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Chapter 7: Bankruptcy liquidation

Introduction to bankruptcy liquidation (Chapter 7). Created by Sal Khan.

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  • leaf orange style avatar for user Josh Claar
    How did these rules of seniority come to be? Are they the same for every company in every country?
    (4 votes)
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    • blobby green style avatar for user Jimrunsanddives
      The government does not assign seniority and does not create the rules per se. Contracts between the business owners (equity/stock holders) and lenders (debt) determine seniority. Let's say I am a lender and you want a 10-year loan from me. I might insist that you sign a contract that promises (with no exception) to give me your land if you don't pay me back. All goes well and you're paying me back on time. Then, in year 3, you want another loan to expand your business or whatever. I refuse to loan you any more money, so you go to another lender for the new loan. You can't sign a contract with the new lender that promises the land (as collateral) because you already promised the land to me. Assuming you have no other collateral to promise the new lender, he will definitely demand that you pay him a higher interest rate to compensate him. So, in bankruptcy, all the lenders want their money back. But if the only asset that remains is the single piece of land, I am more senior because of the contracts we signed. So, all this boils down to simple contract law. You can't promise the same asset to two different lenders in the event you have to declare bankruptcy. The bankruptcy court simply sorts through the contracts and decides who is first in line for your land if you go bankrupt. If you did promise the land as collateral to two different lenders, then you'd be guilty of fraud and you'd go to jail. I wouldn't have much sympathy for the second lender because he did not conduct good due diligence prior to giving you the second loan. The bankruptcy court would have to decide who gets the land (probably the first lender).
      (19 votes)
  • leaf grey style avatar for user dashpointdash
    So first debtholders get paid and then the seniors, how can a private investor find out
    which place they take in the hierarchy ?
    How is this regulated ?
    (6 votes)
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    • old spice man green style avatar for user TerryMHogan
      If you are owner of common stock, you rank last. In a liquidation bankruptcy all debts get paid before the equity holders receive anything. The only distinction between equity holders is if you hold preferred shares. Preferred shares are generally senior to common shares, but in return for this seniority, you give up voting rights in the company.

      There is a very clear risk-reward relationship. Debt is the most senior, so in that way it can be seen as the least risky (you have the first claim on assets in a liquidation) but it also carries no upside if the company is successful.

      Preferred shares are slightly less risky than common shares in that their dividends must be paid before any common dividends (so if a company was low on cash, they might choose to cancel the common dividend, but continue to pay the dividend on the preferreds - or sometimes the preferreds are cumulative so that when they're not paid, it adds up and gets paid out later if the company returns to good financial position) Since preferred shares are riskier than debt, they generally reward investors by paying a slightly higher rate, and they are usually more liquid than debt. Because they are less risky than common shares, shareholders also give up much of the upside potential (preferred shares don't necessarily increase in value as the company increases in value) and usually don't get voting rights in the company.

      Common equity ranks last in a liquidation event - so everyone else needs to be paid before equity holders get anything. In return for this increase in risk, there is an increase in potential returns (or reward). If the company does well, the common should increase in price, and higher dividends can be declared. You are also an owner of the company so you can vote at the annual meeting, and if someone wants to buy out the company, they have to pay you.
      (5 votes)
  • blobby green style avatar for user Smaduri1221
    At "" Sal says that there is only $1 million left for the subordinated unsecured debt. Isn't there $2 million left over from the liquidation, because only $3 million was paid out?
    (1 vote)
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    • leafers ultimate style avatar for user Ingo
      At , Sal writes down 6M as debt. At , he then assumes the assets to 'generate' 5M after being sold. Now I assume, he does that, cause he wants this number to be smaller then the debt. (to drive home the senior <-> junior point)

      However, when he fills in the debt numbers again (starting at approx ), they add up to 5M (instead of the 6M) - this is just a little slip-up on his side, I guess...
      He continues anyway, cause he does not want to do the vid again I think (or maybe he really didn't realize the error at that moment). Just assume "Senior Secure" and "Senior Unsecure" add up to 4M and it works again ;)
      (6 votes)
  • blobby green style avatar for user Alex Rich
    Do you have to pay more to receive senior secured bonds? Are there options when buying bonds to purchase secured versus unsecured? How is the tiered system implemented I guess is my question.
    (1 vote)
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  • leaf green style avatar for user Shakalaka
    so, what happens if you sell off your assets and they're worth more (so, if the land goes way up in price, etc. ) let's say you declared bankruptcy, but were able to sell your assets for $20 mil.?
    (2 votes)
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    • male robot hal style avatar for user Andrew M
      Then why did you declare bankruptcy? That was sure a big mistake, because you don't own those assets anymore. Your creditors do, and they - not you - are the ones who sold them for $20 mil. You should have sold the assets yourself, paid your creditors, and never filed for bankruptcy in the first place. Maybe if you were lucky the bankruptcy court would reject your filing.
      (2 votes)
  • leaf green style avatar for user lockinload9
    When buying a bond do you get to choose how much seniority you get?
    (1 vote)
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  • leaf green style avatar for user Norman Au
    With regards to getting the money back for equity holders, are the money refunded back to the equity holders (assuming there is sufficient cash after bankruptcy liquidation) calculated in terms of the equities' book value or is it the market value?

    Or is there another way to calculate the cash refund?
    (1 vote)
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  • male robot hal style avatar for user Jack Rodgers
    What if the about the assets are worth is more than 10m? Does everyone just get more money?
    (1 vote)
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  • mr pink red style avatar for user El
    Is there a hierarchy in equity also?
    As in those who have more shares? or bought the shares earlier?
    (1 vote)
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    • leaf green style avatar for user Ryan
      There can be.

      Often times companies will have certain shares that have more voting rights then others. This allows certain people to remain in charge even though they own less than 50% of all the shares.

      Also one takeover defense is what's called "restricted voting rights." This is a provision a company can have where if you try to takeover the company and acquire a certain amount of shares (say over 20%) you are no longer allowed to vote on shareholder issues.
      (2 votes)
  • blobby green style avatar for user Brian Haydon
    In the case of going Chapter 7, and debts must of course be paid, and then if any is left over, equity holders, how is it CEO's can have "Golden Parachutes"?
    (1 vote)
    Default Khan Academy avatar avatar for user

Video transcript

In the last set of videos, we've hopefully familiarized ourselves with the different ways that a company can raise capital. It can do it through debt or equity. And we learned that debt securities are often called bonds. And equity securities you're probably familiar with. Those are stocks. And then I left you with a cliffhanger. Let draw it so I don't get ahead of myself. So these are the assets of a company and it was able to generate these assets. So there's a couple of ways you can generate assets. You can get investors through equity, and we've done several videos on that. You start with the angel investors, or maybe your rich uncle, and then eventually get venture capitalists, and you do an initial public offering. And then you can do follow-on offerings. And so on and so forth. Now we see governments will buy equity in you if you are a bank that's too big to fail. But we'll do a whole playlist on that. So equity. That's one way that you can get cash or get capital so that you can buy assets to run your business. The other way is you can borrow money from people. So the equity holders are actually the owners of the company. So you might have been part of the equity holder, and you have to sell some of the equity, or sell some shares in your company for someone else to give money. Then they become kind of like your partner. And the other way is you could borrow money. Let me draw that. That we'll just put generally as liability. Debt isn't the only kind of liability, but that's a pretty reasonable simplification for now. There's other things. In general, liability means you owe something to somebody in the future. So these are liabilities. And we'll assume right now that your debt is your main liability. You might have other liabilities. You might have some type of legal liability, where someone is suing you or you had sprayed asbestos on a bunch of playgrounds, thinking that it was actually good for the playground equipment and now there's all of this liability because, well, you get the idea. But from now on we'll have the simplification that debt is your liability. And we said there's different kinds of debt. If you securitize it, it's often a bond. Right? That would be a certificate that's an IOU from a company. It'll pay you coupons or interest and so forth. Or you can also just get regular bank debt, where you owe the bank money. And I left you with a question the last time around. I said, let's say this company goes into bankruptcy. And let's say that these assets aren't worth what we think they are, right? In this world, if we just have to sell off these assets, fine. The debt guys would get paid off. And the equity guys would get left over with whatever else. So let's say if this was on our books. Whenever you hear things like book value, and I've done a couple of videos on book value versus market value, but the book value is essentially what you have on your accounting books. You say that this is worth $10 million. Right? Let's say we've bought land and factories and whatever else worth $10 million. Let's say your debt is $6 million. Then your equity would be worth $4 million. And let's say, for whatever reason, the economy turns south or maybe this was some type of business that's now not viable. So it's going to go into bankruptcy. And I'll get a little bit more specific on the different types of bankruptcy. But we're assuming liquidation. Actually I'll just get specific right now. So when we say bankruptcy, bankruptcy is a very common word. I think most people have a general sense what it means. They know it's bad and it means to some degree that a company can't operate as it was before. But there's a lot of confusion over what it means. There's actually two types of bankruptcy. There's liquidation. And that's essentially saying that, you know what, this business doesn't make any sense. It doesn't make sense to have the employees and run the factories. You're never going to make any money, so you might as well just sell everything you have. You liquidate it all. That's one type. And that falls under the category of Chapter 7. And we're just talking about corporate bankruptcy right now. There's also personal bankruptcy. And maybe we'll do a couple of videos on that. It might be especially relevant in this economy. Well, the other type is reorganization or restructuring. And restructuring says, you know what? This factory here, it's actually making something useful. It's actually generating money. And actually we can get more value for what we have here if we keep it running. And we will just keep it running, and we'll restructure the company. And usually that means changing this side of it. So maybe we'll cancel some debt and all of that. And I'll show you how that's done in a reasonably fair way. But just to understand kind of a simplified scenario, let's take liquidation into consideration. So let's say that this was my website selling shoes online, and that all of a sudden people have stopped wearing shoes. It's just gone out of fashion, so it makes no sense anymore to sell shoes online. So I'm just going to liquidate my assets, my real estate that I might have, my warehouses, et cetera, et cetera. My question that I left you with in the last video was, who gets it? So let's say when we liquidate it-- so we go into bankruptcy and essentially all of the assets are taken into possession by the bankruptcy court-- they're going to sell these assets. And let's say when they sell them, they don't get $10 million for these assets. They only get $5 million for them. Right? I paid for them thinking that they were useful in some way, but they end up not to be, so my assets-- You know what, I just realized when I talked earlier about there's two ways to raise capital, there's a third way to raise capial. Right? You can sell shares. You can issue debt. You can borrow money. Obviously the third way is actually just make money. Right? Once you start a company, hopefully you generate earnings, and that'll also generate cash or capital that you can reinvest in the business. And we'll talk about that. But I just wanted to make it clear that that's obviously the best way to generate capital for your business is when the business itself generates capital. So let's say that these assets, when you actually sell them off, aren't worth $10 million anymore. Let me make the pointer smaller. They're worth $5 million. So my question in the last video is, who gets this $5 million? Do you somehow split it evenly between all of these people? Or does one of them get more of it, or one of them gets less of it? And I think you'll get a sense based on where I took the $5 million out of, who gets the money. It's the debt holders. And the way I drew it right here, you can kind of view it as you go up in this direction, you're getting more senior. Or if you're going down in this way, you're getting more junior. And seniority, when you talk about a company's capital structure, is just, you know what, if there's anything left, who gets their money first? And even within the debt, you'll have different layers of debt. There might be different debt holders who have different levels of seniority. So this one might be called senior secured debt. Senior means they're high up on the stack. They are one of the first people to get their money. And secured means there's actually some collateral on the asset side that they get if the company can't pay. So maybe this is like a piece of land. Right? So just in kind of our everyday personal finance world, your mortgage is actually secured debt. It's secured by the collateral of your home. If you can't pay the debt, the bank comes and takes your home. It forecloses on the property. So that's what secured means. It means that there's some collateral, and in the event of a bankruptcy this guy can immediately go and get the collateral that his debt is secured by. So this is considered a very, very senior form of debt. Senior secured. Then you might have here, you might have senior unsecured. And there's a lot of words around, senior, junior, subordinate, and all of that. But just to get a sense that there's just a hierarchy here. Some people are the first people to get the money, and then whatever money is left goes to this person, then if there's any money left, it goes to this person, and then if there's anything left it goes to this person. And once you're in bankruptcy court it does tend to be a negotiation between the different, you can almost view it as buckets, of debt. And we'll do a more complicated example in the future on that. We'll actually delve into the details of bankruptcy. But this is the general notion. That the senior guys get made whole first, then the more junior guys get whatever's left, and so on and so forth. And if there's no money for the equity, there's no money for the equity. And that makes sense, right? Because the debt holders, all they were getting-- their upside was just interest, right? So they also should get limited downside in the event things should turn bad. Equity holders, they kind of took a gamble. If things were great, they would get all of the upside. And now that things turn bad, they take a lot of the downside. And they're actually lucky that they don't owe money. That's actually the-- I guess you could call it-- the beauty of a corporate structure, that you have limited liability. In some times in history, these people would actually owe the difference. They would actually owe this extra $1 million. They would all go to debtor's prison and all that. But we'll talk more about it in the future. So anyway, just going back on the different tranches of debt, or buckets of debt. So we could call this senior unsecured. And that means that they're still senior. They're still fairly high up the seniority ladder. But they're unsecured. There's no particular assets that they can go run. But as long as there's enough for them, they'll get it. So let me put some numbers here. So let's say there was, I don't know, $1 million of senior secured. Let's say there's $2 million of senior unsecured. And let's say that this is $2 million of subordinated-- subordinated just means they're not senior-- unsecured. So in this reality, what would happen is the bankruptcy court would liquidate all this stuff and then they'll hand it out in order of seniority. These guys get their $1 million back. So they're made whole. And they probably charged a lower interest rate, because they didn't perceive their risk that high to begin with. These guys, right here, the senior unsecured, they'll get the next $2 million. And then there's $1 million left. Right? And that $1 million will go to the subordinated debt. So they'll get 50% of their money back. So they took a little bit of a hit, but that's OK because when things were good, they probably got higher interest to compensate them for their risk. Usually as you get more and more junior and you take on more risk, you get more upside, or more interest. And in this case the equity holders get nothing. They get wiped out. So it just goes to 0. So that's the answer to the question. I said, who gets the money? Well, it's the debt holders get first dibs. And if there was actually $7 million here instead of $5 million, then you would have paid the six off completely, and then the equity holders would've gotten $1 million. And so they would have gotten something if there was enough money to hand it to them. Anyway, in the next video I'll cover-- this was liquidation, where we just say this isn't worth running. Let's just give it all away, or let's sell it, and give it back to our creditors. In the next video I'll talk about reorganization, where we say, hey, you know what? This business is a good business. It just has too many liabilities. See you in the next video.