4 Critical Mistakes That Lead Businesses to Bankruptcy

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One by one they staggered in: Sports Authority, City Sports and Vestis Retail Group — owner of Sport Chalet, Eastern Mountain Sports and Bob’s Stores. Filing their petitions for bankruptcy protection at an unprecedented rate, a host of sporting goods firms caved to a list of foreseen and unforeseen circumstances in the past year.

And they weren’t alone.

The road to Chapter 11 is indeed paved with good intentions. Aeropostale, Pacific Sunwear of California Inc., American Apparel and Quiksilver were also among the footwear and apparel players to add their names to the bankruptcy court docket in late 2015 and early 2016.

According to experts, a confluence of factors conspired over the past few months to create a bankruptcy-laden retail landscape.

“We’re in a difficult consumer environment — there’s just way too much retail in the U.S. right now,” explained Brien Rowe, managing director of investment banking at financial services firm D.A. Davidson. “Teens and millennials are driving a massive migration to online and are also less brand-focused and logo-concerned [than previous generations]. It’s not about behemoth brands anymore. And [consumers] are spending less.”

Nevertheless, experts contend that survival remains a viable option for many companies if they are proactive and avoid common pitfalls.

“[Retailers] must maintain a strong balance sheet and tight inventory control — that’s No. 1,” said Jeff Van Sinderen, senior analyst with B. Riley & Co. LLC. “Debt and lease obligations must be managed carefully so that inevitable downturns can be weathered.”

FN breaks down four prevailing missteps that lead businesses to financial collapse.

Failure to Adapt

While e-commerce has created an exciting new outlet for brands and retailers to promote and sell their wares, difficulties with adaptation have hurt businesses that lack the infrastructure and expertise to manage change in the digital and mobile age.

“The growth of the internet as an avenue of commerce is crushing the small retailer who cannot afford a website,” explained Matt Powell, a sports industry analyst with The NPD Group. “Last year, one in four pairs of shoes sold in the U.S. were sold on the web, and I expect that ratio to increase over time, which will further marginalize the retailer without a web presence.”

Consumer shifts away from the purchasing of “things” and toward experiential spending has only added fuel to the fire. According to Rowe, many behind-the-times retailers have invested heavily in brick-and-mortar footprint at the expense of product assortment and in-store experience.

“Debt is consuming a lot of the cash flow, and some companies are unable to refresh their stores or have interesting merchandise and it becomes a spiral,” Rowe explained. “Sports Authority, EMS and Sport Chalet are great examples of chains having too much retail and not spending enough on making the experience interesting for the customers. They were carrying much of the same goods, and it was not a compelling experience to walk into a Sport Chalet or Sports Authority.”

Sports Authority Sports Authority Rex Shutterstock.

Overexpansion & High Real Estate Costs

There is a good reason why store closures are often the first line of defense in a retail bankruptcy and restructuring plan. Excessive brick-and-mortar expansion is the destroyer of profit margins across every industry, and retail analysts say U.S. retail is at the peak of overexpansion.

“After the Great Recession, the predominant theme became the over-stored domestic landscape — there was simply far too much brick-and-mortar store expansion in the 1990s and 2000s,” Van Sinderen said. “More recently, that has snowballed into severe pressure from e-commerce giants such as Amazon and the general shift toward the consumer making fewer trips to brick-and-mortar.”

Meanwhile, hefty rents — a key issue in the Sports Authority and Pacific Sunwear cases — have also taken a toll, along with other supply-chain and consumer-related challenges that accompany a growing store count. (PacSun emerged from bankruptcy this month after reducing its debt, closing some stores and negotiating lower rent.)

Jay Indyke, partner and chair of the corporate restructuring and bankruptcy group at law firm Cooley LLP, has represented the creditors committees in several high-profile bankruptcy cases including Pacific Sunwear, Vestis and City Sports. Indyke said he’s seen several cases where expansion to new geographic regions, for example, was the undoing of a retail firm.

“City Sports, for one, expanded into the suburbs, and those stores didn’t do well,” he said. “If they had kept [their stores] in the city, arguably, they could have stayed in business. But they expanded into places where they didn’t have the cachet, and it didn’t work out for them.”

Even after filing bankruptcy, some firms that attempt to restructure can fail if they don’t get rid of enough stores, Indyke added.

“[When restructuring], you need to have a viable business plan, and you need to show that you’ve pared down enough and that you have an operating structure that’s going to enable you to keep going so you can get the financing you need to survive,” he said.

Sport Chalet executives store opening Sport Chalet executives at the ribbon cutting ceremony on July 12, 2013, for a new store in downtown Los Angeles. FN Archives.

Outdated & Overused Business Concepts

Many brands and retailers end up on the bankruptcy court docket because they haven’t kept up with the times.

“A number of businesses file for [Chapter 11] because their concept is no longer valid or the consumer’s taste has changed and management hasn’t had the foresight to adapt to those changes,” explained Brad Sandler, whose firm, Pachulski Stang Ziehl & Jones LLP, represents the creditors’ committees in the Sports Authority and Aeropostale bankruptcy cases. (The firm also represents American Apparel and Quiksilver in their bankruptcy cases.)

On the other hand, when a particular product style or business concept has a lot of momentum, new players are drawn to the space, which can lead to an overabundance of similar businesses and product stories.

“Oversaturation has been an issue, and at times there needs to be a shaking out,” Indyke said. “There is a lot of competition in the sporting goods space, and in the case of Sports Authority, they couldn’t keep up.”

Van Sinderen and Rowe shared Indyke’s sentiments regarding competition and the increasingly ubiquitous nature of sporting goods space.

“There were just too many boxes and similar concepts in the sporting good space, and something had to give,” Van Sinderen said. “The strongest players have survived and are now vacuuming up market share, which is creating a healthier environment for that niche.”

City Sports City Sports FN Archives.

Faulty Mergers & Ownership Challenges

The past year and a half has brought a strong wave of mergers-and-acquisitions activity to the footwear and apparel space — and with good reason. Diversification, international growth, increased expertise and eliminating competition are just a few of the potential benefits of consolidation.

However, the dramatic changes that accompany M&A can become a sizable — and even insurmountable — obstacle for companies regardless of what side of the buying and selling they sit on.

“Who owns a business plays a big role,” Indyke explained. “Is it owned by a family that has a long-term, vested interest and wants to keep the business going? Or is the company owned by a private equity firm, which owns a portfolio [of businesses] and has a timeline for what they want to do with each asset?”

In the cases of Sports Authority and Sport Chalet, The NPD Group’s Powell said that new ownership played a pivotal role in each firm’s downfall. (In 2006, private equity firm Leonard Green & Partners acquired Sports Authority, and Vestis Retail Group acquired Sport Chalet in 2014.)

“The biggest issues for Sports Authority and Sport Chalet was the debt that was imposed on the companies after the purchase by private equity [owners],” Powell said.

Other M&A related pitfalls include investing a substantial amount of capital into a purchase that doesn’t pay off and abrupt changes in management that disturb and stifle company operations.