Denying the Undeniable

While attorneys understand very well the argument of plausible deniability in the courtroom, it is far more difficult to accept that defense in the board room. In other words, when something walks like a duck, squawks like a duck, there is a high probability in the world of business that it is… a duck.

Simple as that logic may sound, you might be surprised at how difficult it is for management in many companies to accept their low-flyer status, even when clearly headed for financial insolvency. We often see smart, experienced founders and their senior management teams willfully choosing to ignore the warning signs that signal imminent danger, until their attorney or bank suggests having a qualified restructuring firm intervene.

The High Cost of Capital

The problem may be lender induced. For example, the company may have some type of revolving line of credit on which it has never missed a payment. However, it has defaulted on a covenant or two. Suddenly, the company receives a forbearance agreement from the capital provider — along with a notification that their interest rate will significantly increase going forward. We have seen instances in which a company has received multiple forbearance agreements, stretching well over a year or two, before management felt it was time to bring in professional help.

Instead, there is shock and anger, followed by bargaining (typically unsuccessful), until there is a begrudging acceptance by the borrower. That sequence may make sense to a mental health professional. It does not to a savvy businessperson. The company typically does not have sufficient levels of earnings before interest, taxes, depreciation and amortization to support those interest payments. It is only a matter of time before a substantial increase in debt service will bring a business to its knees.

And yet these companies bravely soldier on, unwilling to face the fact that new financing must be found — and quickly — and believing that everything will be just fine once they make that next big sale, land their next contract, open a new territory, reduce costs, and, well, you get the picture.

Financials Not Well Received

Issues with receivables are another major trigger and hot spot for trouble. A company may have been profitable over several years, but perhaps suffered a significant loss in the most recent year. Management sees it as an aberration. Their bank sees it as excessive risk — not to mention a violation of loan covenants. Many lenders want out.

Beyond the headache of needing to replace that loan at current rates, the company is now saddled with a weak balance sheet, less-than-impressive income statements, and thin cash flow projections. There is another significant and overlooked issue: severely aged receivables. The company is effectively acting as a lender to its customers — at zero percent interest.

When this obvious inequity is pointed out and questions asked as to why such grace is allowed, management has told us, “We don’t want to risk upsetting our customers.” How about the creditors, investors, or employees being asked to do more with less because of cash flow constraints?

Unfounded Optimism

Even when there is acceptance of the unsustainable path a business is traveling and management is convinced it is time to sell, expectations can be wildly out of touch with market reality. That shows up in valuations, of course, but also in the time needed to sell. Take it from experts that have sold multiple companies: It is likely going to require more than 45 days before closing — in some cases, much more.

The irony here is that by continually procrastinating and finding reasons NOT to engage and follow the counsel of their attorney and those who not only specialize in insolvency — but recognize its warning signs — management can speed up the company’s demise. There is always a point in every struggling company’s journey beyond which it simply cannot be saved.

Or, as we like to say (with tongue firmly planted in cheek), “Denial is more than just a river in Egypt.”

Al Davis serves as Principal at Revitalization Partners LLC, a corporate and board advisory firm that specializes in restructuring and receiverships. He is a Court Appointed General Receiver in the State of Washington as well as an interim CEO and advisor to middle market companies. He can be reached at adavis@revitalizationpartners.com or 206.903.1855.