Small businesses fail for many reasons, including some that are beyond your control. It’s the reality of entrepreneurship—not every new business will succeed. Even long-standing companies hit hard times.
Businesses experiencing tough financial situations might consider declaring bankruptcy. While there are cases where business bankruptcy is the right move, it’s not always a good call. If you decide to file for bankruptcy, and your business is a candidate for bankruptcy, you need to know your options.
What is business bankruptcy?
Much like personal bankruptcy, business bankruptcy is a financial process that comes in various forms, each with different consequences and forms of resolution. Federal courts manage business bankruptcy with this business’s sole proprietors or owners. Business bankruptcy does not absolve the filers of all financial obligations.
When is bankruptcy the right move?
Bankruptcy is an option when a debt-laden business is failing, but it’s not always the right option. Even when it is the best choice, there are multiple types of bankruptcy filings, each with advantages and disadvantages. So we asked attorney Michael J. Duffy, who specializes in bankruptcy and business law, to help sort through the do’s and don’ts of filing for bankruptcy. Duffy says small business owners should only consider bankruptcy if their personal assets are at risk.
“If only a limited-liability business entity is suffering financial trouble, the best thing to do is just close the doors and walk away,” he says. “There’s no need to go through any bankruptcy process if the only recourse is against the business.”
As a result, Duffy typically recommends that new business owners organize their enterprise. Becoming a corporation, LLC, or other limited-liability entity can help protect their personal assets from business creditors.
Businesses that operate as sole proprietorships or partnerships expose their personal assets to greater risks. But even when you’ve set up a limited-liability structure for your company, your personal assets may still be in jeopardy. It all depends on how you run your business, Duffy says.
Your assets are at risk if you haven’t separated your personal and business finances. When that happens, “the court will find that there was no separate business entity, disregard it, and put the owner’s personal assets at risk,” Duffy explains.
New limited-liability entities may also be at risk. Usually, banks and other creditors aren’t eager to extend financing to new limited-liability entities. They won’t have sufficient means for recovering money if the business fails. As a result, significant amounts of credit—startup capital, commercial leases, lines of credit, and so on—often require a “personal guarantee.” The business owner must put their personal assets at stake to get approved for financing.
“[The business owner’s] assets are then just as vulnerable as if there was no corporate entity,” Duffy says. “In many cases, the financing is also secured by personal collateral, such as a home.”
This type of collateral can put more than your business at risk. It’s bad enough to lose your business. Avoid getting into a situation where your home and personal assets are also in jeopardy.
Types of bankruptcy
When personal assets, such as a home, are at stake, bankruptcy may be the best way to protect them from creditors. Choosing which type of bankruptcy to file for can be complicated. The decision hinges on state laws and a host of other variables, Duffy says. Understanding the basics can help reduce some of the fears and misconceptions that surround the process.
“You’ve probably heard of Chapter 11 bankruptcy, but that’s generally only useful for larger-scale operations, particularly publicly traded companies,” Duffy says.
That’s because it’s time-consuming and costly for all involved.
“In most cases, if a business is failing, creditors want to cut their losses and liquidate. They’re not interested in going through a complicated and expensive process of reorganizing the company,” he says.
Duffy notes that Chapter 11 may provide the best outcome for business owners who have a high personal net worth and regular income. For small business owners, the better options may be Chapter 7 or Chapter 13 bankruptcy, he says. In the simplest terms, Chapter 7 bankruptcy is a liquidation that marks the end of the business. Chapter 13 is a repayment plan that could enable the business to stay afloat and succeed in the future. Think of Chapter 7 as a stopping point. And Chapter 13 is the chance for a fresh start.
The debtor’s income, assets, amounts owed, and financial goals are key for choosing Chapter 7 or Chapter 13. Though, the court may choose for you. Low or nonexistent income and asset value, combined with a large amount of debt, make Chapter 7 more likely. A higher income and asset value, combined with lower debt, make Chapter 13 the probable path.
4 ways to avoid filing for business bankruptcy
To avoid bankruptcy scenarios altogether, Duffy says, avoid using your personal assets to start or operate your business. And if your business hits bumps in the road, consider cutting back rather than doubling down. Meanwhile, a business plan can help you make informed decisions, avoid future pitfalls, and guide you when you’re unsure of what to do next. But if Duffy has you thinking bankruptcy is the best route for your business, consider some additional routes before making the big decision.
1. Examine your current debts
First, review the current amount you owe creditors. Then look at your current financials to see if you can afford to make payments on loans with the most aggressive interest rates. Making small payments can be a sign of good faith with the creditors and reduce your debt.
Not every creditor will drop your interest rates or lower the amount you owe. But some may take your payment as a sign that you’re attempting to turn things around. They may lower your interest or total debt, providing a little debt relief.
2. Contact vendors and property managers
You likely have vendors and landlords who play a vital role in your business. Both of these parties gain nothing if you declare bankruptcy. In some cases, helping you through your difficult financial situation may be in their best interest.
Reach out to your vendors and see if you can negotiate a lower rate for supplies or services. If nothing else, see if they can reduce the size of your orders to accommodate your situation. Then call your landlords and do the same. See if they can lower your rent at all or offer assistance in any form. You only stand to lose the time it takes to talk to them.
3. Sell what you don’t need
Your business likely has some items sitting around that you aren’t using or that you could substitute. Take stock of your business’s supplies, including appliances and services, and determine if you can cut any of them.
It’s also easy to let monthly service costs pile up. Look over the services your company uses to see if you can reduce operating costs. For example, if you have a business phone plan and aren’t using anywhere near the data limit, reduce it.
4. Tap into your network
Friends, family, and professional contacts are all a part of your network for a reason: They like you. Don’t hesitate to reach out to those you trust when you’re going through a difficult time. Even if your network can’t offer financial help, they may help you think of new ways to improve your business or save money and avoid bankruptcy.
Business bankruptcy is for emergencies only
Bankruptcy is a big deal, so you should treat it as such. Take careful stock of your financial situation and consider all your options—not just bankruptcy. And speak with a financial adviser before making your decision.
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