Chapter 7: Bankruptcy liquidation | Stocks and bonds | Finance & Capital Markets | Khan Academy

In the last set of videos, we've
hopefully familiarized ourselves with the different
ways that a company can raise capital. It can do it through
debt or equity. And we learned that debt
securities are often called bonds. And equity securities you're
probably familiar with. Those are stocks. And then I left you with
a cliffhanger. Let draw it so I don't
get ahead of myself. So these are the assets of a
company and it was able to generate these assets. So there's a couple of ways
you can generate assets. You can get investors through
equity, and we've done several videos on that.

You start with the angel
investors, or maybe your rich uncle, and then eventually get
venture capitalists, and you do an initial public offering. And then you can do follow-on
offerings. And so on and so forth. Now we see governments will buy
equity in you if you are a bank that's too big to fail. But we'll do a whole
playlist on that. So equity. That's one way that you can
get cash or get capital so that you can buy assets
to run your business. The other way is you can borrow
money from people. So the equity holders
are actually the owners of the company. So you might have been part of
the equity holder, and you have to sell some of the equity,
or sell some shares in your company for someone
else to give money. Then they become kind of
like your partner. And the other way is you
could borrow money. Let me draw that.

That we'll just put generally
as liability. Debt isn't the only kind of
liability, but that's a pretty reasonable simplification
for now. There's other things. In general, liability means you
owe something to somebody in the future. So these are liabilities. And we'll assume right
now that your debt is your main liability. You might have other
liabilities. You might have some type of
legal liability, where someone is suing you or you had sprayed
asbestos on a bunch of playgrounds, thinking that it
was actually good for the playground equipment and now
there's all of this liability because, well, you
get the idea. But from now on we'll have the
simplification that debt is your liability. And we said there's different
kinds of debt. If you securitize it,
it's often a bond. Right? That would be a certificate
that's an IOU from a company. It'll pay you coupons or
interest and so forth.

Or you can also just get regular
bank debt, where you owe the bank money. And I left you with a question
the last time around. I said, let's say this company
goes into bankruptcy. And let's say that these assets
aren't worth what we think they are, right? In this world, if we just
have to sell off these assets, fine. The debt guys would
get paid off. And the equity guys would get
left over with whatever else. So let's say if this
was on our books. Whenever you hear things like
book value, and I've done a couple of videos on book value
versus market value, but the book value is essentially
what you have on your accounting books. You say that this is
worth $10 million. Right? Let's say we've bought land
and factories and whatever else worth $10 million. Let's say your debt
is $6 million. Then your equity would
be worth $4 million. And let's say, for whatever
reason, the economy turns south or maybe this was some
type of business that's now not viable.

So it's going to go
into bankruptcy. And I'll get a little bit more
specific on the different types of bankruptcy. But we're assuming
liquidation. Actually I'll just get
specific right now. So when we say bankruptcy,
bankruptcy is a very common word. I think most people have a
general sense what it means. They know it's bad and it means
to some degree that a company can't operate
as it was before. But there's a lot of confusion
over what it means. There's actually two types
of bankruptcy. There's liquidation. And that's essentially saying
that, you know what, this business doesn't
make any sense. It doesn't make sense
to have the employees and run the factories. You're never going to make any
money, so you might as well just sell everything you have.
You liquidate it all.

That's one type. And that falls under the
category of Chapter 7. And we're just talking
about corporate bankruptcy right now. There's also personal
bankruptcy. And maybe we'll do a couple
of videos on that. It might be especially relevant
in this economy. Well, the other type is
reorganization or restructuring. And restructuring says,
you know what? This factory here,
it's actually making something useful. It's actually generating
money. And actually we can get more
value for what we have here if we keep it running. And we will just keep it
running, and we'll restructure the company. And usually that means changing
this side of it. So maybe we'll cancel some
debt and all of that. And I'll show you how that's
done in a reasonably fair way. But just to understand kind of
a simplified scenario, let's take liquidation into

So let's say that this was my
website selling shoes online, and that all of a sudden
people have stopped wearing shoes. It's just gone out of fashion,
so it makes no sense anymore to sell shoes online. So I'm just going to liquidate
my assets, my real estate that I might have, my warehouses,
et cetera, et cetera. My question that I left you with
in the last video was, who gets it? So let's say when we liquidate
it– so we go into bankruptcy and essentially all of the
assets are taken into possession by the bankruptcy
court– they're going to sell these assets. And let's say when they sell
them, they don't get $10 million for these assets. They only get $5 million
for them. Right? I paid for them thinking that
they were useful in some way, but they end up not to
be, so my assets– You know what, I just realized
when I talked earlier about there's two ways to raise
capital, there's a third way to raise capial. Right? You can sell shares. You can issue debt. You can borrow money. Obviously the third way is
actually just make money.

Right? Once you start a company,
hopefully you generate earnings, and that'll also
generate cash or capital that you can reinvest in
the business. And we'll talk about that. But I just wanted to make it
clear that that's obviously the best way to generate capital
for your business is when the business itself
generates capital. So let's say that these assets,
when you actually sell them off, aren't worth
$10 million anymore. Let me make the pointer

They're worth $5 million. So my question in the
last video is, who gets this $5 million? Do you somehow split it evenly
between all of these people? Or does one of them get more
of it, or one of them gets less of it? And I think you'll get a sense
based on where I took the $5 million out of, who
gets the money. It's the debt holders. And the way I drew it right
here, you can kind of view it as you go up in this
direction, you're getting more senior. Or if you're going down
in this way, you're getting more junior.

And seniority, when you talk
about a company's capital structure, is just, you know
what, if there's anything left, who gets their
money first? And even within the
debt, you'll have different layers of debt. There might be different debt
holders who have different levels of seniority. So this one might be called
senior secured debt. Senior means they're high
up on the stack.

They are one of the first people
to get their money. And secured means there's
actually some collateral on the asset side that they get
if the company can't pay. So maybe this is like
a piece of land. Right? So just in kind of our everyday
personal finance world, your mortgage is
actually secured debt. It's secured by the collateral
of your home. If you can't pay the debt,
the bank comes and takes your home. It forecloses on the property. So that's what secured means. It means that there's some
collateral, and in the event of a bankruptcy this guy can
immediately go and get the collateral that his debt
is secured by. So this is considered a very,
very senior form of debt. Senior secured. Then you might have here, you
might have senior unsecured.

And there's a lot of words
around, senior, junior, subordinate, and all of that. But just to get a sense that
there's just a hierarchy here. Some people are the first people
to get the money, and then whatever money is left goes
to this person, then if there's any money left, it goes
to this person, and then if there's anything left
it goes to this person. And once you're in bankruptcy
court it does tend to be a negotiation between the
different, you can almost view it as buckets, of debt. And we'll do a more complicated
example in the future on that. We'll actually delve into the
details of bankruptcy. But this is the general
notion. That the senior guys get made
whole first, then the more junior guys get whatever's left,
and so on and so forth. And if there's no money for the
equity, there's no money for the equity. And that makes sense, right? Because the debt holders, all
they were getting– their upside was just interest,
right? So they also should get limited
downside in the event things should turn bad.

Equity holders, they kind
of took a gamble. If things were great, they would
get all of the upside. And now that things turn
bad, they take a lot of the downside. And they're actually lucky that
they don't owe money. That's actually the– I guess
you could call it– the beauty of a corporate structure, that
you have limited liability. In some times in history, these
people would actually owe the difference. They would actually owe
this extra $1 million. They would all go to debtor's
prison and all that. But we'll talk more about
it in the future. So anyway, just going back on
the different tranches of debt, or buckets of debt. So we could call this
senior unsecured. And that means that they're
still senior. They're still fairly high
up the seniority ladder.

But they're unsecured. There's no particular assets
that they can go run. But as long as there's enough
for them, they'll get it. So let me put some
numbers here. So let's say there was, I don't
know, $1 million of senior secured. Let's say there's $2 million
of senior unsecured. And let's say that this is $2
million of subordinated– subordinated just means they're not senior– unsecured. So in this reality, what would
happen is the bankruptcy court would liquidate all this stuff
and then they'll hand it out in order of seniority. These guys get their
$1 million back. So they're made whole. And they probably charged a
lower interest rate, because they didn't perceive their risk
that high to begin with. These guys, right here, the
senior unsecured, they'll get the next $2 million.

And then there's $1
million left. Right? And that $1 million will go
to the subordinated debt. So they'll get 50% of
their money back. So they took a little bit of a
hit, but that's OK because when things were good, they
probably got higher interest to compensate them
for their risk. Usually as you get more and more
junior and you take on more risk, you get more upside,
or more interest. And in this case the equity
holders get nothing. They get wiped out. So it just goes to 0. So that's the answer
to the question. I said, who gets the money? Well, it's the debt holders
get first dibs. And if there was actually $7
million here instead of $5 million, then you would have
paid the six off completely, and then the equity holders
would've gotten $1 million. And so they would have gotten
something if there was enough money to hand it to them. Anyway, in the next video I'll
cover– this was liquidation, where we just say this
isn't worth running.

Let's just give it all away, or
let's sell it, and give it back to our creditors. In the next video I'll talk
about reorganization, where we say, hey, you know what? This business is a
good business. It just has too many
liabilities. See you in the next video..

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