In the last video we talked
about the scenario where a company, for whatever reason,
it just couldn’t pay it’s debt holders. So let’s say these are debt
holders right here. This is the debt, or
the liabilities. It couldn’t pay it’s
debt holders. It went into bankruptcy, and it
was determined that these assets that it had right here,
that it made no sense operating them as a company. And then the bankruptcy court
essentially just decided to liquidate it. And we learned that the debt
holders were actually more senior to the equity holders. And they get paid first. And if
there wasn’t enough money to pay all of the debt holders,
then the equity holders got nothing. And that was called
a Chapter 7. We’re just focusing on the
corporate world right now. Maybe we’ll do personal soon. So that’s Chapter
7 liquidation. That was the last video. And in that case, and I think
that’s what most people associate when you say that a
company has gone bankrupt. That it’ll just disappear. That people just say,
OK, these assets don’t make any sense. They can’t pay these guys. We’re just going to take these
into possession by the courts and then just liquidate
the assets. But that raises kind of an
obvious question of, well, what if these assets are
worth something? What if I sell a socks website,
and socks have gotten even more popular. And the only problem is I just
can’t pay all of the interest that I owe on the debt. Right? Maybe, for whatever reason, I
took out a really crazy loan that was variable rate. Or for some reason, I have to
pay back some loans because I messed– and I’ll talk
more about covenants and things like that. Covenants are pretty much a
bunch of rules that the debt holders say, look, you’re good,
but if any of these x, y, or z things happen, we can
take you into bankruptcy. And we could force you
into bankruptcy. So maybe because of that,
I’m in bankruptcy. But it’s determined that these
assets, right here, are actually worth more as an
operating entity than they are if you were to liquidate them. A good example might be, I don’t
know, a car company. Right? Let’s actually take this example
as a car company, because it’s very salient to
our, at least it was– I’ve heard a lot less about the auto
bailouts, but it was very salient at the end
of last year. So let’s say that these are
car factories and land and whatever else. And if we’re the debt holders,
and let’s say it goes into bankruptcy. Let’s say this is
generating cash. And I’ll teach you in a future
video how do you see what is the cash being generated
by the assets. And then you have to subtract
out the cash that has to be used to pay the debt holders,
because you’re paying interest, and then what’s
left over for equity. And I’ll show you how to do that
on an income statement. But let’s say this is generating
a lot of cash. Right? It’s generating a good bit of
cash, but let’s say, these guys eat up interest. Right? So some of the cash will go to
the debt holders as interest. And let’s say, for whatever
reason, either interest rates went up, or they had a bad
quarter or a bad year, and they just didn’t generate enough
cash, let’s say they couldn’t pay off one of
the debt holders. And that debt holder says,
hey, you couldn’t pay my interest payment, or
you couldn’t pay the principal payment. I’m taking you into
bankruptcy. Right? I’m taking you into
bankruptcy. So it goes into bankruptcy. And in this situation,
immediately we realize it makes no sense to shutter
this asset. If we were just to shut down
the factory and lay off the employees, we’re going to get
nothing for these assets. Because the land is in a part of
the country where’d there’s no obvious buyer for the land. An empty car factory is pretty
much useless, especially when the other people in the industry
are in no mood to buy the factories from you. So everyone decides that it’s
in their best interests to keep this thing running. So what happens is that the
debtor stays in possession of the assets. So you can kind of view the
debtor as the equity holders and the management
of the company. So they stay in possession
of the assets. And actually what happens is–
because these guys didn’t have enough cash to pay off their
debt holders– what happens is that they take on a
new loan, called a debtor-in-possession loan. And this new loan is the
most senior loan. It’s called DIP financing. It’s actually a great business,
although it’s become scarce recently. It’s a great business
because you’re at the top of the stack. You’re more senior than
even the senior guys. And it’s called DIP financing. Debtor-in-possession
financing. And what this provides is a
company with some kind of cushion cash so that it can keep
operating, so it can keep the lights on. So it’s essentially a debt. It’s just a very senior
type of debt. And it happens once a company
has entered bankruptcy. Right? And this bankruptcy that
we’re going to talk about is Chapter 11. Chapter 11 restructuring. And in Chapter 11 restructuring,
you keep operating the company. You might do some things on the left-hand side of the equation. You might want to sell off some
of the assets and all of that, but we won’t
go into that. Most of what you do is you
rearrange this side of the balance sheet. And this is why, you probably–
every airline has, some of them, have gone into
bankruptcy multiple times, but they still exist. It’s not
like when you go into bankruptcy the company
just disappears. The assets will persist and all
of this gets reorganized on this side. A lot of times when someone goes
into Chapter 11 and then they come out of it and they
go back into it, they call that Chapter 22, and
then Chapter 33. I think you get the idea. So anyway, what happens
in Chapter 11? So the assets– essentially it
becomes kind of the bankruptcy court takes over, and they
hire some investments. They’ll get the
debtor-in-possession financing so that the company has some
cash to operate, pay the bills, and pay the employees
and whatever else. The company keeps operating as
it always would so it can pay its suppliers and operate
as a regular business. And then all of these guys
hire a bunch of lawyers. And they start negotiating
with each other. And essentially there will be
a bank associated with the bankruptcy court whose whole
job– and it’s all part of a negotiation– is
to value this. And it’s often, maybe this
debtor right here, he’ll hire one bank. This debtor will
hire one bank. Maybe the management will
hire another bank. And everyone’s going to come
up with bankruptcy plans. But bankruptcy plans
are usually of one or more varieties. It’s essentially just saying,
well, we need to value these assets, right? We’re not selling it. So we’re not just going
to get cash. We’re going to hire
some bankers. And we’ll do a lot of videos
on that in the future. And they’re just going to say–
based on the prospects of this company, how fast it’s
growing or how fast it’s not growing, or how much cash it’s
generating in a year– they’re going to assign a value to it. So let’s say that this guy up
here, he hires a banker. And this banker says– Let’s
say this was originally the same situation. This was $10 million. Let’s say that the liabilities
were $6 million. And that the original equity
was $4 million. Right? And let’s say these bankers
evaluate the business. They make detailed models. They take it in the context of
the current macro environment. And they say, you know what? I think this company
is actually only worth $5 million. And given that it’s worth $5
million, and we think that it can sustain– it’s only worth $5
million and there’s no way that it can pay interest
on $6 million of debt. Right? It doesn’t have enough cash to
generate $6 million of debt. We think it can afford
$2 million of debt. Right? So what will happen is,
the new company– And this is just a plan. And then once you have a plan,
then everyone has to vote on it, and there are things called
cram downs– and we”l do that in more detail–
but the plan will say, you know what? The assets are worth
$5 million. I thought I was using
the square tool. Undo. This plan might say, you
know, those assets are worth $5 million. And the company can only handle
$2 million of debt, not $6 million of debt. So now, it can only handle $2
million of debt, and then there will be $3 million
left of equity. Right? And I’ll call this
the new equity. Because sometimes this
can get confusing. So let’s just say for a second–
and I want you to think about it– what is
everyone’s incentive? This guy up here, his incentive
is to value the company as lowly as
possible, right? Because then he gets more
of the company. I think that’ll be clear
to you in a second. This guy’s incentive
is to say, no, this company is worth a lot. So all of you guys are going
to get paid back and then I get what’s left over. And you’re probably asking, what
do you get paid back for not liquidating it? And the answer is the new
shares of the company. So what happens is that this
stock– let’s say this plan gets passed. This plan right here. In this situation, these
guys up here were the most senior, right? Let’s say there was $2 million
of senior debt up here. Let me write that in
a different color. There’s $2 million of
senior debt up here. So what they’ll do is they’ll
actually get $2 million of the new debt. They’re most senior. And then all of these other $4
million, who are more junior– let me see if I can
color it in. I know it’s hard to read– these
other $4 million guys, instead of getting any kind of
cash or any kind of debt securities for having been owed
this money, they’ll get the new stock. So they’ll get $3 million
of new stock. Let me see if I can
draw that in. So this $3 million of new equity
will go to these guys. And this unsecured guy down
here, he’s not going to get as much equity. He’ll be impaired
a little bit. And the old equity guys, the
stock’s going to go to 0. They’re not going
to get anything. So the old shareholders of the
company are wiped out. They go to 0. And essentially, the debt
holders become the new shareholders of the company. You’ll often see when a company
goes into bankruptcy but it’s getting reorganized,
you’ll often see some people start to buy up this debt or
these bonds, right here, because they want to be the
new equity holders. When this company emerges from
bankruptcy– let’s say that this is how it emerges from
bankruptcy– they want to be these guys, the new
equity holders. Because usually when you value
it, you want to undervalue it a little bit. I know I’ve overdrawn this
picture a little bit too much. But the debt guys, especially
the senior debt guys, they want to be safe. They want to say,
you know what? We’ve already been hurt
by this company. They’re already not
paying our debt. We want to assign as low a
possible value to the company as possible– in this
case $5 million– so that we make sure. Hopefully the company ends up
being worth $10 million again, in which case these guys
right here make out like bandits, right? If the company was really worth
$10 million but the bankruptcy court values it at $5
million, these guys get all of the shares of the company. These guys get wiped out, even
though the company really was worth something. So let’s say the company emerges
from bankruptcy like this, but it actually turns out
there were $10 million. Then let’s say a year
later the company starts doing well again. And let’s say that someone could
value the company again at $10 million. Now it only has $2
million of debt. And now you have $8 million
worth of equity. So these guys– maybe they were
owed $2 or $3 million before, and they got $3 million
of the new equity, they might have made
out like bandits. Because now all of a
sudden, that equity could be worth a lot. That’s not always the case. But that’s the view from the
debt holders’ point of view. The equity holders, you can
imagine, they don’t want to be left with nothing. They’ll hire their
own bankers. And their bankers, they’ll
probably submit a plan that says, no, no, no, no. This company is worth
at least $8 million. So up here $8 million. And we think it can handle
$4 million of debt. So they’d want a scenario like
this, where they think the company’s worth $8 million. It can handle $4 million
worth of debt. And so it has $4 million
worth of equity. And of course, the first $6
million of the value– so the $4 million of debt, and then $2
million of the equity will go to the debt holders, right? Because they were owed $6
million to begin with. And then what’s left over, which
is essentially– so this is $2 million of equity, and
then you’d have $2 million of equity here– this $2 million
of new equity, right? This is the new shares of the
company will be given to the old shareholders
of the company. So that’s what the shareholders
want. I know this gets a little
confusing, but it all ends up being valuing the assets as you
emerge from bankruptcy. You say, you know,
it’s generating cash, it’s worth something. And then you pay people off
according to seniority. And first you pay them off. You say, OK, I still
owe you some money. But this company can’t support
$6 million of debt. It can now support $2 million. And whatever’s left, people
are paid with actually shares– new shares–
of the company. Not the old shares. So the old shares
will go to 0. So you can imagine a world
where GM goes bankrupt. Right now, the shares
of GM go to 0. GM old goes to 0. But the assets keep operating,
and that’s why some people are a little bit misleading in
this whole automotive bankruptcy debate. They’re kind of using scare
tactics to say, oh, if GM goes bankrupt, then these assets are
just going to disappear. No, they’ll just
keep operating. If it makes sense to operate
them, they’ll keep operating. The only people who
will lose big are the old equity holders. And then some of the unsecured,
the more junior levels of debt, will probably
lose some money. But if the assets are
worth operating, they’ll continue to operate. And if the people, if it makes
sense to have them employed, they’ll keep working. See you in the next video.