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At $6 billion, is the Avaya debt too much to overcome?

As the UC vendor files for bankruptcy protection, it assures customers that products and services will continue. But, as the Avaya debt story unfolds, what's after Chapter 11?

After Avaya Inc. filed for Chapter 11 bankruptcy protection last week, reactions ranged from worry to relief. Avaya filed voluntarily with the stated objective to improve its structure.

The filing affects Avaya and most U.S. subsidiaries. Most foreign affiliates are not included. Avaya is actually about 158 separate entities that employ about 9,700 people worldwide. The entities that filed for Chapter 11 represent about 3,800 employees.

In 2007, the independent, hardware-focused company was debt-free and had nearly $1 billion in the bank. Its future looked bright and attracted many courters.

But the Avaya debt also started in 2007, when the company was taken private by TPG and Silver Lake. It was the height of the economic boom fueled by fraud in housing, and the deal was structured as a leveraged buyout.

The tide turned soon after, beginning with the crash in 2008, which took out near-term sales. Avaya's private-company status likely helped it weather the storm. Longtime competitor Nortel didn't fare so well. The Avaya debt mounted when the company bought Nortel's enterprise assets during its bankruptcy proceedings. Today, the Avaya debt totals about $6 billion.

Telecom shifts from hardware to software

The bigger problem was the industry went through some profound changes with new technologies, buying and delivery methods, and competitors. Most significantly, telecom, like so many other industries, moved away from hardware.

Today's systems are software-based and designed for third-party servers. And apps are replacing telephones.

Customers don't even pay the lower purchase price; instead, they are gravitating toward a monthly rental model. The vendors are seeing their reduced revenue arrive over the life of the system, rather than with the initial implementation.

Avaya dug itself into a hardware-sized hole in a software- and services-based industry.

Avaya leadership reassures customers

In a video to customers, Avaya CEO Kevin Kennedy spun the filing as "a positive step forward." He said Avaya will "emerge from this process stronger than ever." He said Chapter 11 will enable Avaya to restructure its balance sheet with less debt.

He assured customers there will be no disruptions during this process; specifically, nothing is being discontinued, offices will remain open and contracted services will be delivered.

As a rule, healthy companies don't file bankruptcy. So, what's going on?

Key to Kennedy's confidence is the belief that Avaya is structurally a healthy company. He pointed to several indicators, including a strong migration from hardware to software services, ongoing improvements in operating profitability and impressive gross margin. He even listed several well-known brands that survived Chapter 11, such as General Motors.

To be fair, many Chevy and Buick owners missed the Chapter 11 ordeal that GM completed. But customers of the now-defunct GM brands of Pontiac, Hummer, Saab and Saturn likely noticed the restructuring.

As a rule, healthy companies don't file bankruptcy. So, what's going on?

Debt restructuring can be tricky business

Kennedy's figures ignore the Avaya debt. Most companies would have impressive numbers if they could ignore debt. And, at $6 billion, it's a lot to ignore. Last year, Avaya reported total revenue of $3.7 billion and a net loss of $750 million.

The $6 billion question is how to make the debt go away.

The $6 billion question is how to make the debt go away. Avaya has been exploring options, including the sale of entire divisions and its intellectual properties. Evidently, none of those solutions were acceptable to Avaya, potential acquirers or the various stakeholders. Such an agreement would require voluntary acceptance across the board.

For example, Kennedy mentioned debt-to-equity swaps as a potential solution. This would convert Avaya's IOUs into Avaya stock certificates. The tricky part is agreeing on the exchange rate -- not once, but multiple times, as the debt falls into different classes, rates and interest rates. As Kennedy said, the devil is in the details.

Under Chapter 11, such negotiations are determined by a court -- eliminating the voluntary acceptance part. But, it's also a doubled-edged sword. Normally, corporate executives are first obligated to company shareholders. In Chapter 11, the court prioritizes the lienholders.

Avaya may already have a plan that it just needs the court to impose, but there's no guarantee the court will do so. The court may come up with other ideas.

Financial burdens thwart innovation

The Avaya debt could be restructured in more sustainable ways, and the vendor could come out of this intact.

The other extreme outcome is pieces get sold off to the highest bidders. The logical chunks are its intellectual property stash of some 5,400 patents and its three business units: contact center, unified communications and networking. When it comes to selling off divisions, there is a gray area between Chapters 11 (reorganization) and 7 (liquidation).

Avaya's core portfolios are in decent shape. But its financial burdens have likely prevented it from developing its own cloud service and limited its sales and marketing efforts.

Avaya entered these proceedings reasonably prepared. It has filed a number of motions to direct the court, and it obtained a debtor-in-possession loan with Citibank for $725 million to provide a cushion during the changes.

Next Steps

Take a look at Avaya's cloud-based UC products.

Avaya's UC platform boasts a bevy of features.

Avaya's contact-center platform considered a strong asset.

Dig Deeper on Unified Communications Architecture and Service Models