Growth | April 2012 | By John Morell

Bankruptcy Could Save Your Business

Filing for bankruptcy isn’t always a bad thing. Here’s how to do it right.

Sbarro's emerged from Chapter 11 bankruptcy early this year.
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The term bankruptcy tends to elicit doom-and-gloom thoughts from business owners. But experts say bankruptcy doesn’t have to be a bad thing. In fact, by filing for bankruptcy, operators can shed the weight of their debts and get back on the course toward success.

Just ask Sbarro. The leading Italian quick-serve chain filed for Chapter 11 bankruptcy in April 2011, citing high wholesale food costs as the primary reason for its trouble. The company emerged from bankruptcy last November without 70 percent of its previous debt and with an infusion of $35 million from a new ownership group.

James Greco, Sbarro’s new CEO, says the restructuring saved the brand.

“We’re going to remake this into a new, thriving company in the marketplace, and it couldn’t have happened without the bankruptcy filing,” he says.

Of course, bankruptcy doesn’t rescue every brand. Operators who don’t know how to navigate the process appropriately won’t always find sunnier skies on the other side of bankruptcy.

“Business people don’t dream of failing, they dream of succeeding and they consider what it takes to get there,” says Anthony Calamunci, an expert on franchise law with law firm Roetzel & Andress. “That may be why when things do fail, it can get very complicated.”

Along with Sbarro, there have been other well-known restaurant brand names on the court docket the last couple of years, many because they were unable to survive the economic turmoil that set in four years ago. Companies like Friendly’s, Fuddruckers, Real Mex Restaurants Inc., and Perkins & Marie Callender’s Inc. all filed for bankruptcy.

“Restaurants have been hit very hard by the Great Recession because, like many retail businesses, they’ve had to survive a double-whammy,” Calamunci says. “Not only have consumers tightened their spending, but real estate has taken a big hit and that has turned many once-promising balance sheets upside down.”

Although many financial experts see the economy improving, or at least leveling out in 2012, some observers say there’s more upheaval in store for businesses.

“There’s a lot of reorganization out there that needs to be done for many business people, particularly those in the quick-serve industry, to succeed again,” says Dave Spargo, a principal with real estate and restructuring firm Huntley, Mullaney, Spargo & Sullivan.

Spargo says that for restaurants especially, profit margins are so tight there’s little room for flexibility if the business takes another hit. “If the road they’re on has limited traffic because of road repairs or there’s a price spike in a key ingredient, they can get into real financial trouble,” he says.

Because of this, he says, operators should know the bankruptcy options available to them.

The ultimate bankruptcy is a Chapter 7 liquidation, in which any business assets are sold to the highest bidder and the owner walks away from the business. But the bankruptcy path that most businesses try to maneuver is Chapter 11, or reorganization, to try to salvage the operation.

In Chapter 11, the secured creditors—in the case of a quick-serve operator, usually the bank that lent money for equipment and startup costs—and the landlord are paid what they’re owed over time plus the promise that payments going forward will be prompt. Unsecured creditors, like vendors, are generally paid a percentage of what they’re owed over time based on the reorganized company’s ability to repay its debts, which could range from 100 percent to pennies on the dollar.

Spargo worked on the recent restructuring of Round Table Pizza Inc., a California-based pizza concept. Over 10 months the company reorganized its real estate leases, which were dragging it down; preserved its employee ownership; and paid its vendors 100 percent of past due obligations.

However, success stories like Round Table Pizza’s and Sbarro’s are not always common in the restaurant industry. Many concepts are overwhelmed by bankruptcy and fade away.

“If you’re filing a Chapter 11 plan in which you’re paying your food suppliers 10 cents on the dollar for all that you owe them, you’re going to have to consider how they’ll do business with you in the future,” says Scott Dillon, a senior bankruptcy attorney with New York City–based Tully Rinckey PLLC. Dillon has worked with several restaurant franchisees on their bankruptcy cases.

“Odds are you’re going to have to find new suppliers, and they may not be eager to work with you. They may want cash upfront.”

But Spargo says reorganization can help relations with vendors.

“Maybe they are only getting a percentage of the past due, but they know as part of the plan that the day after you’ve filed your reorganization, they’re going to get paid in full so they may not run away from you,” he says.

For franchisees, the franchisor plays a vital role in the bankruptcy process because most franchise agreements state that bankruptcy is a trigger for the company to take back the franchise.

“It’s an example that when you’re having difficulties, you need to be in communication with the company, but when it comes time to file, everyone’s interests are going to diverge,” Calamunci says.

For a franchise to pull out of a bankruptcy successfully, he says, the operation’s key players need to get on the same page. “It’s examining the lease, the economics, and coming up with a plan for the franchisor so they don’t have their management team spending all their time on this one unit,” he says.

Spargo says the lender, the landlord, the franchisor, and the franchisee have to work together in a bankruptcy restructuring, “because a failed franchise leaves an empty storefront for the landlord, a closed location for the company, and doesn’t do anyone any good.”

Each bankruptcy case can differ dramatically based on the calculations of earnings before interest and taxes, rent, and amount leveraged. But Calamunci says operators who do what it takes to see the process through will be rewarded.

I’m working with a franchisee now that has figured out that a change in location will turn the business around,” he says. “It’s a big move, but they’re willing to make that move to save it.”