Companies rely on liquidity to stay afloat. In addition to cash flow, businesses can receive liquidity through financing from banks, credit from vendors, and loans from investors, owners, or other insiders. However, businesses sometimes find themselves in a difficult situation where their options for liquidity run out. When businesses lose their existing means of traditional financing, it can be difficult or impossible to get advances or new loans. Debtor-in-possession, or DIP, financing is a potential solution to this problem.
After filing Chapter 11 bankruptcy, the current management or board of directors stay in possession of the business. This is where the term "debtor-in-possession" comes from. Although the business has filed for bankruptcy and is only able to maintain operations because of their loan, the business owners are still in control of the company.
DIP financing is a form of lending used when businesses fall into default and file for Chapter 11 bankruptcy. This type of bankruptcy favors reorganization over liquidation, so bankruptcy law outlines DIP financing guidelines that benefit both the borrower and the lender.
This type of financing is intended to help businesses in bankruptcy reverse their course, restructure their finances, and recover from their financial crisis. It can only happen when lenders believe that the company has a reasonable chance of recovering and a clear plan to turn their business around.
When a business receives DIP financing, they use the money to keep their business afloat throughout the bankruptcy proceedings. The money can go toward the following expenses:
Approving loans for a business in bankruptcy can be risky. Creditors would be unlikely to offer a loan to a company that is struggling so much with liquidity, so bankruptcy law provides some incentives for lenders to offer DIP financing. The law states that DIP creditors must receive payment before any other creditors, which makes this an attractive opportunity for lenders. Also, if the company is liquidated, the DIP creditor gets first priority on assets.
Businesses usually apply for DIP financing at the beginning of the bankruptcy process. The earlier a business gets financing, the better their chances are of successfully restructuring their business. Unfortunately, some businesses fail to apply in time because the management is in denial about their financial situation.
The company first must find a willing lender. The lender and borrower will have to negotiate until they come to an agreement on terms. Then, they'll negotiate on the size and structure of the loan.
Once a creditor has approved the company's proposal, they must seek approval from the bankruptcy court. The bankruptcy court decides whether or not to approve the loan based on the loan terms and the company's likelihood of repaying the debt.
The business will be required to pledge assets as collateral that amount to enough to cover the loan. The business owner may have to give a personal guarantee that the debt will be repaid. Typically, the financing terms will include priority security interest in the pledged collateral, a market rate or premium rate of interest, and other protections for the lender.
Another common loan term is an approved budget, which includes a forecast of the following expenses:
If the business currently has secured loans and wants to borrow an amount that is equal or greater to their existing loan, they must get the current lender's consent first. They also must convince the bankruptcy court that the current lender will be protected.
In many cases, a creditor who has already given loans to the business provides the DIP financing. Even if the creditor has declined to make advances outside of the bankruptcy, the additional protections involved in DIP financing can make this type of loan worthwhile.
When negotiations are complete and the bankruptcy court has approved the terms, the company management informs their vendors, suppliers, and customers that they will remain in business. These parties can expect the business to make payments and provide services while it reorganizes and recovers from the bankruptcy.
Debtor-in-possession financing can save bankrupt businesses from liquidation. Although the loan terms are strict and require court approval, the financing can provide you with the cash you need to stay afloat while you restructure your business. If your company is in the process of filing for Chapter 11 bankruptcy, you may benefit from reaching out to local creditors to ask about DIP financing.