Editor’s Note: Lawrence A. Katz is a shareholder and Kristen E. Burgers is a principal in the Tysons, Virginia, office of Hirschler Fleischer. Katz and Burgers represent debtors and creditors in a wide range of matters, including chapter 11 bankruptcy reorganizations, liquidations, out-of-court restructurings, bankruptcy court litigation, mediation and distressed asset sales.
The pair recently represented Hellbender Brewing Company LLC in its Chapter 11 reorganization proceedings before the U.S. Bankruptcy Court for the District of Columbia.
In their column for Brewbound Voices, Katz and Burgers provide an overview of the bankruptcy process and discuss the tools available to a debtor in bankruptcy.
When Trouble Is Brewing
Despite slowing growth trends within the craft beer segment, the United States has added about 1,500 breweries since 2015.
According to trade group the Brewers Association, there were 5,234 craft breweries operating in the U.S. in 2016, compared to 4,504 in 2015. The organization, which represents the interests of small and independent beer companies, recently reported that the number of U.S. breweries had finally reached 6,000.
While the future looks relatively bright for the craft beer industry in general, such rapid growth is often accompanied by problems. Increased competition and saturated markets can lead to economic hardships, putting smaller breweries at risk.
We’ve already seen a number of U.S. breweries grapple with that increased competition: Most notably, a pair of San Francisco breweries — Speakeasy Ales & Lagers and Magnolia Brewing – staved off elimination after going through receivership and bankruptcy procedures.
In this article, we will further discuss the circumstances that can lead to financial distress, how chapter 11 bankruptcy may alleviate that distress and what entrepreneurs can do to better position their companies for success.
Problems that can lead to financial distress
The proliferation of craft breweries is both a blessing and a curse. Demand for craft beer continues to grow and new players enter the market in response to the demand. At some point, however, the market will become oversaturated. Supply will outpace demand and every brewery will have to work harder – and smarter – to differentiate itself from the competition and maintain its market share.
Every business venture has inherent risks. With craft breweries, those risks are particularly high, due in large part to the significant up-front fixed costs required to start a brewery. Not only do you need to buy expensive, specialized brewing equipment, but you also need to rent commercial space that is large enough to house your raw materials, equipment and finished product. It also needs to be located near a reliable source of water, easily accessible for the distribution of your product and – if you intend to open a tasting room – has curb appeal.
The fixed monthly payments on the equipment loan and the commercial lease will be substantial. Once a new brewery has exhausted its startup capital, it will need strong sales to meet these fixed payments and the many other costs of operating a brewery and producing beer.
When startup and operating costs combine with increased competition and market saturation, the risk of financial problems increases exponentially. If your brewery is facing such challenges, Chapter 11 bankruptcy may provide tools to address the problem.
Chapter 11 bankruptcy protection
When confronted with overwhelming financial burdens, a bankruptcy filing can help you manage and prioritize your obligations to third parties and ensure the long-term survival of your brewery.
For business bankruptcies, there are two options: Chapter 7 and Chapter 11. A Chapter 7 bankruptcy is a straight liquidation, where a trustee is appointed to wind down the business, liquidate the assets, and distribute the net proceeds of the liquidation to creditors. In contrast, a Chapter 11 bankruptcy may be a liquidation or a reorganization.
Under either scenario, management typically remains in control of the business and guides the business through either the liquidation or reorganization, as appropriate. Of course, whenever possible, reorganization is the preferred course of action.
Chapter 11 bankruptcy offers many benefits and tools to aid a debtor in the reorganization process. Some of the more important tools are:
- Automatic Stay: Filing for bankruptcy operates as a stay against actions by creditors to collect a debt or enforce a lien against the debtor’s property (among other things). This is one of the fundamental bankruptcy protections, and it is intended to give the debtor a “breathing spell” to reorganize its business.
- Assumption or Rejection of Leases and Contracts: A debtor may either “assume” or “reject” a lease or executory contract. By rejecting a burdensome lease or contract, a debtor can potentially eliminate a large, fixed payment or an unfavorable agreement. The threat of rejection may enable a debtor to renegotiate a lease or contract on more favorable terms.
- Payment of Tax Claims Over Time: The IRS and other taxing authorities are often among the debtor’s largest and most demanding creditors, with strong statutory powers at their disposal to enforce the payment of taxes. To ease the burden of back taxes, a debtor is given the opportunity through a plan of reorganization to pay certain tax claims over a five-year period.
- Cramdown: While the legal rules are complex, a debtor may be able to confirm a plan of reorganization that pays creditors less than one hundred cents on the dollar through a “cramdown.” Creditors may be forced to accept partial payment in full satisfaction of their claims.
Positioning a brewery for success
Bankruptcy is, of course, a last resort, but may prove necessary. Some of the things you can do to minimize the risk of having to file for bankruptcy include:
- Don’t Start in a Deficit: When you first open your doors, be sure you have sufficient capital, including an adequate reserve for the unexpected. If you start in a deficit, it will be difficult, if not impossible, to catch up.
- Think Big, Start Small: Big, successful breweries don’t happen overnight. If you overcommit and overspend at the outset, you risk compromising your growth over the long haul. Be patient, and set realistic expectations for deliberate, strategic growth.
- Enter Distribution Agreements with Caution: Self-distribution takes more initiative and manpower during the startup phase, but you get to know the market and your customer base intimately, and you get to retain more of the profits. When you think the time is right to enter into a distribution agreement, get your professionals involved. Distribution agreements are complex legal documents: Without professional guidance, you will be at a major disadvantage when negotiating terms with your future distributor.
- Involve Professionals Early: Yes, accountants, lawyers, and financial advisors are expensive. But they are not nearly as expensive as making an unwitting mistake that can’t be easily undone. Entrepreneurs should budget money for professional advice and guidance at the outset.