Navigating the Storm: A Guide for Boards and Management on Handling Predatory Financiers

In the complex and often turbulent waters of corporate distress, debtor-in-possession (DIP) financing emerges as a "beacon of hope", offering firms a lifeline during bankruptcy proceedings. However, this lifeline is not without its perils, as predatory DIP financiers can steer a vulnerable company toward even rockier shores. As boards and management navigate these troubled waters, understanding the nature of predatory DIP financiers, the alternatives to DIP, and adopting strategic do's and don'ts is critical to safeguarding the company's value and future.

In April 2020 amidst COVID 19 a mass layoff plan began across all industries. In the tech sector, the first reports were about 21,000 employees across more than 200 startups who got laid off since early March 2020, according to Layoffs.fyi, a San Francisco-based job-loss tracking project. Since early 2020, Layoffs.fyi has been keeping track of these stats, more info is provided below.

Understanding Predatory DIP Financing

Predatory DIP financiers, often called "vulture investors" or "the undertakers" of Wall Street/Silicon Valley/etc., i.e. investment bankers who specialize in lending to companies in distress. They do this by offering terms that may be overly onerous or designed to convert debt into controlling equity stakes under favorable conditions for the lender but not necessarily for the company. These financiers deal in private (typically VC-funded) and publicly traded companies. While these financiers can provide the necessary capital to keep a company operational through bankruptcy, their involvement can come with strings attached that potentially compromise the long-term interests of the company, its employees, and other stakeholders.

The Do's

1. Do Conduct Thorough Due Diligence: Before entering into any DIP financing agreement, conduct a comprehensive review of the terms and the financier's track record. Look for red flags such as excessively high-interest rates, onerous repayment terms, or conditions that could rapidly dilute existing equity.
2. Do Seek Multiple Proposals: Competition is your friend. By soliciting multiple proposals, you not only gain leverage in negotiations but also a clearer sense of the market rate for DIP financing terms.
3. Do Negotiate Strongly: With the future of the company at stake, negotiate every term to maintain as much control and flexibility as possible. This includes interest rates, covenants, and any equity conversion terms.
4. Do Consult with Legal and Financial Advisors: Engage experienced bankruptcy attorneys and financial advisors early in the process. Their expertise is invaluable in evaluating terms, conducting negotiations, and ensuring that the agreement aligns with the company's best interests.

The Don'ts

1. Don't Rush the Process: Desperation can lead to poor decision-making. While time is of the essence in distress situations, rushing into an agreement without proper due diligence can be far more detrimental in the long run.
2. Don't Overlook Other Financing Options: DIP financing is not the only option. Explore all alternatives, including asset sales, equity injections from existing stakeholders, or traditional loans, even if they require significant restructuring.
3. Don't Ignore the Long-Term Impact: Consider how the DIP financing terms will affect the company's ability to emerge from bankruptcy as a viable entity. Short-term relief should not come at the expense of long-term viability.
4. Don't Isolate Stakeholders: Keep open lines of communication with all stakeholders, including creditors, employees, and shareholders. Their support can be crucial in navigating bankruptcy successfully and may offer alternative solutions or concessions that reduce the need for predatory DIP financing.

Alternative Options?

Before resorting to DIP financing, boards, and management must explore all available alternative financing options. One often underutilized strategy is conducting a rights offering, which involves issuing new shares to existing shareholders at a predetermined price, usually at a discount to the market price plus a cash warrant as an incentive. This approach not only allows the company to raise necessary capital but also allows existing shareholders to maintain or even increase their stake in the company, thereby avoiding the complete loss of ownership that typically occurs with DIP financing under bankruptcy proceedings.

Rights offerings can be particularly effective in rallying the support of the company's existing shareholder base, demonstrating confidence in the company's recovery plan, and aligning the interests of shareholders with the long-term success of the company. Additionally, this method can sometimes be more cost effective and quicker to execute than securing new external financing, especially in cases where shareholder support is strong and the company's recovery prospects are credible.

Furthermore, management should consider other financing alternatives such as asset sales, strategic partnerships, and IP licensing - but not to the trolls! - (*see PS note at the end of the article on patent troll organizations and strategies), or mergers and acquisitions that can provide the needed liquidity without the stringent conditions attached to predatory DIP financing. Leveraging the company's assets, whether through direct sales or as collateral for more traditional forms of financing, can offer a lifeline without ceding control to external parties.

THE GREAT UNWINDING...

As discussed further above, Layoffs.fyi has been keeping track of important stats since COVID-19 so let us take a closer look:

In 2023, 1190 tech companies have reported 262735 employees being laid off and as you can see below, layoffs picked in Q1 2023.

Experts say that the true depth of the layoff impact is much more widespread, with more than 5 people affected per lost job, especially in tech.

A Cautionary Tale: The Case of "ToyCo"

One illustrative cautionary tale involves a fictional company, "ToyCo" (a stand-in for any number of real cases), which found itself in financial distress and turned to DIP financing as a lifeline. The board and management, under the pressure of looming bankruptcy and eager to secure immediate financial relief, partnered with a financier known for aggressive terms. This partnership was made without comprehensive due diligence or exploring alternative financing options, driven by a subset of board members and upper executives, who stood to gain personally from the specific DIP financing terms through various pre-arranged agreements.

As ToyCo proceeded through bankruptcy, the predatory nature of the DIP terms became apparent. The financier exerted undue influence over the restructuring process, pushing for asset sales at fire-sale prices to entities indirectly related to the financier, further diluting the value accessible to other stakeholders. Moreover, the restrictive covenants and high repayment rates imposed by the DIP financing severely limited ToyCo's operational flexibility, hindering its recovery and ability to invest in growth opportunities.

Ultimately, ToyCo emerged from bankruptcy as a shell of its former self, with the majority of its assets liquidated and the remaining operations significantly downscaled. The company's inability to adapt and grow in the post-bankruptcy period led to its eventual dissolution, with significant job losses and the erosion of shareholder value. The actions of the board members who facilitated this predatory financing, prioritizing personal gain over the welfare of the company and its stakeholders, were later scrutinized and resulted in legal challenges and reputational damage.

Conclusion

ToyCo's story serves as a stark reminder of the importance of adhering to the do's and avoiding the don'ts when navigating DIP financing. Boards and management must prioritize the long-term viability of the company over short-term gains or personal interests, ensuring that all decisions are made with a comprehensive understanding of their implications and in the best interests of all stakeholders and holding management accountable. The presence of predatory DIP financiers in the market necessitates a cautious and strategic approach so that companies can better position themselves to navigate the storm of bankruptcy, emerge intact, and steer toward a more stable and prosperous future.

Further reading/sources:

• American Bankruptcy Institute. "Debtor-in-Possession Financing: Funding a Chapter 11 Case."
• Harvard Law School Forum on Corporate Governance. "Debtor-in-Possession Financing: Strategies for Distressed Businesses."
• Journal of Financial Economics. "The Costs and Benefits of Securing Debtor-in-Possession Financing."
• The Turnaround Management Association. "The Use of Debtor-in-Possession (DIP) Financing in Corporate Turnarounds."
• U.S. Securities and Exchange Commission. "Bankruptcy: What Happens When Public Companies Go Bankrupt."

PS1: Why you should avoid IP Licensing and/or selling your IP to Patent Trolls:

Tech companies rich in intellectual property (IP), particularly those with extensive patent portfolios, must be vigilant in avoiding entanglements with patent troll organizations, formally known as "Non-Practicing Entities" (NPEs). These entities, which own patents but do not produce goods or services based on them, often engage in aggressive litigation, seeking to enforce patent rights against alleged infringers to secure licensing fees or legal settlements.

• For companies with significant IP assets, the threat posed by patent trolls is not just the potential financial burden from legal costs and settlements, but also the distraction and diversion of resources from innovation and productive business activities.
• Engaging in protracted legal battles with patent trolls can stifle a company’s ability to invest in research and development, undermine its competitive edge, and dampen its spirit of innovation.
• Furthermore, the reputational damage from being targeted by patent trolls can affect stakeholder trust and customer perception, potentially impacting the company's market position.
• Certain DIP Financiers may purchase IP assets and then turn around and directly transact with patent troll organizations. The truth eventually comes out... a variation of the ToyCo case.

Thus, companies with substantial IP assets should proactively adopt strategies to protect their patents from exploitation by patent trolls. This can include thorough patent portfolio management, strategic patenting to cover core technologies comprehensively, and engaging in collective defense mechanisms like patent pools or defensive patent aggregations (a great example is the LOT Network). These steps can help deter patent trolls by making it more challenging and less lucrative to pursue litigation, thereby safeguarding the company’s innovation and long-term growth potential.