Who Has the Reins? Maximizing Value of a Service Business in Chapter 11
by: Dan Rexford
Equity Partners Inc.; Easton, Md.
Experienced professionals know that parties will have varying amounts of leverage as the dynamics of a chapter 11 case unfold, and these professionals carefully take their understanding of this leverage into account when they plan their activities and advise their clients. In many instances, the party with the greatest leverage is often overlooked or given short shrift: the employees.
In virtually every business the employees are critical, but in service businesses, they hold the reins. Demoralized, unmotivated employees can bring a service organization to its knees, causing value to quickly dissipate as the financial statements worsen with each passing month. Employee departures can cause the loss of critical accounts and much-needed revenue. The refusal of a key player to go to work for the buyer, or to sign a noncompete clause, can certainly be the death knell for a transaction.
This is not to say that much has not been written, discussed and implemented to address employees in chapter 11 scenarios. Many articles have been written and much discussion has surrounded key employee retention programs (KERPs), and the annals of the turnaround literature are filled with treatises on the importance of employee communication.
While these measures are all well and good, they may not go far enough, and professionals would be well served by not relying on them. In 2008, the value of a medical services company that had filed chapter 11 plunged because employees who felt like they may get the short end of the stick pulled back hard on the reins. Although the employees were incorrect, as so often happens, it did not matter because perception became reality. A tremendous amount of time and effort was spent putting going-concern offers on the table and getting the offers court-approved, but when a key employee refused to stay on, buyers faltered. Four steps may have prevented the value plunge:
- Seek resolution as quickly as possible. Human resource studies show that uncertainty causes the greatest stress for employees. Few things are less certain than the outcome of a bankruptcy filing. Everything that can be done to speed up the process should be done.
- Ensure that debtors adopt good communication practices. Since most debtors-in-possession (DIPs) do not avail themselves of turnaround professionals, turnaround literature is of little benefit. A DIP needs to be reminded and directed at every turn that it is its fiduciary duty to keep morale high and motivation strong to maximize value. Furthermore, if a key employee is going to hold a deal hostage, early and frequent communication may flush those issues out sooner rather than later. Professionals should heed the warning that DIPs frequently underestimate the importance of proactively communicating. In fact, they may have a tendency to virtually ignore even their key players, assuming their relationships are so solid that they will carry them through. Have you ever noticed that family members will often treat each other more harshly in times of conflict than they would treat friends or even strangers? DIPs behave similarly.
- Insist that retention plans be implemented for all employees. At times, this could involve additional compensation-"pay to stay" bonuses and the like. At a minimum, the question "what can we do to keep our team engaged and motivated?" must be answered and an action plan must be implemented. DIPs, particularly if they are owners, often overestimate the strength of their relationships with employees and overlook them as they deal with their attorneys, bankruptcy reporting requirements and the like.
- Anticipate and plan for transitioning employees to new partners or owners, or figure out how to transition without them. Usually, new money is required to maximize the value of the estate-an equity infusion, refinancing, joint venture or a §363 sale. DIPs tend to believe that employees will do what they tell them is good for them and happily sign on with new ownership, but often, the debtor is simply not as beloved as he or she believes, and employees balk.
This tendency to neglect preparing employees for transition is the most problematic: Will the new owners or partners complete a transaction without the cooperation of the employees? In fact, it was this straw that broke the camel's back with one medical services company. The DIP did not prepare his key employees for a transition, causing him to lose a substantial amount of noncompete compensation and the forgiveness of his personal guarantees when the successful bidder at a §363 auction decided not to close because the employees balked at cooperating.
Of course, often the key employee is the manager and/or owner of the DIP, which can really complicate things. In a sale process, it pays to find out early under what terms that key person will stick around, if at all. Sadly, when the key employee is also the equity, it can be difficult to gain cooperation from someone that is seeing their equity position wiped out. You'll need to identify ways to motivate this person to cooperate, or your sale transaction has little chance of making it to court approval, let alone closing.
In the end, the situation with the medical services company described above was salvaged because the bank agreed to expand the role of the investment bankers to include managing the company until a sale could be closed. With a disinterested party doing the communicating, all employees were retained, vendors secured a new paying customer and the secured creditor recovered more through a going-concern sale than it would have through liquidation.
Although professionals rarely have direct responsibility for addressing employee concerns, ignoring them may well cause value to fall precipitously. A better course is to recognize that employees hold the reins in service businesses and to use every opportunity to impress upon the DIP that addressing these concerns is of paramount importance. Speaking of reins, while you cannot make them drink, you should at least lead the horses to water.