More Lone Star beer was sold at the Armadillo than anywhere else save the Astrodome, and the ecology-minded Wilson was responsible for bringing back the recyclable longneck (although long-necks were never served in the Armadillo, since they made handy weapons). But the same attitudes that lent so much charm to the place created many of the problems that continually plagued it. Genuine rednecks and hippies didn't always get along. The Armadillo quit serving Lone Star in 1974 in protest of the brewery's sponsorship of armadillo races, which the staff contended was cruel treatment of the animals. Scuffles in the hall cropped up sporadically, coming to a violent head in 1975 when staff artist Ken Featherston was killed by a pistol-wielding patron who had mistaken him for a bouncer.

Though the folks at the Armadillo brought a wider audience to Willie Nelson, they finally got fed up with some of the members of Nelson's coterie, who carried their outlaw image to the extreme. An irrevocable split between the two factions occurred in 1972, after the Armadillo helped to promote the pivotal Dripping Springs concert. Worst of all, the loose, communal method of operating the place was ineffective. In November 1976 Wilson stepped down, and three months later the Armadillo filed for bankruptcy. It probably would have folded then if not for the efforts of a lanky, Lincolnesque musician named Hank Alrich. He recapitalized the company, pared down the staff, and continued to operate on a shoestring. The image of the Armadillo as the cradle of country rock and Texas hip lost some of its luster, but Alrich made the facility work by booking more frugally and by confining musical risks to aesthetically satisfying acts like jazz artists Anthony Braxton and Sam Rivers. Alrich also managed to revive the Armadillo record label, releasing products by the Bugs Henderson Group and the Cobras and keeping the small in-house studio busy. The Armadillo was almost in the black.