When you’re starting a small business, the possibility of filing for bankruptcy is probably the farthest thing from your mind. While bankruptcy is certainly not the most fun topic (and is hopefully a reality you’ll never have to face in the course of running your business), it’s still important to know the basics about it. That way, should things ever head in that direction, you’ll be well-informed and able to make the best choice for your business.
What is Bankruptcy and What Leads to It?
Bankruptcy is a possible legal consequence of a person or a company becoming insolvent, (i.e., no longer being able to pay off their debts to their creditors). A company can run into insolvency when there is a decrease in cash flow, an unexpected hike in expenses, or simply from poor cash management.
A bankruptcy filing is usually initiated by the debtor, and is imposed by court order. As the debtor, your company’s assets and liabilities are assessed. Those assets can then be liquidated to pay off the outstanding debts owed to your creditors. Certain creditors may have preference over your company’s assets, meaning they would need to be paid off first. Once you’ve made it through the bankruptcy proceedings (a process that will be guided by your trustee in bankruptcy, a representative who takes care of the administration of the bankruptcy and the distribution of assets), you will be relieved of your debt obligations.
Types of Bankruptcy
Depending on the way your business is structured and where you’re located, there are different ways you can file for bankruptcy. For instance, if you’re operating in Canada as a sole proprietorship or partnership, then you would have to file for bankruptcy as an individual, not as a business. This would mean that filing for bankruptcy would likely have heavy toll on you and your business partner personally.
In the US, the main types of bankruptcy are Chapter 7, Chapter 11 and Chapter 13. In broad terms, Chapter 7 is used for liquidation; Chapter 11 is used for reorganization; and Chapter 13 is used for adjusting debts owed by individuals with regular, reliable income. Chapter 7 is the most straightforward: assess, liquidate, and pay. Note though, that if you file for Chapter 7, you cannot do so again for seven years. (Translation: don't think of Chapter 7 as a free out.) Chapter 11 and Chapter 13 are actually somewhat similar in that their main objective is to establish a repayment plan that is developed after assessment usually by a trustee.
Alternatives to Bankruptcy
Making it through bankruptcy can give an individual or company a chance to get a fresh start—a clean financial slate, if you will. However, filing for bankruptcy is a very serious decision, both at a business and personal level, and is not to be taken lightly. Especially as a small business owner, there are high costs and consequences that need to be considered.
Before starting bankruptcy proceedings, explore the possibility of making alternative payment arrangements with your creditors. This more informal arrangement could allow you to avoid the cost and hassle associated with the legal proceedings involved in bankruptcy.
And remember: a bankruptcy will stay on your credit report for a number of years (the exact number depends on where you/your business is located and whether it’s your first bankruptcy). This can look bad in the eyes of potential lenders and creditors in the future.
As with all major financial decisions, a lawyer or financial advisor (not a blog post) should be your primary point of consult. Said differently, the content in this post is not financial or legal advice.
For some helpful hints about managing your company’s debts to avoid facing the possibility of bankruptcy in the first place, take a look at our post on understanding good debt versus bad debt!