Debtor-in-Possession (DIP) Financing Can Help Turn a Company Around Following Bankruptcy
Businesses in financial distress typically find that their sources of new funding shrink just when they need financing the most. Their ability to obtain new advances from current lenders may be cut off, and they may also fall into default.
For many distressed companies, however, there is hope for new financing. If they file for Chapter 11 bankruptcy protection, they may be able to take advantage of debtor-in-possession (DIP) financing to help them reverse course, give them restructuring support and return to profitability.
What is the Meaning of Debtor-in-Possession (DIP) Financing?
Debtor-in-possession or DIP financing is funding provided to a business that has filed for Chapter 11 bankruptcy protection from creditors. It is typically available to companies where lenders believe the company has a credible chance and a viable plan to turn itself around. It is not available to firms that simply want to liquidate the company. A post-petition lien is created after filing.
The term “Debtor-in-Possession” refers to the fact that the current management and board of directors remain “in possession” of the business following its Chapter 11 bankruptcy filing. Many small business owners are not aware that they can obtain financing to turn their company around after they have declared bankruptcy.
Many lenders see Debtor in Possession financing as an attractive lending opportunity because of the special treatment that business bankruptcy loans receive under U.S. bankruptcy law. Under the law, DIP creditors must be repaid before other creditors. In fact, many lenders will commit to a DIP Chapter 11 loan while they would not make a loan commitment to the same business in the absence of a bankruptcy filing.
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What is the Debtor-in-Possession (DIP) Process?
In DIP restructuring finance, the assets pledged as collateral must be sufficient to cover the business bankruptcy loan. Here’s how the DIP Chapter 11 loan process works:
When the company has located a lender willing to finance their turnaround, the company seeks court approval from the Bankruptcy Court. Typical DIP financing terms include a “first priority” security interest in the collateral, a market rate or even premium rate of interest, an approved budget, and other lender protections. Creditors may object to the loan if they feel they will be made worse off. The Bankruptcy Court will decide whether to approve the loan.
If a company in Chapter 11 bankruptcy has existing secured loans, and it wants to borrow on a secured basis that is equal or senior to the existing loans, (1) it will need to obtain the existing lender(s)’ consent to the new loan, or (2) it will have to convince the Bankruptcy Court that the existing lender(s) will be “adequately protected,” i.e., that they will not be made worse off by the new loan.
A current lender who provided financing to the firm prior to its bankruptcy filing may be willing to commit to a DIP business bankruptcy loan, even if it has declined to make further advances prior to the bankruptcy proceeding. In addition to the added protections under the Bankruptcy Code, the lender may also have its own goals in making the DIP loan, for example, to help improve the company so that it can ultimately be sold to another party.
If the Bankruptcy Court approves a DIP loan and finds that it was made in good faith, the loan will not be subject to legal challenge. That differs from the same loan made outside of bankruptcy, which might have been subject to challenge.
The bottom line is that while there may be some problem issues, in the appropriate circumstances, a distressed company may be able to take advantage of the DIP financing procedures under Chapter 11 of the Bankruptcy Code. In doing so, it can obtain the liquidity it needs to finance a turnaround or restructuring, or to finance the process of selling the company, even if it could not obtain such a loan outside of bankruptcy.
How is Accounts Receivable Factoring used in DIP financing?
Companies can also use factoring as a financing tool in DIP financing – a possibility that many small business owners do not realize. In fact, accounts receivable financing can be one of the most flexible ways to obtain financing and recapitalization during the Chapter 11 bankruptcy process. Factoring can be a win-win for both the borrowing company and the factoring firm. The borrower obtains needed financing that is not based on its own credit status, and the factoring firm achieves priority status under the Bankruptcy Code.
What is the Difference Between Exit Financing and DIP financing?
Debtor in Possession (DIP) financing is part of a company’s Chapter 11 bankruptcy working capital strategy. The funding is available while the company is going through reorganization, hoping to eventually come out of bankruptcy with a stronger balance sheet, and a plan to move forward. Exit financing is the company’s post-bankruptcy funding package. In smaller deals, lenders often negotiate and commit to a debtor-in-possession and an exit facility at the same time. This is known as a “DIP rollover.”
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The Bottom Line
If your company is experiencing financial distress, it’s important to consult an experienced bankruptcy attorney and/or a restructuring or turnaround specialist to determine all of your viable options. You may be able to do a workout or other restructuring process outside of bankruptcy. However, if you determine that Chapter 11 bankruptcy is your best option, DIP financing may provide a strong opportunity to help turn your company around. With Paragon as your DIP Lender, we can offer our years of expertise in DIP, exit financing, and other creative debt solutions.