Restructuring versus bankruptcy filing.

It's not difficult for lenders to see the red flags of troubled customers. When one of these flags is raised and the customer company has creditors stretched to the limit, the lender is expected to step in and minimize the damage, that is, if it is still possible.

Such was the case for Southern California-based Applause, Inc., late in 2000, when the plush toy maker was on the verge of bankruptcy. With more than $100 million in debt, the company had reached the point of near foreclosure. At this stage of a company's demise, its lender would assume that every potential life-saving measure has been taken. Also at this time, the lender would need to freeze loans and credit lines. While it is in a bank's best interest for its customer to turn around, banks cannot take on the problem themselves.

Applause--An Overview

Applause LLC is one of the world's most diversified gift and specialty marketers. Founded almost 35 years ago, Applause offers specialty retailers classic licensed stuffed toys. Some of their more popular characters are made for Disney, Looney Tunes, Star Wars, and Sesame Street.

Over the years, Applause has enjoyed its fair share of successes and proved its ability to achieve market penetration. These strengths are part of the reason the company is still on its feet today and why it went through quite a scare a few years back. Steady successes were part of the company's history as it grew, but nothing prepared the company for three spectacular years in the mid 1990s when Applause had homerun hits. The homerun hits brought in approximately $50 million, exceeding Applause's typical base by roughly 10 times. In a period characterized by blockbuster movie deals that included Star Wars, Toy Story, and The Lion King, Applause became dependent on these enormous revenues. It also became quite confident about maintaining them.

Forecasting based on this unprecedented growth started the trouble. In anticipation of skyrocketing revenues, Applause invested heavily in growth. Since it was so highly leveraged, the company was under enormous pressure to chase after higher revenues. At one point, Applause purchased enough inventory for $160 million in sales, with 25 percent of that coming from movie deals alone. The breakeven point was almost twice what it was running at, or $200 to $250 million. The problem: The company was stalling out at $130 million to $140 million.

Two factors created problems with Applause's projected revenue. First, Applause was not in the business of making movies, so the company did not know how to forecast when hits were on the horizon. Second, there were no hit toys during this time period. Add a softening economy, and Applause's financial situation weakened quickly.

The Time of Decision

Applause's lenders were rightfully preoccupied with protecting their assets. Commercial lenders typically base decisions on past experiences and how the numbers played out under similar circumstances. It's not really a lender's job to see beyond the underlying value in debtor companies that seem to be in hopeless situations. Most lenders haven't been trained to read between the lines and uncover mismanagement or senseless marketing decisions. By doing so, however, lenders can consider alternatives with more objectivity. In retrospect, Applause had three alternatives:

File Chapter 7: This would mean complete liquidation, translating into the loss of approximately 200 jobs in Woodland Hills, California. It also meant no chance of ongoing business and no possibility that investors would recoup their losses.

File Chapter 11: Eighty-five percent of all bankruptcy filings end in liquidation. Of course, the hope would he that Applause would file Chapter 11, restructure its debt, and find a buyer. But bankruptcy isn't necessarily the best vehicle with which to resolve credit problems.

Friendly foreclosure or restructuring the balance sheet: A potentially better approach would be to give creditors all the information they need, that is, to fully disclose Applause's financial position. When a company is overloaded with debt and has poor cash flow, it does not necessarily mean that the company will not be able to continue. A company with valuable products, customers, and assets could be overburdened with too much debt, too many layers of debt, or the wrong kind of debt. When a good company with great products is deeply in debt and lacks liquidity, interest payments absorb all its revenue. In turn, they sap operating capital, and it becomes impossible to move ahead. Typically, a business in this position is forced to close its doors. But some more fortunate companies collaborate with turnaround experts and their creditors to restructure the balance sheet.

Financial Restructuring

Applause hired turnaround experts to conduct a financial restructuring. A third party familiar with companies in crisis and unaffected by close company ties can act decisively to bring about change quickly, when time is of the essence. To bring Applause out of crisis, the best plan was to find the company a buyer.

Unfortunately, most of the strategic buyers were competitors who weren't interested because they knew Applause was having trouble. Why buy the company when, by doing nothing, Applause would go under and the creditors would get the business anyway? The only credible buyer was Bob Solomon, who had sold Applause five years earlier. The crisis team helped Solomon find financial backers to buy Applause.

When a lender is trying to assess the likelihood that a company will survive, it is helpful to evaluate interim goals and determine whether or not they are being reached. When lenders see debtor companies making progress, a successful outcome is more likely. In Applause's case, the turnaround experts tackled the following goals:

Gain control over cash. By stabilizing

Applause's cash flow and getting the company to a breakeven point, other options opened up. The first step was to gain control over the cash by determining where the cash was in the company and/or where the cash could be accessed immediately. The consultants reconciled accounts and created an inventory of cash. For the crisis team, this cash wasn't being gathered to carry on the business. It answered questions such as whether there were any checks that had been written but not yet cashed. From there, the team created a reporting mechanism. Beginning with the cash available, where should it be deployed? This meant converting from accrual accounting to pure cash accounting. Clearly, profit and loss was not as important as knowing how long the company had to survive before it would run out of money.

Open lines of communication with the lender. Applause's turnaround experts introduced complete, open communication to lenders in order to help the lenders understand Applause's problems. At the time, there was already a consortium of banks deciding whether or not to write off their loans. With full information, it became apparent that liquidation would only generate enough to repay lenders a small percentage of what they were owed. This put a new light on how much extra time should be given.

Coordinate and manage unsecured creditors. When a company is as overleveraged as Applause was, trade creditors are also exposed, pulling them in a position of undeserving risk. When trade creditors hire attorneys and make impulsive decisions, senior lenders sometimes react in skittish ways that force disclosure. Again, third-party communication with unsecured creditors gave breathing space to the troubled company. Even when the news is not good, the creditor can see the advantages of moving the company forward.

Pay attention to company strengths. This step made real sense in Applause's situation. A downsizing plan was designed to focus on the company's core strengths and products. Two areas became key: trimming fat from the organizational structure and reducing inventory by cutting back on the number of items (stock-keeping units) in stock. The crisis team members stepped into decision-making roles and helped the CEO through the period of transition. Its new structure enables Applause to live on its core business and expand or contract to meet variations in sales. Applause does this by outsourcing peak business. While outsourcing costs a bit mere, Applause gains flexibility to handle sales fluctuations without destroying the base organization.

Seek a buyer. Often the best solution is to find a strategic buyer. Applause's majority shareholder and CEO explains, "The problem with the company was that it had relied primarily on licensed and entertainment products. Sales were raging while a movie, a character, or a license was hot, but these phenomena always peaked and then slowed up. It was a formula for failure to rely too heavily on hot properties." Solomon's philosophy was to create a balanced portfolio of stable proprietary brands along with classic characters and some entertainment properties, without overrelying on any license, product, or retailer. Applause's crisis consultants helped the company obtain a $25 million revolving line of credit with GMAC. Despite its 20-year track record, Applause was essentially a start-up and needed to work hard to obtain credit.

The Commercial Lender's Point of View

Applause ended up a successful turnaround, showing that troubled borrowers can recover. By taking corrective action, it may be possible to repay loans, save businesses, and preserve jobs. The challenge to the lender is to distinguish a company that can recover from one headed for failure.

Lenders do best evaluating a company's circumstances when they isolate them from any other situations. They must look at both the numbers and the inherent value in the company. When value is found--so is opportunity. Lost funds are recovered and a working relationship is reestablished. For a sick company to recover it must be able to stabilize cash flow, reestablish credibility with lenders, organize unsecured creditors, focus product development, and perhaps even locate a strategic buyer. Finally, lenders must watch for signs that borrowers have reached what's called lender fatigue. When someone from the lending side feels affronted or believes that the management team has lied, lender fatigue is likely to set in.

Certainly there are situations where filing Chapter 7 or Chapter 11 is a failing company's best choice. But a lender could save millions by learning whether it's worth the time, effort, and investment to investigate a turnaround.

Adam Michelin is a partner, heading the CEO and technology practice, in the consulting firm, Kibel Green, Incorporated. He can be reached at [e-mail].