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The loan to own

by contributor Robert Trodella, Jones Day | Published March 13, 2012 at 1:27 PM

This article explores some paths that are available to a venture investor who is interested in acquiring the assets of its funded enterprise in a manner that minimizes litigation risk. Some of the very protections early-stage investors bargain for at the outset of their investment are often the same factors that can elevate the scrutiny they might receive should the companies they invest in experience financial distress. Chief among these is the control they exert through board appointments and as a significant shareholder. Simply put, the power to shape a company in good times can elevate litigation risk in bad times.

Venture investors are often best situated to acquire and maximize the asset value of a struggling company given their insider knowledge and ability to efficiently redeploy those assets through alternative investment vehicles. But a potential pitfall is that creditors, other shareholders or a trustee in bankruptcy might later bring suit for fraudulent conveyance or breach of fiduciary duties.

In these circumstances the investor is well advised to run its acquisition through an independent fiduciary, either in bankruptcy or through a state law mechanism known as an assignment for the benefit of creditors, or ABC. When preparing for that possibility, the investor may wish to restyle its response to company requests for additional liquidity, from equity to secured debt. These "loans to own" offer an appealing approach to distressed asset acquisitions, and with the imprimatur of a third party should insulate the investor from litigation risk.

Whether you manage an investment fund or make strategic investments for an operating company, those investments can place your company in a role of significant influence. A common example is the early-stage investor whose investment heft is such that it can dominate shareholder voting while also having the benefit of board designation rights.

With that context, assume your portfolio company is quickly burning through cash and requires additional financing. You are contemplating advancing further funds but want to elevate recovery rights should the company fail. You call your counsel to discuss potential risks and choices.

Undoubtedly the first issue your counsel will focus on is that your company wears at least two hats -- it is a substantial shareholder, and by attribution, a director. The practical effect of this status is that transactions between you and the company will be subjected to heightened scrutiny in an environment where potential insolvency has elevated fraudulent conveyance and fiduciary duty concerns. That reality means that any number of parties have derivative standing to challenge your transactions with the company.

With this in mind, counsel provides the following framework as your guide:

Insist on secured debt. Even if the company reasonably expects to turn to profitability in the near term, at some point investors should consider whether requested funding to reach that point should be made on a secured-debt basis. Doing so provides the company with critical cash while also protecting the investor in the event of a liquidation given the right to foreclose or credit-bid its debt in an asset sale. Advice: Provide short-term loans tied to a credible budget while also requiring that some of the loan proceeds be used to fund a marketing process and, ultimately, a sale of the company's assets should it fail in its turnaround efforts.

Recalibrate expectations. Those who run early-stage companies are accustomed to equity financing, not debt. They are consummate evangelists for their company and may press to leave their balance sheet unblemished by anything other than vendor debt, with the pitch that even another equity raise will ultimately be rewarded. Advice: Resist the temptation to continue business as usual and insist that every additional dollar you provide be in the form of secured notes. Be firm in setting expectations. Set performance benchmarks, which if not met, will require the company to implement a structured wind-down.

Reasonable business purpose. There is nothing per se wrong with an insolvent company taking on additional debt. The test is whether the board acted with due diligence and good faith to pursue a business strategy that it reasonably believes will increase the company's value, even if doing so involves incurring more debt. So long as the company pursues that strategy in good faith, its lender should not be tagged with a claim that it aided and abetted a company's "deepening insolvency." Advice: Obtain representations from the company that its financial condition has not been misrepresented to others and that wage claims are current; obtain covenants to ensure that status does not change. Consider funding in discrete tranches tied to benchmarks such as receipt of purchaser letters of intent or the hiring of business brokers or financial advisers.

Disclose and recuse. Because board members appointed by a stockholder are considered "interested" in transactions involving that stockholder, they are not entitled to the benefit of the business judgment rule with respect to those transactions. Absent approval by a majority of disinterested directors, they must prove the entire fairness of the transaction. Advice: Disclose the conflict as it pertains to additional financings and the potential for enforcement of the lien; recuse the director from discussions regarding, and from voting on, the transaction. Consideration should also be given to whether your board designee should retain separate legal counsel to provide independent advice.

Third-party protection. A common issue in loans to own is one of optics and control. Even lender-investors and board members with the best intentions run the risk of second-guessing. That risk is minimized where decision making concerning the sale process, and ultimately the sale itself, is placed in the hands of a third party. The calculation there often comes down to a balance of relative risks, delay, cost and control. The higher the risk, the more consideration should be given to running the process through a bankruptcy. But more often sufficient protection can be achieved, at substantially less cost and delay, by hiring an assignee for the benefit of creditors to assist in marketing, and, ultimately, to effect the sale of the company's assets. Advice: the greater the appearance of your control over the company, the greater the benefit of having a third party ultimately decide the fairness of transactions.

You will need bankruptcy court approval of post-bankruptcy loans should you decide a wind-down is best managed through a bankruptcy. If the possibility of a turnaround remains, you can sequence this by providing one or more loan advances prebankruptcy, with later rounds conditioned on the company filing bankruptcy and court approval of the loan and other protections. Couple this with an asset purchase agreement that seeks court approval of you or your designee as the stalking-horse bidder, and the right to credit-bid both your pre- and postpetition debt against the asset purchase price.

If you're the successful bidder, the bankruptcy court's sale order will protect against fraudulent conveyance attack. If you're outbid, at the very least your loan will be repaid, and with court approval, you might also receive a breakup fee. Because all significant postpetition decisions require bankruptcy court approval, bankruptcy reduces if not eliminates board liability for actions taken after the petition date. Additional benefits from the bankruptcy include the ability to take assignment of potentially valuable leases, contracts and license rights. Care should also be taken to ensure all potential claimants against the company receive notice and opportunity to object to the proposed sale. Doing so substantially reduces successor liability risk.

Of course, with a bankruptcy, the company will need to open the sale to outside bidding and likely a public auction. But it is precisely through that open process that your bid will be vetted and ultimately protected.

The ABC option should also be carefully weighed. That path avoids the stigma, cost and delay of a bankruptcy. And, together with the company, you can select the assignee. Because most assignees cannot be expected to operate the company for any substantial period, the company can hire, with your approval, an assignee to market the company's assets for some period of time preassignment. A general assignment to the assignee of all company assets, together with your lien rights, would then be effected. The assignee would then enter a purchase agreement with you or a higher bidder (after your right to credit-bid). Releases can be obtained from the assignee, who can assign to you as purchaser, all company rights to pursue claims, including those against board members. Since the assignee takes assignment of all company assets, immediately upon assignment the board can resign and free themselves of further decision making. As a secured creditor, you should gain comfort knowing that a sale or other disposition of secured assets is "commercially reasonable" under the Uniform Commercial Code when accomplished by an assignee. Assuming care is taken that the assignee adopted a sale process intended to maximize value, fraudulent conveyance risk is also considerably reduced.

Although sales through an ABC are highly efficient and offer several buyer protections, they are not without drawbacks. These include the requirement for board and shareholder approval of the assignment. This latter point may make it impractical for a company with a diverse group of shareholders. Also, the making of an assignment will likely trigger contract defaults, which will need to be managed. And, unlike in bankruptcy, an assignee cannot override contract anti-assignment provisions. Finally, although the ABC process is cheaper than a bankruptcy, for example, the assignee does not work for free. As the secured creditor, you will be the likely source to fund those efforts, but can do so as part of your secured loan advances.

The ability to protect equity investments in a troubled business is uncertain at best. But to the extent the assets of that business offer value if redeployed in another of your portfolio companies, you should consider approaching further funding on a secured debt basis with an eye toward applying that debt as a tool toward ownership should the company fail to rebound. Doing so is perfectly appropriate, but is best structured by inserting a third party into the process, whether through a bankruptcy or an ABC.

Robert Trodella is a partner in Jones Day's San Francisco office. His practice focuses on commercial law and finance matters, both in and outside of bankruptcy.

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Tags: assignment for the benefit of creditors | startup | VC | venture capital

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