Growing macro-economic uncertainty leads many founders and startups to worry that the venture-capital and private equity tap will soon dry up. At the moment, the Swiss market still sees many financing and M&A transactions, but investors are increasingly cautious and we do expect the deal flow to decrease. Transactions are led at slower paces and investors’ due diligence requests are increasingly stringent. Unfortunately, this will likely lead many startups to see the end of their runway and potentially be in distress.
The general idea of distressed M&A is to execute a transaction despite the grim situation, by which the startup’s essence and value proposition will survive while often letting the legal entity be liquidated. This option can constitute an opportunity for the startup’s founders, but also existing or new investors. The overarching goal is to shed the startup’s accumulated debt and give the business a new launch.
Define the Value worth Saving
The first step when considering a distressed M&A transaction, both from the startup’s perspective or from a potential investor’s, is to consider what the core value of the startup is, which is worth saving.
This will in particular include:
- any patents or other intellectual property (software, non-patentable IP, trademarks, etc.) at the core of the startup’s value proposal;
- any tangible assets enabling the startup’s value proposal and business;
- contracts that are material to the startup’s project, including namely suppliers, service providers and customers;
- the startup’s goodwill and reputation;
- talents that are material to the project’s success, including founders but also key employees.
Identify Potential Partners
Once it’s clear what value needs to be saved, it’s time to define who will save it. This entails searching for the right partners who would be willing and capable to purchase the startup’s business and finance its survival.
In first instance, the startup’s key stakeholders should be considered, including founders, investors, creditors and partners. Any person who has an interest in the startup thriving should be on your list of first line contacts. You will need to show vulnerability by admitting the difficulty that the startup is in, but do bear in mind that the next best alternative is often to let the company be liquidated and let its value go to waste. This grim alternative is a strong incentive for your stakeholders to support a distressed M&A transaction.
Strategic or financial investors are the second category of persons that may be worth contacting. When looking at this category, the thinking is the same as when looking for investors or purchasers in more common circumstances.
In any event, a big difference with traditional M&A or financing transactions is that a distressed transaction could allow these persons to reap much of the startup’s value at a much lesser cost, hence increasing the investors’ value for money.
Possible Deal Structures
Given that one big target of a distressed M&A is to shed the “rotten” parts of your startup (in particular its debt), the transaction will need to focus only on specific assets. Hence, these transactions will usually take the form of an asset deal, whereby the investor will be able to pick and choose the purchased assets.
When deciding whether to use asset deals or share deals, Swiss M&A practice greatly favors the latter, therefore these transactions will often be transformed in a share deal by proceeding to a hive-down. The idea is that the startup will incorporate a new wholly own subsidiary and transfer all of its valuable assets to that subsidiary. In a second step, the new subsidiary will then be sold in a share deal with the investor.
Distressed M&A is very asset-centric, and the company’s directors will therefore be put in the driver’s seat. Shareholders will, on the other hand, be left with little to no power, except as provided for in the company’s shareholders’ agreements.
Inherent difficulties and Procedural Enablers
Debt protection
By definition, distressed M&A entails “playing with fire“, as the company will be close to illiquidity or over-indebtedness. Before these risks materialize, Swiss companies can request to be put under debt protection. Under this protection, similar to the American Chapter 11, all creditors whose claims accrued prior to the protection will no longer be able to sue the company or enforce their claims., hence giving time for the company to find a solution.
To favor the saving of companies, this debt protection is easy and fast to obtain. Very strict scrutiny is however then put on the company. All running costs and debt accruing after obtention of debt protection must be paid on time, failing which the company will immediately be put in bankruptcy. Furthermore, a commissary will be appointed to overview the company’s activities while under protection and ensure that its legal obligations are respected. In particular, the commissary (and additionally the court in most cases) will be required to approve any transaction alienating assets of the company.
Swiss case law and practice allows to use debt protection as an enabler of distressed M&A:
- “Pre-pack” deals are expressly allowed, meaning that asset deals can be negotiated before protection, and executed under protection with the court’s (or, depending on timing, creditors’) blessing.
- It’s also possible to start negotiating the deal after the company is put under protection, and execute it with the commissary and court’s (or, depending on timing, creditors’) blessing.
Bankruptcy
In some rare cases, distressed M&A deals can also be executed after the company is put in bankruptcy. In particular, the bankruptcy authorities will seek to sell the company’s assets at the highest price possible to repay the creditors to the highest extent possible.
Directors will be interrogated by the liquidators in order to assess the value of the assets. At that point and though this is uncertain, it may be possible to push for a deal to happen in the form of an asset deal.
Bankruptcy officials often don’t have an exhaustive understanding of the value that lies in a startup’s assets and patient explanation and guidance is often needed to achieve this. Furthermore, when possible, liquidators must hold an auction process to sell assets at the best price. This can sometimes in practice be avoided if a potential purchaser is already known before the bankruptcy proceeding commence.
The main advantage (but also danger) of acting in bankruptcy is that – contrary to debt protection – the company no longer needs to pay running costs when in bankruptcy, as it is required to stop doing business. This means that no funds need to be wasted to keep the startup on respirator. However, a strong disruption in business continuity will be created.
Practical Tips
When considering distressed M&A as a startup director or founder, the following points should be kept in mind:
- Start considering distressed M&A well before the end of your runway in order to maximize chances of success. Distressed M&A is much faster paced than traditional deals, but there are limits to what is possible.
- Director’s (civil and criminal) liability can easily be incurred if the board is not very cautious about its fiduciary duties to the company. In particular, directors should:
- ensure that social insurance payables are always executed in time;
- ensure that all transactions are negotiated at arm’s length;
- always keep an eye on liquidity and level of debt and the obligations connected to this, mainly to file for bankruptcy in the required cases.
- Do not fear and avoid debt protection or bankruptcy, when it becomes necessary. These situations are of course a sign that the company has reached a grim situation, but they are designed to help further the company’s interests. The involvement of institutional actors (commissaries under debt protection and liquidators in bankruptcy proceeding) is of course intrusive but also allows for much of the responsibility and liability for the situation to shift away from directors.
