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Debt restructuring can be a useful tool for both well-performing companies and for companies experiencing financial distress. Pre-IPO startups should understand the basic elements of debt restructuring and the steps involved.

When a Startup May Consider Debt Restructuring

A company’s capital structure is the mix of debt and equity used by a company to fund its business operations and growth. Some startups may be debt-free; however, the capital structure of a startup is typically consists of some combination of equity and debt. In fact, it is useful to have debt in the capital structure because the use of leverage can help a company grow faster.

Sometimes companies run into difficulties meeting their debt obligations when they become due and need debt restructuring. Companies in this situation will explore ways to restructure their debt. To restructure means to make changes to the capital structure. Typically, restructuring involves out-of-court negotiations between the company and its creditors. However, in more severe circumstances, a company may opt for in-court proceedings.

Out-of-Court Restructuring

Debt restructuring is an option both for startups that are performing well financially as well as for startups facing more challenging financial circumstances. A variety of considerations weigh into this decision. Startups may want to restructure their debt to improve cash flow, refinance at lower interest rates, or change repayment terms. In addition, debt restructuring can provide an opportunity to renegotiate other terms of a credit agreement.

For some startups, an unfortunate turn in financial circumstances can force debt restructuring upon the company to avoid bankruptcy. Therefore, in those cases, creditors will have the upper hand in debt restructuring negotiations.

Not all creditors are equal. A particular creditor’s recovery will depend on its order of priority. In the vernacular, this is a capital structure hierarchy or debt waterfall. Higher-tiered creditors receive receive principal and interest payments from the company before lower-tiered creditors. Typical ordering in the debt restructuring waterfall starts at the top with super senior priority debt. Following this, the ordering proceeds downwards with senior secured debt, secured debt, senior unsecured debt, subordinated debt, hybrid debt, and equity.

In-Court Debt Restructuring

In-court restructuring typically arises when a startup is financially distressed. This startup initiated this process when it files for Chapter 11 bankruptcy.

A case filed under Chapter 11 of the United States Bankruptcy Code is known as a “reorganization” bankruptcy. The goal of this process is for the company to reemerge as a viable business via debt restructuring and other means. In a Chapter 11 bankruptcy, a company creates a reorganization plan. This plan outlines how the company intends to reorganize its assets, debts, and overall business affairs to become more sustainable. The Chapter 11 process involves private negotiations between the company (the debtor) and its creditors to alter the loan terms. A court-appointed trustee supervises the process.

Starting the Chapter 11 Case

A Chapter 11 case begins when the company files a petition with a bankruptcy court. Such a petition can be voluntary or involuntary. A startup filing a voluntary petition must disclose certain documents to the court, including a schedule of its assets and liabilities, a schedule of its current income, and a schedule of current leases. In an involuntary petition, a company’s creditors seek the money the company owes them, so the creditor(s) file the petition. However, the company must file similar financial schedules with the court.

Chapter 11 bankruptcy is distinct from Chapter 7 bankruptcy, another common form of business bankruptcy. Chapter 7 bankruptcy is a “liquidation” bankruptcy rather than debt restructuring bankruptcy. While Chapter 11 involves reorganization of a company’s assets and liabilities, Chapter 7 requires the company to liquidate, or sell off, its assets. The proceeds of the liquidation are used to repay the creditors.

Although in-court restructuring is not as common as out-of-court restructuring, there are certain advantages to a company filing for bankruptcy that are not present in the out-of-court context. In a court supervised restructuring, the court can provide an “automatic stay.” Creditors are not allowed to collect money from the company during the period in which the automatic stay is effective. Another advantage not available outside of the courtroom is that the court can impose a “cram down” provision. As outlined in Section 1129(b) of the U.S. Bankruptcy Code, cram down provisions mandate that all creditors follow a reorganization plan specified by the court.

Implications for Startups

Financing is vitally important to a growing startup. Therefore, startups should have a solid grasp of their capital structure, including the implications a split between equity and debt could have down the road. By understanding debt restructuring options and the way they can be used, startups can be prepared for unexpected scenarios. Furthermore, this know