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We have all been reading the news of the many failed dot-coms. The stories are always the same. After raising millions of dollars and spending most of it on advertising and Web site design, a dot-com is unable to raise further capital and fails. Many dot-coms have evaporated overnight. In December 2000 alone, 40 Internet startups went out of business, costing investors more than $1.5 billion. Only 10 of these companies are in bankruptcy. The rest simply closed their doors. For those in the bankruptcy community, the boom in business from failed dot-coms has not materialized as expected because of the assumption by many failed dot-coms that they have no assets worth saving. The point of this article is to explain that for almost every dot-com that fails, there are usually three valuable assets that with proper planning and advice, can realize substantial value for the creditors and shareholders. A HYPOTHETICAL INVOLVING HOT COMPANY.COM Hot Company.Com (“HotCo”), a hypothetical company, opened its doors in the summer of 1997. HotCo’s business plan was to establish a Web site so consumers could purchase mint-condition classic children’s toys. HotCo developed relationships with toy manufacturers and classic toy retailers and collectors that allowed HotCo to have available hundreds of classic toys without having to actually purchase inventory. HotCo’s Web site contained graphics displaying myriad toys, the prices for each toy and hotlinks to other, related information sites. Within several months of opening for business, HotCo’s Web site was receiving hundreds of visitors a day. HotCo went public in the fall of 1998 and raised $40 million in equity. With the proceeds of the public offering, HotCo hired 40 employees, entered into a five-year lease (with the right to renew for an additional five years) for a full floor of space in downtown San Francisco and spent a lot of money on advertising. By the following year, almost all of the $40 million had been spent and, although toy sales were brisk, the cost of filling orders, maintaining the Web site and continuing to advertise resulted in continuing losses. Due to the drop in interest in dot-coms in the capital markets, HotCo could not raise further capital through subsequent public offerings. Due to the fact that it had no hard assets to give as collateral, HotCo could not obtain loans, either. Realizing that in several months HotCo would be out of money and unable to continue to operate, management met with bankruptcy counsel. WHAT VALUE DOES HOTCO HAVE IN BANKRUPTCY? The picture is not promising for the future. Many dot-coms in similar situations simply shut down. If a bankruptcy is filed, it is a Chapter 7 liquidation done solely to wind up the company’s affairs and allow the board members and officers to move on to greener pastures. However, HotCo, like almost all failed dot-coms, has three potentially very valuable assets: 1) Its net operating losses. 2) Its lease. 3) Its status as a public entity. We’ll review them individually. THE NET OPERATING LOSS IS A VALUABLE ASSET The most valuable assets of many failed dot-coms are their net operating losses (NOL). NOL is simply the amount of accumulated losses reported and reportable to the Internal Revenue Service. Essentially all dot-coms experience large losses in their first year of operations. In the case of most failed dot-coms, they never make a profit. NOL can be used as an offset against taxable income in future years. In HotCo’s case, if all $40 million in capital raised has been spent, HotCo’s total NOL would approximate $40 million. If these losses could be used against profits, a tax savings of approximately $14 million would be realized. The question is: If HotCo is never going to make profits, how can it realize the value of the NOL? If the NOL can effectively be transferred to a new entity that will have taxable profits, the value of the NOL can be realized. NOL can be offset against taxable income for a period of 20 years after the year in which the loss was reportable to the IRS. 26 U.S.C. 172. There are several important tax rules that must be complied with to successfully transfer the NOL to a new entity. The tax laws are contained in Title 26 of the U.S. Code (the Tax Code). Sec. 382 of the Tax Code sets forth rules limiting net operating loss carry-forwards on a change in the ownership of the tax entity. If an ownership change occurs while the company is in bankruptcy, less-stringent carry-forward limitations apply. There are two primary rules for retaining NOL. First, the new company must continue the “business enterprise” of the old company. 26 U.S.C. 382(c)(1). Second, at least 50 percent of the new company must be owned by the former shareholders and creditors of the old company. 26 U.S.C. 382(l)(5). HotCo must find a new investor who can incorporate into its business operations the business enterprise of HotCo. This is not as hard as it may first appear. The statute requires that the new company continue a trade or business that is substantially the same as that conducted by the old company but does not require that the structure of the business that produced the loss be continued. Exel Corp. v. United States, 451 F.2d 80 (8th Cir. 1971). Thus, any company that sells goods through the Internet would be a potential new investor. The limitation on ownership change is trickier but can also be dealt with. To create a new entity, HotCo will need to file a plan of reorganization that calls for a new investor to own a portion (not more than 50 percent) of the reorganized HotCo and for the balance of the shares to be owned by HotCo’s existing creditors and shareholders. Thus, a new investor cannot acquire more than 50 percent of a new entity through a bankruptcy plan of reorganization. However, if the new investor is identified before HotCo files for bankruptcy, the new investor can become a secured creditor of HotCo before the bankruptcy filing. Then, through a plan of reorganization, the new investor can acquire a controlling interest in the reorganized debtor (that is, the new company) through conversion of the new investor’s secured claim against HotCo into shares of the reorganized debtor. Sec. 382 would require that the debt converted to equity arise in the ordinary course of the business of HotCo. 26 U.S.C. 382(l)(5)(E)(ii). Thus, it may be safer to arrange for a new investor to achieve a majority interest in the new company by a combination of conversion of pre-bankruptcy debt and new money; the investor can acquire a full 50 percent of the new entity in exchange for new money without running afoul of section 382. All is not lost even if HotCo cannot find a new investor until after it files for bankruptcy protection. The new investor could acquire a noncontrolling interest in the new company in exchange for new money, and the new company could concurrently become a member of a limited liability company whose managing member is the new investor. The best way to structure a specific transaction is going to be different every time. The cost of retaining counsel to protect the NOL, however, is very likely to be a fraction of the value obtainable by saving it. THE BUSINESS’S LEASE AS A POTENTIALLY VALUABLE ASSET Almost every commercial lease negotiated today contains provisions either prohibiting the tenant from assigning the lease or conditioning the lessor’s consent to any assignment on the assignee’s agreement to pay to lessor the then market rent for the space. These provisions are enforceable in almost every state. However, such anti-alienation provisions are unenforceable under bankruptcy law. 11 U.S.C. 365(f). Thus, if the market rent today is higher than the rent set forth in HotCo’s lease, HotCo could assign its rights under the lease for value. It just so happens that rents today for commercial space in San Francisco, as compared to the rents negotiated in the fall of 1998, are at least 30 percent higher. The amount of money a third party may be willing to pay for HotCo’s lease rights could be very substantial. If any officer or shareholder of HotCo provided a guaranty to the lessor, be careful. Although HotCo can assign its lease rights while in bankruptcy, such assignment may create a liability under the guaranty. The lessor can argue that the guarantor must honor the lease even though HotCo can avoid the anti-alienation terms of the lease. That is, the lessor can sue a guarantor for the difference between the market rate for the space at the time HotCo assigned its lease rights and the rent set forth in the lease agreement. There is no established case law addressing this issue, and there are good arguments as to why the guarantor should not be liable to the lessor in such a situation. If guarantors are involved, however, the bankrupt company should get counsel experienced in this area of law before proceeding. THE VALUE OF GOING PUBLIC CAN BE SUBSTANTIAL The value of becoming publicly owned is substantial. Being public means that the owners can more easily sell their shares. That substantially increases the value of having an interest in the company. For example, 1 percent interest in a privately held company is rarely valuable. It yields no control over the company; such an owner could not force the company to pay dividends or otherwise affect how the company does business. The fact that shares in privately held companies cannot be traded on an exchange such as Nasdaq or the New York Stock Exchange means that it will be difficult to find a buyer. However, an interest in a publicly owned company whose stock trades on a recognized exchange can be sold in minutes. Most companies go through a lengthy, costly administrative process to become public companies. However, a privately owned company can become publicly owned simply by merging with a publicly owned company. If a public company is failing and is about to, or has, shut down its business, a private company can acquire that public company for less than it would cost in fees and costs associated with getting approval and completing an initial public offering. Thus, any privately owned business may be willing to pay substantial value simply for the value of HotCo’s status as a public company. The benefit in a bankruptcy proceeding to realize such value is that HotCo can issue shares without complying with federal, state and local laws requiring registration of a sale of securities. 11 U.S.C. 1145(a)(1). There are potential difficulties, however. For example, section 1141(d)(3) denies a debtor a discharge of its debts if it fails to engage in business after plan confirmation. Absent the discharge of all liabilities of HotCo, no party is going to be interested in acquiring it. This problem can be dealt with by ensuring that the acquiring company engages in at least one line of business similar to HotCo’s. Further, section 1145 of the Bankruptcy Code eliminates the exemption for complying with registration laws if the shares are not given principally in exchange for an interest or claim against the debtor. 11 U.S.C. 1145(a)(1)(B). This hurdle can be overcome by making the acquirer a creditor of HotCo before the shares are issued. As with the NOL, you need counsel to help you realize the value of the value of this asset. CONCLUSION When all seems lost, do not forget that lost money can be a valuable asset. Dot-com failures are losing billions of dollars. These equity losses become NOL. Retaining NOL can be complex, but the value of tax losses can be enormous. The sooner this value is identified, the more likely that a transaction can be structured allowing a business to realize that value. The value of a lease can also be tricky to realize. But in many major metropolitan areas, leases entered into a few years ago can be worth substantial sums. Finally, the value of having “gone public” should not be wasted. The three assets identified here are the principal, but not the only, assets of a failed company. Be sure to analyze closely all possible sources of revenue before closing the books on the company. Craig M.. Rankin is a partner at the Los Angeles-based bankruptcy boutique Levene, Neale, Bender, Rankin & Brill, and a former clerk for a U.S. bankruptcy judge. He can be reached at [email protected]

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