansed” of non-assignability or change-of-
control provisions (except for certain contracts such as personal-services contracts and
certain 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 to

bankruptcy court approval after notice to interested parties and a hearing. To ensure that
the debtor has obtained the “highest and best” price for its assets, an auction will usually
be conducted under the supervision of the bankruptcy court. Accordingly, the threshold
question 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 just
wait to see the final sale terms approved by the bankruptcy court and then decide whether
to 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 an
adequate due-diligence investigation; (ii) the ability to set the threshold price and terms
of the sale; and (iii) the ability to negotiate certain deal protections and bid procedures, as
discussed below. The major risk to being the stalking horse, of course, is bidding too
high -- 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-bankruptcy

context, a buyer generally negotiates solely with the distressed target’s management and
need not deal with its creditors (except where the buyer is seeking amendments to debt
documents or waivers, etc.). In a Section 363 Sale context, however, there are a number
of different constituencies -- often with disparate interests -- with which the buyer must
deal, 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 buyer
understand the debtor’s capital structure and the dynamics of the various pieces and then
keep all of the relevant constituencies “on board” throughout the negotiation process. To
be sure, a Section 363 Sale will generally require the support of secured creditors unless
the sale proceeds are adequate to pay them in full. If there are first-lien holders and
second-lien holders, and the first-lien holders will be paid in full, but the second-lien
holders will not, the second-lien holders may be able to block the sale. Moreover, equity
holders and/or unsecured creditors will often oppose a Section 363 Sale if their interests
have not been adequately addressed (e.g., if only secured creditors are being made whole

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by the sale) and they think a plan of reorganization would be more beneficial to them --
though a Section 363 Sale may generally be approved over their objection.

9. Focus on the Bidding Procedures in the Purchase Agreement. If the buyer is

willing to be the stalking horse, it must bear in mind the context of the transaction and the
competitive environment discussed above (i.e., the likelihood of a subsequent auction).
Indeed, the purchase agreement that the stalking horse executes must be approved by the
bankruptcy court and will serve as the bid document against which other parties will
submit their proposals. Accordingly, it makes strategic sense to keep the agreement as
simple as possible and for the buyer to rely on its due diligence and the order of the
bankruptcy court for protection rather than comprehensive representations and warranties
and indemnification provisions (which will significantly discount its bid). The most
effective use of the stalking horse’s leverage is in connection with the negotiation of
bidding procedures, including: (i) a bid deadline and an auction date, (ii) qualified bidder
criteria provisions (e.g., no financing conditions), (iii) overbid requirements and matching
rights, (iv) a termination fee and expense reimbursement provisions and (v) auction rules.

10. A “Pre-Pack” May Be a Good Alternative. Time is often the buyer’s biggest
(and least predictable) risk in connection with purchasing distressed assets in the
bankruptcy context. The debtor’s filing may, for example, trigger protracted negotiations
among the various constituencies, unexpected claims, litigation, etc. Accordingly,
“prepackaged” Chapter 11 plans (“Pre-Packs”) -- which may include a Section 363 Sale -
- are becoming more prevalent (particularly in light of the increased costs and the
difficulty of existing management to control the bankruptcy process under the
Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, the new bankruptcy
law that went into effect in October 2005). Indeed, where a company has a sound
business model, but is overburdened by debt, a Pre-Pack may be particularly appealing to
avoid the risks of purchasing distressed assets in the non-bankruptcy context (discussed
above), coupled with the lower approval thresholds of Chapter 11.

Scott Edward Walker is a former big-firm New York corporate lawyer, with 15+
years of sophisticated corporate-transactional and securities-law experience. Mr.
Walker is the founder and CEO of Walker Corporate Law Group, LLC, a boutique
corporate law firm specializing in the representation of entrepreneurs and their
companies, with offices in Beverly Hills and Washington, D.C. You can learn more about
Mr. Walker’s practice at www.walkercorporatelaw.com, and he can be reached at
swalker@walkercorporatelaw.com. Please note that the foregoing article has been
provided by Mr. Walker solely for informational purposes and does not constitute (and
should not be construed as) legal advice in any respect. Mr. Walker expressly disclaims
all liability in respect of any actions taken or not taken based on any contents of the
article. Copyright © 2009 Scott Edward Walker. All Rights Reserved.
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