Small businesses fail for many reasons, including some that are beyond the owner’s immediate control. It’s a reality of entrepreneurship — not every new business will succeed, and, sometimes, even long-standing companies hit hard times.
One common thought among businesses experiencing tough financial times is declaring bankruptcy. While there are cases where business bankruptcy can be the right move, not all businesses should go this route. Furthermore, there are numerous types of bankruptcy. So, even if your business is a potential candidate for bankruptcy, you need to know your bankruptcy options first.
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. Business bankruptcy is handled by federal courts and involves the sole proprietor in the event of a sole proprietorship, or in the event of a corporation, all of those involved in ownership of the company.
One common misconception about bankruptcy, both for personal and business use, is that it absolves the person of all financial obligations. This isn’t the case as bankruptcy often involves the dissolution of the company, selling of assets or hefty fines.
When is bankruptcy the right move?
Bankruptcy is an option when a debt-laden business is failing, but it’s not always the right one. Even when it is the best choice, there are multiple types of bankruptcy filings, each with their own advantages and disadvantages.
We asked attorney Michael J. Duffy, who specializes in bankruptcy and business law, to help sort through the dos and don’ts of filing for bankruptcy. To determine if it’s worth speaking with a bankruptcy lawyer and taking the measure further, consider the following points.
Risk to your assets
Duffy says small-business owners should only consider bankruptcy if their personal assets are at risk. “If only a limited-liability business entity were 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 as a corporation, LLC or other limited-liability entity to 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, depending on how you run your business, Duffy says.
One common reason for this risk is that you haven’t properly separated your personal and business finances. When that happens, Duffy explains, “The court will find that there was no separate business entity, disregard it and ‘pierce the corporate veil,’ putting the owner’s personal assets at risk.”
Another common reason is that banks and other creditors usually aren’t eager to extend financing to new limited-liability entities. That’s because the creditor won’t have sufficient means for recovering its 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,” meaning the owner must put his or her 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 puts your business and home at risk. It’s bad enough to lose your business, so 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 in a business failure, bankruptcy may be the best way to protect them from creditors. According to Duffy, choosing which type of bankruptcy to file for can be complicated because it hinges upon state laws and a host of other variables. Understanding the basics can help reduce some of the fears and misconceptions that surround the process.
First, let’s dispel a myth: If you’re considering a bankruptcy filing, it’s unlikely to be the type most people think of first.
“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, such as banks, want to cut their losses and liquidate. They’re not interested in going through a complicated and expensive process of reorganizing the company.” Duffy notes one exception: Chapter 11 may provide the best outcome for business owners who have a high personal net worth and regular income.
The far more likely choice for a small business will be either Chapter 7 or Chapter 13 bankruptcy, he says. In the simplest terms, Chapter 7 bankruptcy is a liquidation that effectively marks the end of the business. Chapter 13, on the other hand, 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 as the chance for a fresh start.
The debtor’s income, assets, amount owed, and financial goals are key criteria in choosing between Chapter 7 and Chapter 13. The court may make the choice for you. Low (or nonexistent) income and asset value combined with a large amount of debt make Chapter 7 more likely, while higher income and asset value combined with lower debt make Chapter 13 the probable path.
Duffy’s tips for avoiding financial trouble
Duffy also has some advice for avoiding bankruptcy scenarios in the first place. Whenever possible, avoid using your personal assets to start or operate your business. If your business does hit bumps in the road, consider cutting back rather than “doubling down.”
“It’s better to retreat and regroup than go big and be wiped out,” he says.
Last, but definitely not least, write a business plan, Duffy urges. “So often the losses that lead to bad financing decisions can be easily avoided if there is a proper business plan that is followed.”
A business plan can help you make informed decisions, avoid future pitfalls and have a guide for the future when you’re unsure as to what you should do next. If you don’t already have one, write a business plan yourself or contact a professional planner.
Things to consider before bankruptcy
If Duffy’s advice has you thinking bankruptcy could be the best route for your business, put that thought on ice for a moment. There are some additional routes to consider before making the big decision to declare bankruptcy.
1. Examine your current debt
First things first, take a look at the current amount you owe creditors. Then, look at your current financials and see if you can afford to pay even a little of the loans with the most aggressive interest rates. This can be a sign of good faith with the creditors and help you with the second part of this step: contacting them about lowering your interest or even reducing your debt.
While not every creditor will simply drop your interest rates or lower the amount you owe, some will take your payment as a sign that you’re attempting to turn things around and lower your interest or total debt, providing at least a little debt relief. This approach is similar to the one taken by most debt relief agencies but with the added benefit that it won’t cost you anything but time.
2. Contact vendors and property management
You likely have numerous vendors that play a vital role in your business, as well as someone you owe rent to each month. Both of these parties gain nothing if you declare bankruptcy, so helping you through your difficult financial situation is in their best interest in most cases.
Reach out to your vendors and see if you can negotiate a lower rate for your supplies or their services. If nothing else, see if they can reduce the size of your orders to better accommodate your situation.
Next, call your landlord 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, so don’t hesitate to make this effort.
3. Sell what you don’t need
Your office or business likely has some items sitting around that aren’t being used or can be substituted. Take stock of your business’s supplies, including things like appliances and services being used, and determine if any of them can be cut. For example, if you’re rarely faxing things, you can probably sell that fax machine.
It’s also easy to let monthly service costs pile up. Look over the services your company uses and see if you can reduce any 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 can likely help you think of new ways to improve your business, or at least save money and avoid bankruptcy.
It’s also possible people in your professional network have some freelance work you can tackle on the side. A little bit of money can go a long way when you’re in the midst of a financial hardship.
Business bankruptcy: For emergencies only
Bankruptcy is a big deal and should be treated as such. Just like a flare gun stowed away on a life raft, treat it like you only get one shot. Take careful stock of your financial situation, consider all your options — not just bankruptcy — and speak with a financial adviser before doing anything drastic.
Your business is the product of your dreams and hard work. Remember that during this difficult time, and don’t hesitate to reach out to your friends and family. We’re all cheering for you!