Investors looking to buy a bankrupt business have a lot to consider. Buying a business through bankruptcy comes with risks but can also come with significant financial potential. The process can be long and complicated, but knowing the steps can help you make the best choices every step of the way.
Below you will learn how to buy a bankrupt business, the possible opportunities associated with such a purchase, and the risks involved before starting the process yourself.
Types of Bankruptcy
There are various reasons a business will go bankrupt. Common examples include
- Poor management
- Economic decline
- New regulations
- New liabilities
All of these reasons affect the bankruptcy and purchasing processes for the new company that takes over.
With that in mind, in the U.S., there are two types of bankruptcy that a business can file for:
Chapter 7 bankruptcy results when a company goes out of business and appoints a trustee to liquidate and distribute assets to its creditors and owners. Additionally, debts are separated into priority debts, secured debts, and non-priority unsecured debts, which are paid with what comes from the liquidated assets.
Chapter 11 bankruptcy is the most common and occurs when a company continues business as usual while creating a reorganization plan to come back from bankruptcy.
This type of bankruptcy is unlikely to provide the opportunity for buying the business unless the company’s plan is rejected by the owners, creditors, or court or if the business cannot remain profitable after the plan is accepted.
Why Invest in a Bankrupt Company?
Bankruptcy is often associated with failure. If a company declares bankruptcy, it tells investors, competitors, and consumers that the business is in trouble. However, it’s all about perspective. For some investors, bankruptcy is a sign of a new opportunity.
Falling prices make it cheaper for investors to pay in, especially if they believe that profits will rise in the near future. Sometimes it’s the best option for businesses to declare bankruptcy as they reorganize their strategy. This situation is appealing to investors because it means low-priced stocks.
Bankrupt companies have the opportunity to come back from bankruptcy with streamlined operations and an increase in profits, causing their share prices to increase in value. But it’s also possible they are unable to return from the downfall.
Investing is always risky, but with those risks comes the opportunity for investors to make a significant profit.
Compliance With Bankruptcy Law
Before learning how to buy a bankrupt business, it’s crucial to understand and follow bankruptcy law. The transactions of any business that files for bankruptcy are subject to evaluation by creditors and the court.
To purchase the business, you must comply with all bankruptcy regulations. Otherwise, you may experience unwanted liability, or the sale could be considered fraud.
Many companies purchase a bankrupt business under Section 363, which is an effective method to buy the business or its assets without a reorganization plan included. The sale allows the debtors to sell their assets and fulfill their obligations to the creditors.
This way, the new business buyers are also clear of any liabilities.
How to Buy a Bankrupt Business
The process of buying a bankrupt business may seem simple at a glance. But there are various risks associated with acquiring a bankrupt business.
For instance, the problems that caused the bankruptcy may still exist. If there is no easy solution to these problems, they may repeat and lead to a bad investment. It’s also common for bankrupt businesses to have a mountain of debt that cannot be quickly paid off in cash.
But with the proper knowledge, funds, and experience, it’s possible to buy a bankrupt business and make it profitable. Below are the steps required to make it possible.
1. The Early Stages
So, how to buy a bankrupt business? Once you know what business you want to buy, the next step is to review all the documents. These important documents include court documents, a comprehensive account of operational demands, and the businesses’ financial standing.
After reviewing the documents, you can determine if you have the financial means and expertise to salvage the business or prepare it for liquidation. Both decisions require research and familiarity with the bankruptcy and purchasing processes.
2. Preparing for Purchase
Before you can establish a concrete purchase plan, you need to work with, and potentially negotiate with, the business creditors to determine the purchase price.
They often present a percentage they find appropriate according to the type of business and how much they believe it’s worth. The creditors will also come up with a payment structure or plan for proving the payments.
You may want to come up with a negotiation strategy beforehand. Specific strategies will be more effective according to the type of business up for purchase, the underlying debt of the business, and the type of creditors.
Moreover, the type of business and the severity of the situation can cause you to work with either secured or unsecured creditors, bondholders, shareholders, and vendors.
3. Presenting an Offer
One of the most important steps to know when it comes to learning how to buy a bankrupt business is how to present an offer to the judge. Buying a company in bankruptcy always requires a judge to sign off on the offer.
In this step, you will need to make a case for your offer. While making your case, you can get a good idea of whether the judge is more or less likely to accept your offer.
The judge can make helpful suggestions as you move ahead in the process. If the judge approves and signs off on your offer, you are ready to move on to the next step in the purchasing process.
4. Placing a Bid
The final stage to buying a bankrupt business is placing a bid. This bidding process involves submitting a formal bid to the court along with a deposit that makes up a percentage of your bid.
Keep in mind the bid percentage varies according to the state you live in and the court overseeing the transaction.
If the judge approves your bid, you can now purchase the business.
5. Buying Assets
Another important step when learning how to buy a bankrupt business is understanding what to buy from the company.
When purchasing a bankrupt business, buying company assets rather than stock is recommended. There are always exceptions, but purchasing assets is financially safer.
For instance, many asset purchases come with tax advantages. Purchasing assets also comes with a decreased risk of liability, which is important in this process.
You may want to purchase specific assets, such as equipment or inventory, another cost-effective method to get the materials you need. However, it’s important to keep in mind that purchasing assets this way takes longer than other methods. That’s because several parties are involved in the approval process.
While it can take a week or two to complete some purchases, creditor objections and or extended negotiations can cause asset purchases to take much longer. Therefore you should plan accordingly and consider the specifics of the purchase to meet a realistic timeline.
Risks of Investing in a Bankrupt Business
On paper, investing in a bankrupt business seems easy. But there are many risks associated with purchasing a bankrupt business.
For example, the company’s shares may not accurately reflect its value. As a result, it’s more profitable to sell.
Also, the issues that caused the bankruptcy in the first place may be challenging to fix. Therefore, they may repeat unless there is a way to solve them throughout the acquisition process.
Another major threat to new investors is referred to as vulture investors. These investors or investment groups profit from buying large stakes in bankrupt companies under Chapter 11 before new issues are shared.
These investors have tools to discover the value of companies going under before anyone else to secure a majority of the post-bankruptcy shares. As a result, they are often the first sellers once the company has recovered.
Knowing when it’s the right time to invest comes from in-depth research or, according to investors, due diligence. Companies with a solid foundation that entered bankruptcy due to extreme circumstances make the best investments. These circumstances include identifiable liabilities, such as poor selling of products, failed buyouts, and unfavorable lawsuits.
Businesses with low market cap stocks are also more likely to be unwanted by vulture investors. Low market caps are often mispriced. These factors increase the chances of the company’s stocks having a better value than assessed.
Even if you know how to buy a bankrupt business, you can be subject to these risks. That’s why you must do your research and follow all the process steps.
The Bottom Line
Navigating bankruptcy is complex and often drawn out. However, some businesses can re-emerge and be profitable once again – and you’ll be prepared to handle the risks since you have learned how to buy a bankrupt business.
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