The Bankruptcy Process

Yesterday I was talking with a bankruptcy attorney.  We have mutual friends and since Chicago is the smallest big town in America, we decided to have coffee.  The subject of bankruptcy came up.  He has also been a real estate investor, and has been an investor in distressed debt.  He’s been busy since 2008!

I told him I didn’t know the actual process of bankruptcy.  He put it pretty succinctly:

1. Entity can’t pay it’s bills, so the creditors foreclose.
2. They get a judgement, and the creditors hold the judgement
3. They use any cash left over in the entity to pay out accounts payable.
4. In Illinois, after 45 days, they hold an auction for the entity.
5. If no one bids, they hold the asset and own 100% of the equity
6. Their choice whether to recapitalize the asset, or sell off pieces, or figure out some other way to monetize it.

Pretty straightforward and simple.  I asked him, “What about startups and convertible debt?”  So many startups are using convertible debt to do initial financing so I found the question intellectually interesting.

It’s the same process.  In step 5, the debt holders would own 100% of the equity and the founders would be wiped out.  It’s step 6 that is tricky for startups.

Usually, there isn’t an intellectual property that is worth anything.  If the business failed, it’s highly doubtful that the holders of the equity would want to recapitalize it.  But, there might be rare instances where the original founders had a fabulous idea that showed some traction, but just weren’t the right people to run the show and bankruptcy was the only way to get rid of them.  Of course all this is on a case by case basis.

As the startup world starts to zero in on frothiness, burn rates, and potential of a downdraft in the stock market that leads companies to vaporize, it’s worth thinking about.

Debt is a double edged sword when it comes to startups.  It’s non-dilutive to equity holders.  For some that might be appealing.  If you can’t service the debt, or if you haven’t modeled a catastrophic event that upends your cash flows, debt becomes the blade that takes the company down.

Yet another reason why I prefer priced rounds better than convertible debt.