Chapter 11, Pt. 2: Hard Lessons from the Chapter

This is a continuation of the series that began with Chapter 11: To File or Not to File

t shirt final.jpgConvinced that we could get all our creditors’ cooperation without formally filing for protection under Chapter 11, we proceeded nonetheless to get experienced professionals on board. The workout team was assembled — insiders including myself and my CFO, our chairman, a bankruptcy attorney from our law firm, and a workout specialist, Ralph. Except for the two pros, we were all new to this . . . and school was now in session.

Lesson No. 1: Make sure you have the right workout team.

Ralph was not what you’d expect. Rumpled, belly-over-the-belt, pinky ring. (We later concluded his approach was effective because the creditors would never confuse him with being a ‘slick suit’ out to take advantage.) But we were awed by his work. Like Harvey Keitel’s character in Pulp Fiction who masterfully wipes away every trace of a grisly crime, then goes out for breakfast — Ralph was more artisan than artist. With speed and precision he wended through our 97 creditors, triaging them into three buckets, getting cooperation to his plan — in writing — from nearly all of them in a matter of weeks. The guy knew what he was doing.

He also knew well the brick wall that lay ahead: the largest, secured creditors. When it came down to it, it took just three of the 97 creditors — the owner of our million-dollar testers, the bank holding the lease on our 100,000-square-foot facility, and our primary equipment lessor — to nix the deal.

Lesson No. 2: Large secured creditors know that their chances of recovering debts depend on a company’s survival — and chances of that are much better behind bankruptcy law’s skirts.

By law, the big guys had the power to force us to file . . . and they did. Lord knows I wanted to avoid it, from a personal standpoint. See, the secured creditors had also sealed the fate of my founder’s shares, roughly 15% of the company. Why? Because in a Ch. 11 reorganization, all bets are off — the capitalization chart is wiped out, and a new one gets put in its place. If not handled properly, this could be a big problem for your stock-incentivized employees. (Remember the importance of those neurons.)

Lesson No. 3: Take good care of the workforce.

Without any cajoling, the Board agreed to reconstitute employee stock options — a design engineer with options for 1% of the old company would end up with 1% of the new company. Simple, straightforward. As for me, I was at the mercy of the Board, who couldn’t see their way clear to reconstituting my ownership entirely since, despite all good intentions, I was a member of the management team that presided over the meltdown. (Unlike today, people once believed in management accountability.) But as the saying goes, 2% of something is better than 100% of bupkus.

What followed was nothing short of a casebook classic on Chapter 11 — if not a Guinness record. The company went in and out of bankruptcy in 88 days. We had done everything right, and it was a beautiful thing.

Lesson No. 4: Provide a sufficiently creditor-approved plan to the bankruptcy judge on the day you file.

More often than not, companies in trouble file for Ch. 11, then take three months or more to develop the plan, only to have it stall somewhere between the bankruptcy judge and disgruntled creditors. We had nary a complaint from any of our creditors, and here’s why.

First, the 74 smallest ones — those owed less than $10,000 — were paid 100% on the dollar. (Ralph knew the little guys would make the most noise, and it’s never worth the trouble to pay them anything less.) Total paid to this group: $294,000. The next class of creditors (the 19 owed between $10,000 and $100,000) would receive 75 cents on the dollar. This group too had no issues. Total paid out: $343,000. Lastly, the four secured creditors — owed a whopping $4.2M — were paid 10 cents on the dollar, plus given low-priced warrants to purchase shares of common stock. Everyone took the deal (technically, they had to — once the judge’s gavel comes down, it’s the law), with the exception of the bank, which had a policy against owning shares in customers’ companies, and forewent the warrants.

New money was of course equally crucial to the plan. Most — but not all — new funding came from existing investors. The proposition was: “œYou’ve already put $4M into this fine company, which bought you 15%. You could write it all off “¦ but why not put an additional $400,000 in, and reclaim your 15% in the newco?” It worked with every investor except a few of the European ones (Europe still hasn’t fully grasped the Ch. 11 concept). In all, $2.5M of new money came in — enough to get the company through to solid profitability and positive cash flow. (Don’t forget, we were growing our business of building and selling chips all through the process. Customers have less of a problem with it than you might think — after all, who of us didn’t fly Delta or United through their bankruptcies?)

Lesson No. 5: Do your best to maintain morale, but remember — the employees that stick around through tough times are the only ones you should have hired in the first place.

The final elements to consider were the intangibles — company culture and morale were big ones. (Don’t underestimate the importance of changing the logo!) We knew at this point that it was really just about the employees, now down to 75 die-hards. True, despite every effort to retain them — the ‘Oh, Thank Heaven . . .’ t-shirts (playing off the popular convenience-store jingle at the time) were a touch I’m especially proud of — you’re bound to lose a few. But as the manager of the team that remained, I still get misty thinking about the quality, perseverance, and attitude of the group.

Filing for protection under Chapter 11 is a grave decision — and not the right prescription for every ailing business. Our company was a superb candidate because it had the right fundamentals — strong demand for its products, a solid asset base in intellectual property, willing investors, and leadership capable of boosting morale while managing the day-to-day business.

Chapter 11, Pt. 1: To File, or Not to File?

Misery final.jpgIt’s a timely topic, but when asked to detail my experience with Chapter 11, the line that came to mind was from the end of ‘Misery’, when James Caan is lunching with his agent: “Gee, if I didn’t know better, I’d think you were asking me to dredge up the worst horror of my life, just so we could make a few bucks.” But though I never hope to put the experience to use again, it provided valuable lessons (plus, my company — Lattice Semiconductor — prevailed, and grew to a quarter-billion dollars in sales) and serves as a cautionary tale to entrepreneurs as we enter some tough times ahead.

So here is the tale — of a company that ran up expenses too far ahead of revenue, hit the wall, then succeeded with a ‘do-over’ by putting one of America’s great pieces of legislation — the 11th Chapter (Reorganization) under Title 11 (Bankruptcy) of the United States Code — to work.

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The old regime ousted, my new CFO and I (promoted to COO) — several months into a salary moratorium, since the company was down to the very last of its cash — were on a mission to raise fresh capital. First on our list of VCs was NEA, and we were hiking up Knob Hill (ridiculous, but we were trying to save cab fare) to the exclusive San Francisco club where the Sand Hill Road VCs had deigned to meet us. We hurried through the massive portico, past — was that a cellist? — down a triple-wide marble staircase to an enormous room with nothing but an easel and elegantly set table.

But we weren’t to dine that day.

The VCs motioned to us just as lunch was being served, and we earnestly began the pitch for our hot computer-chip company. But by the time we realized we weren’t getting fed, it was pretty clear they weren’t going to invest either.

What we did give us that day was a lesson — etched forever in my memory of pristine crystal and gilt-edged china on crisp linen. (Was it because it served as so perfect a metaphor for the venture capitalist ideal . . . or were we just hungry?)

“œWe VCs like to pull ourselves up to a fresh table,” the lead partner said, stroking the linen and aligning his silverware for emphasis. “œYou’re going to have to clean house.”

We knew what he meant — or thought we knew. Though we had sales exceeding $1M a quarter and referenceable customers like Compaq, we had problems. A burn rate that would snap your neck, for one — $750k a month, anchored by a 10-year building lease and a crushing debt load. Then there was that undigestible shareholding of my megalomaniacal co-founder, whom we had forced out only weeks before: an eye-popping 35% ownership in the company.

These were problems we naïvely believed a fresh round of financing could fix. But the VCs had dosed us with reality that day. Despite how hard we’d worked to get where we were — endured three months without pay . . . gritted through laying off a third of our 175 employees . . . pulled off the board coup and CEO ouster — the barons of Sand Hill Road had declared us unfundable. To pound the table-setting metaphor one last time: we were the morning after a bacchanalian orgy.

The Unutterable

Back at our offices, none dared utter ‘Chapter 11′ outside the board room. It wasn’t shame we feared, but the booming voice of conventional wisdom: as a chip company, you’re dependent not just on intellectual property, but on know-how — an asset buried deep in the neurons of key engineers. Spook them, and you’re liable to ‘lose the recipe.’ (The semiconductor business is legendary for nuances wildly affecting yield, also known as KGD or known good die per wafer — the all-important metric that dictates profit and loss.) The thinking was, if you so much as mention Chapter 11, key employees flee, production goes to hell, and you’re left with . . . nothing.

Management and investors gnashed and thrashed over whether to file. While the Code was drafted with us in mind — keeping the creditors at bay and allowing you to conduct business as usual as you work out a plan to repay them — we couldn’t get over our fears. So, like others before (and many to follow), we came to an ill-informed conclusion: We’ll work everything out without filing for Chapter 11. Surely everyone will go along with it, since it will have a much better chance of success! Who wouldn’t prefer it to being crammed down by a curmudgeonly bankruptcy judge? It will be so much more . . . civil!

Only, it doesn’t work that way. Next in Part 2: Hard Lessons in the Chapter.