There are several situations (financial and non-financial) which may trigger the need for financial restructuring, such as when your business is in financial difficulty and cannot pay its debts (financial or commercial) or breaches its covenants.
In such distressed situations, stakeholders (debtors and creditors) want to protect their position and provide a stable platform for the company.
If you are struggling with unmanageable debt and it is causing your business financial stress, it is important that you act quickly. Whether you have run into money troubles because of unemployment, illness, or taking on too much debt, the first step in taking control of the situation is to ask for help.
• There may be help available. Depending on the jurisdiction, this could include financial advisory services to discuss your situation and help you to get back on track.
There are a wide range of options for improving the financial health of the company – from self-initiated operational improvements and out-of-court workouts, to court-supervised reorganisation procedures, and bankruptcies. If financial distress becomes unmanageable, you should move from consensual solutions to formal insolvency. Here is an illustrative example of the flow of the different processes:
Monitoring your business is an important aspect of preventing financial distress. By regularly monitoring your business reports, you are able to react to any possible irregularities. Some examples include monitoring quarterly and annual reporting, business planning and annual budgeting. Monitoring your business is one element of thee early warning system as a tool used for recognising distressed signals and warnings. When the EWS recognises distress, it is time for the business to look into the matter.
In most businesses, closer monitoring of your business will be based on reviewing your short-term financing needs and potentials. A typical approach to this area is whether a business can secure the 13-week cash flow needed to stabilise the business. (This is also an element of financial restructuring.) Warning signals relating to deteriorating cash and liquidity should never be ignored, especially as small businesses depend highly on their cash liquidity and do not have as wide a set of options as larger businesses.
Financial and operational performance improvement programme (FOPIP)
If your business does not require an entire business turnaround or business exit, you should first look into a FOPIP (financial and operational performance improvement programme). A FOPIP is an informal plan created by the owner or management team in order to try to restructure the business or implement selected improvements to stabilise its financial and operational performance without conducting any formal actions.
If successful, having a FOPIP plan will help you deal with the distress without the formal process of restructuring. It starts with conducting a current state analysis of your business and determining the future state model, as well as an action plan to accomplish it. If the FOPIP works, you can continue business as usual.
If the FOPIP is unsuccessful, you should start the process of financial restructuring. This process will typically involve an independent business review, along with planning and money management, out-of-court workouts (OCWs), turnaround, formal reorganisation and formal liquidation.
Independent business review
The first step of financial restructuring is an independent business review (IBR). An IBR is conducted within the business. The purpose of an IBR is to identify the key problems or issues with the financial performance, identify options and develop solution recommendations. Objectives that should be assessed during this review include:
• whether management has developed financial forecasts which are consistent with its declared strategy
• whether those assumptions are supported by the facts
• what would be the possible financial impact of any departure from those assumptions.
Cash forecasting and management
Cash forecasting and management is the next step in financial restructuring. During this step you should set up cash flow forecasting (and especially a rolling forecast that will be in line with your new business conditions (the financial challenges that have arisen), as well as test out the cash outcomes. The goal of this step is to understand and stabilise the cash flow and liquidity. For more details on cash planning and management, follow this link.
Turnaround is the part of the process in which you address all the elements of underperformance and rehabilitate your business in order to meet your financial objectives. If you complete this step successfully, you can continue business as usual.
You may also choose to enter private discussions with your creditors on an out-of-court workout to amend the terms of any financing arrangements. This can be conducted in parallel with any operational turnaround.
Out-of-court workouts (OCWs)
During financial restructuring, and restructuring in general, your focus should always be on internal processes as the first steps, such as IBR, cash forecasting or negations. If those do not suffice, you should try further consensual negotiations, such as an out-of-court workout (OCW) with your creditors. An OCW is a consensual and contract-based negotiation without judicial intervention between a debtor and one or more creditors that is frequently used to restructure the debtor’s liabilities.
OCWs are often considered a part of financial restructuring and if all creditors agree and your financial stability is restored, you can go back to business as usual. You should be aware that creditors who have not participated in the negotiations or have not agreed to the settlement can sue for their debt and enforce their claims.
If you cannot get the necessary support from all your creditors for an OCW, you may try concluding an agreement via a formal reorganisation procedure in which you typically need only the support of your majority creditors to bind all of your creditors: minority creditors are forced to accept the procedure. Depending on the jurisdiction, a hybrid procedure may be available that combines OCWs with a formal court approval within a reorganisation.
This illustration provides an example of different processes, from informal OCWs to formal insolvency proceedings.
Based on World Bank Toolkit for Out-of-Court Workouts. World Bank Document
When arranging out-of-court workouts, a business may have to negotiate with a number of different creditors. The International Federation of Insolvency Professionals (INSOL) has published guidance for debtors and creditors in the form of principles for multi-creditor workouts. The principles cover the topics from financial circumstances to governance of the processes and provide guidance on the best examples and leading practices. For more guidance, see here.
Negotiated out of court settlement with creditors
When your business is unlikely to recover but you are still solvent, you may wish you to consider working together with creditors to wind down your business in an orderly out-of-court process.
When going through a negotiation with creditors, a number of different sensitive (and not always comfortable) topics will come up for discussion, such as reducing or eliminating some of the business’s debts.
Negotiation is generally a powerful tool when restructuring your business in the early stages, especially when going through financial restructuring. Depending on your circumstances, you may be able to resolve your debt problems by negotiating a settlement with your creditors. Negotiating with your creditors (mainly credit institutions) to restructure debts can provide a sustainable path going forward. Learn the basics of how to handle difficult conversations and disputes to assist you in your processes.
If you plan to negotiate with creditors, it is a good idea to get your accountant, lawyer or budgeting expert to help.
Illustrative example of out-of-court negotiations
A small family hotel business opened its doors to public a couple of months before the Covid-19 pandemic crisis emerged globally. Before opening this hotel, the family was already in the hospitality business, renting a couple of apartments in the city centre. The owner had the necessary knowledge and expertise to run a hotel, and understood well the key elements of the business operations.
In order to be able to establish the hotel business, the owner took out an SME-targeted loan with a bank. The terms initially agreed were already preferable with a two-year grace period and attractive low interest rates.
As the negative effects of the pandemic hit travellers worldwide and what was normally a very touristic city and season was suddenly closed for visitors and travellers, the hotel needed to close its doors as well. The negative effect lasted for a couple of months, posing significant challenges to the sustainability of the investment and future business generally.
Faced with this situation, the owner performed the following activities:
• Set up a meeting with the bank (creditor) to negotiate the extended terms, prolonging the contract duration and increasing the grace period for the duration of the negative lockdown effects. In practice, this was an additional 6 months.
• Reviewed and activated government support for the specific hospitality and travel sectors and also support related to keeping workers in employment throughout the period of disruption.
• Negotiated with suppliers regarding contracts and continuation of the business after the period of disruption and, in the meantime, cancelled long-term contracts with suppliers by invoking force majeure.
After conducting these initial actions, the owner decided to review the financials of his business. After careful review, he noticed that the business’s cash was not sufficient to last for a period longer than two months. This meant that he was not able to ask the bank for an additional short-term loan. Therefore, the owner decided that the business’s best option was to operationally restructure and provide a different array of services, at least until the crisis was over. The small hotel changed its primary focus from providing overnight stays to renting out the rooms and hotel spaces to customers that needed private office space.
Model standstill agreement
To stabilise the business you can reach an agreement with your creditors where they agree not to take steps to enforce their debts against the business for a short period during which you negotiate the terms of a restructuring agreement. This temporary agreement is known as a standstill agreement as creditors agree to ‘stand still’ for a period and not take any enforcement action. The period of standstill should be designed to give the business owners and creditors sufficient time to consider restructuring options such as recapitalising, rescheduling of debt or other alternatives.
A standstill agreement removes the immediate pressure on the business and preserves the status quo. Often banks have their own form of standstill agreement and will supply you with this, but for other types of creditors such as trade creditors, you can use this standard document template to prepare a model standstill agreement.
• The model agreement identifies ‘standstill issues’ and invokes a ‘standstill period’ during which the party owed performance (the creditor) agrees not to seek certain remedies, and the party owing performance (the debtor business) agrees that it will not undertake a range of acts that may ultimately harm the other party.
During the standstill period, the rights of creditors should be taken into account and you should not take any actions which could negatively affect the likelihood of creditors being repaid.
• Examples of such prejudicial action would include:
— offering security to non-participating creditors
— transferring assets that form security for creditors away from the business
— selling assets to third parties at an undervalue or to creditors who, because they are already owed money, will not pay for them
— running down or shifting value from the business so that the prospects of repayment to the relevant creditors are diminished.
• Incurring new additional borrowings or credit from parties who are not relevant creditors can also be an issue of sensitivity, as can the use of techniques such as factoring or leasing to raise new finance.
During the standstill period, you should provide, and allow relevant creditors access to, all relevant information relating to your assets, liabilities, business and prospects, in order to enable a proper evaluation to be made of your financial position and any proposals to be made to relevant creditors.
Businesses that are able to agree on a debt restructuring with their creditors through a formal or informal reorganisation process will need to prepare a restructuring plan.
• It is important to remember that, in most cases, you need to prepare and enter into a new agreement or contract with your creditors on which you agree the terms of the restructuring, such as a rescheduling of debt repayments and so forth. Your restructuring plan will become your new business strategy and operational performance plan.
• A restructuring plan often resembles the original business plan, with the key difference that it is based on a new financial restructuring plan (a new financial and liquidity position) which should be complemented with operational improvements to secure long-term sustainability.
• Here you can find a typical structure of a restructuring plan.
When a restructuring plan is developed and approved, the resulting plan effectively supersedes your original business plan. This is likely to be more detailed and time-sensitive than a traditional plan. One key to success is how effective you are in adapting to changes during the implementation phase.
• The restructuring plan is prepared based on communication and negotiations with creditors and needs to be adhered to.
• Each restructuring initiative should be considered as a standalone project which needs to be implemented and monitored.
You need to be aware that deviations from the restructuring plan and any further business underperformance may put you at risk of insolvency.
If none of the less formal procedures are successful, you will need to start a formal reorganisation. Formal reorganisation is a court-supervised procedure through which entities that cannot repay debts to creditors may impose a reorganisation plan on all of their creditors subject to obtaining majority creditor consent and satisfying any other legal conditions to achieve a restructuring. In some jurisdictions this can be partially completed out of court and the agreement submitted to the court for its approval.
Formal reorganisation includes court-supervised reorganisation procedures where you will try to reorganise your financial liabilities and create a capital structure which will be appropriate for your operations, future cash flow and profitability.
Read the next article for more details on formal insolvency procedures.