Liquidity Shocks, Security Design and Organizational Change

This paper studies how a firm can optimally resolve financial distress ex post. We model a firm hit by a liquidity shock and requiring an additional liquidity injection to continue its operations. We find that, in the case of a small shock, the firm should withstand the shock through debt renegotiation. In the case of a medium shock, the firm should withstand the shock through mergers and acquisitions. In this case, financial restructuring must be simultaneously designed to preserve the incentives of the manager and induce the investors to provide liquidity. The debt holders must forgo part of their original holdings and share with the liquidity providers through a combination of debt and equity. The manager must hold equity or options. In the case of a large shock, the firm should be liquidated. This paper provides the first study on how a firm simultaneously seeks an acquisition and restructures its financial claims to resolve financial distress, and also adds to the literature by showing that the optimal resolution policies depend on the level of adverse shocks. JEL Codes: G34, D86.