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Current time:0:00Total duration:14:05

Video transcript

in the last video we talked about the scenario where a company for whatever reason it just couldn't pay its debt holder so this is the debt holders right here this is the debt are the liabilities it couldn't pay its debt holders it went into bankruptcy and it was determined that these assets that it had right here that no 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 this equity and that was called so that was a chapter 7 and 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 when you when you say that a company has gone bankrupt that it'll just disappear that people to say okay 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 a kind of an obvious question of well what if these assets are are worth something you know what if I sell a Sox website and Sox have gotten even more popular and the only problem is I just can't pay all of the interest that I owe on the 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'm s you know my 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 as 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 and you know a good example might be I don't know a car company right so let's say let's actually take this example as a car company that's very it's very salient to our do at least was I've heard a lot less about the auto bailouts but it was very sealing the end of last year so let's say that you know these are car factories car factories and you know land and whatever else and if we're the debt holders and it goes into bankruptcy and let's say it only went into bankruptcy this is generating cash and I'll tell you 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 you know the cast it 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 shuttering in a good bit of cash but let's say you know these guys eat up interest right so some of the cash will go to the debt holders as interest now 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 take you into bankruptcy so it goes into bankruptcy and in this situation rail will immediately we realize that you know it makes no sense to shudder this assets if we were to just shut down the factory and lay off the employees we're going to get nothing for these assets because you know the land is in in a part of the country where you know there's no obvious buyer for the land empty car factory is pretty much useless especially when the other people in the industry are no in no mood to buy the factories from you so everyone decides it's in their best interest to keep this thing running so what happens is 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 what actually what happens is because you know these guys didn't have enough cash to pay off their debt holders what happens is 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 and it's actually a great business although it's become scarce recently dip financing it's a great business because you're at the top of the stack your your more senior than even the senior guys 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 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 chapter 11 restructuring and a chapter 11 restructuring you keep operating the company and what you want to do is you want to essentially I mean you might do some things on the left-hand side of the curve 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 you know the ivory airlines have 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 and a lot of times when someone goes into chapter 11 and then they go there you know they come out of it and they go back into it they call that chapter 22 and then chapter 33 and I think 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 investment don't 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 and operate as a regular business and then all of these guys hire a bunch of lawyers all of these guys hire a bunch of lawyers and they start and well I'll include just these guys and they start negotiating with each other and essentially there'll be a bank associated with the Bankruptcy Court whose whole job and it's all part of the negotiation is to value this and it's often you know maybe maybe this debtor right here he'll hire one bank this debtor or 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 you know one or more varieties it's essentially just saying well you know 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 you know based on the prospects of this company how fast it's growing or how fast it's not growing or how much cash is generating a year they're going to assign a value to it so let's say let's say that this I up here he hires a banker and this banker says let's say let me let me let's say this this was originally same situation for 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 you know they take it into context with the current macro environment and they say you know what I think this company is actually only worth 5 million dollars I think this company is worth 5 million dollars and given that it's worth 5 million dollars and we think that it can sustain that it can sustain I don't know only it can't you know it's only worth 5 million dollars and there's no way that it can pay interest on 6 million dollars of debt right it doesn't have enough cash to generate 6 million dollars of debt we think it can afford 2 million dollars of debt right so what will happen is the new company and this is just a plan and then once you have a plan that everyone has to vote on it and there's things called cram downs and we'll do that in more detail but the plan will say you know what the assets are worth 5 million dollars so I want to thought is using the square tool undo this plan might say you know those assets are worth 5 million dollars so assets are worth 5 million dollars and the company can only handle 2 million dollars in debt not 6 million dollars a day not 6 million dollars of debt so now you can only handle 2 million dollars of debt and then there will be 3 million dollars 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 look and I want you to think about it what's 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 clearer to you in a second and this guy's incentive 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 that leftover and and you're probably asking what do you get paid back if there's not not actual for not liquidating it and the answer is the new shares of the company so what happens is is that this stock gets let's say this guess this this plan gets passed this plan right here in this situation these guys up here we're the most senior right let's say there was two million dollars of senior debt up here let me write that in a different color and it gets very there's two million dollars of senior debt up here so what they'll do is they'll actually get two million dollars of the new debt their most senior and then all of these other these other four million dollars who are more junior let me see if I can color it in I know this is hard to read these other four million guys instead of getting 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 three million dollars of new stock let me see if I can draw that in they'll get the three million dollars of new stock so this three 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 he'll be impaired a little bit and the old equity guys the stock is going to go to zero they're not going to get anything so the old share hold of the company are wiped out they go to zero and essentially the debt holders the debt holders become the new shareholders of the company these guys become the new shoulders of 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 you'll see people buy up these bonds because they want to be the new equity holders they want to when the 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 a little bit at least these I know I've over drawn this picture a little bit too much but the debt guys especially the senior debt guys they want to assign 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 or in this case five million dollars so that we make sure you know hopefully this the company who ends up being worth ten million again in which case these guys right here in which case these guys right here make out like bandits right if the company was really worth 10 million but the bankruptcy court value it's at 5 million these guys get all of the 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 ten million dollars that 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 two million dollars of debt and now you have 8 million dollars worth of equity so these guys you know maybe they were owed 2 or 3 million dollars before they got 3 million dollars 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 what how 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 say they'll hire their own bankers and their bankers they'll probably submit a plan that says no no no this company it's worth at least 8 million it's worth at least 8 million so you know it's up here 8 million and we think it can handle I don't know 4 million dollars of debt so they'd want a scenario like this where they think the company is worth 8 million 8 million it can handle 4 million dollars worth of debt and so it has 4 million dollars worth of equity and of course the first 6 million dollars of the value so the 4 million dollars of debt and then 2 million of the equity will go to the debt holders right because they were owed 6 million dollars 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 will go 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's all about 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 can't support 6 million dollars that it can now support 2 million and whatever is else whatever is left people are paid with actually share new shares of the company not the old here so the old shares will go to zero 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 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 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