Your business is in trouble. Your credit rating with your suppliers is slipping, and your cash flow is dwindling. It may be time to start winding down your start up.
Here are a few facts you should know:
- Corporations, limited liability companies, and partnerships are legal entities, separate from their shareholders or partners. The owner of a corporation is a shareholder and the owner of a limited liability company is a member. The entity can file either a Chapter 7 or Chapter 11 bankruptcy in its own right.
- A proprietorship is an extension of the owner; it cannot file bankruptcy alone. If the business finances are out of control, then the proprietor must file bankruptcy since the assets and liabilities of the business are really the proprietor’s assets and liabilities. In this case, the individual may be eligible to file a Chapter 7, Chapter 11, or Chapter 13. The good news is that it is usually less expensive to reorganize both the business and your personal finances in a Chapter 13 than it is to reorganize the business alone in a Chapter 11.
Reorganization or liquidation?
Should the business be reorganized or liquidated? A certified bankruptcy law specialist can help you identify the source of the financial problem your business is experiencing and make recommendations about whether you should reorganize or liquidate.
Reorganization – Chapter 11
- A reorganization cannot create a market, increase gross revenue, or make up for a poor fit between the skills available and the skills required to run your business or a changing market.
- Reorganization could possibly free up cash from servicing the old debt to permit the continuation of current operations. It could also permit rejection of leases or contracts that are no longer advantageous or it could prevent the loss of vital assets or cash to creditor collection activities.
- Reorganization under a Chapter 11 bankruptcy is time consuming and expensive. The owners and managers must comply with the requirements of the bankruptcy system, interface with the counsel, and negotiate with the creditors.
- The trade-off for the protection of the automatic stay requires that the debtor provide full disclosure of the business's financial condition to creditors and the court—both at the beginning of the filing and on a monthly basis thereafter—and operate as a fiduciary for its creditors while the bankruptcy is in process.
- At a time when business owners are already extremely stressed by their company's unstable financial situation, reorganization can be draining, both financially and physically. The management has to find the time to participate in numerous bankruptcy proceedings while fulfilling reporting obligations and simultaneously covering legal expenses.
- If your business requires little capital, has few assets, and is really just an extension of your skills and personality, it may not pay to reorganize. The best-case scenario might be to liquidate the business through bankruptcy and start over in a fresh entity.
Reorganization – Chapter 13
A proprietorship is an extension of the owner; it cannot file bankruptcy alone. If the business finances are out of control, then the proprietor must file bankruptcy since the assets and liabilities of the business are really the proprietor’s assets and liabilities. In this case, the individual may be eligible to file a Chapter 7, Chapter 11, or Chapter 13. The good news is that it is usually less expensive to reorganize both the business and your personal finances in a Chapter 13 than it is to reorganize the business alone in a Chapter 11.
Liquidation – Chapters 11 and 13
Liquidation through Chapter 11 or Chapter 13 might provide time for the sale of the business as an ongoing concern, which in turn, may provide ongoing jobs for the work force under new ownership. It would also allow the assets to be sold at a higher price. The resulting proceeds could then be used to pay
- unpaid salaries or severance pay for employees, and
- outstanding bills.
The bankruptcy could then be converted to a Chapter 7 or even dismissed if bankruptcy protection is no longer needed.
Liquidation - Chapter 7
A Chapter 7 may be the best choice, whether for the individual or a corporation, when
- the business has no future,
- it has no substantial assets or qualities that cannot be reproduced after bankruptcy, or
- the debts are so overwhelming that restructuring them is not feasible.
Individuals can get a discharge of the dischargeable debts and a chance to start over.
Corporations, however, cannot get discharges, so a corporation will not get the fresh start by filing a Chapter 7 that an individual will. Nonetheless, Chapter 7 can provide for an orderly liquidation of the corporation under the direction of the trustee and at no expense to the shareholders. Also, creditors will be paid to the extent of the assets available and in priority of their claim, and former management is assured that the available assets after the expenses or the Chapter 7 are paid will be used to pay taxes for which the individuals may be personally liable. Many assets can be protected by filing a Chapter 7.
There is no clear or universal answer as to whether a failed business should file under Chapter 7, a liquidation process. The decision depends on the value and nature of the assets, the attitudes of the creditors, and the availability of management to oversee the process.
Companies can go out of business without filing bankruptcy. They simply liquidate their assets and cease operations. Creditors still have the right to recover their claims from the assets of the corporation. If there are no assets, the corporation cannot be further harmed by lawsuits that try to collect from the corporation.
The danger to management in this approach is the tendency of some creditors to assume that the business's closure and its failure to pay is due to some wrongful conduct by the officers or owners. As a result, they may sue the officers as well as the corporation to collect the debt. While the claim against the individuals may be invalid, the individual has to appear and defend him or herself in the lawsuit, or a judgment will be entered against him or her.
A major reason to form a business as a limited liability company (LLC) or corporation is to provide limited liability to the members or shareholders. Creditors know this and usually require that members or shareholders sign personal guarantees as a condition of making a loan, providing supplies, materials, or products.
A personal guarantee is an agreement between the shareholder or member and the lender or supplier. The shareholder or member agrees to be personally responsible for the debt if the LLC or Corporation does not pay. In addition to signing personal guarantees to get operating money, many small businesses pay for goods and services with personal credit cards issued to the shareholder or member. When the business falters and is not able to pay the debt, the shareholder or member who owns the credit card or signed the personal guarantee is held liable and is often forced to file for bankruptcy protection.
In summary, closing down a business outside of bankruptcy can be time consuming, may delay the opportunity to get a fresh start, and opens the window for disgruntled creditors to sue.
Bankruptcy, on the other hand, is simple:
- You can engage the services of a certified bankruptcy law specialist who will guide you through the legal bankruptcy maze.
- The bankruptcy trustee becomes responsible for liquidating your assets, returning the equipment, and dealing with your creditors.
- The bankruptcy trustee also has the power to sell leases despite anti-assignment provisions and to avoid levies and writs of attachment, recovering value for creditors that is not possible outside of bankruptcy.
- Creditors are not as likely to name management in collection actions.
- The automatic stay prevents aggressive creditors from diverting cash that could be used to pay taxes, employees, and guaranteed debts or from recovering property needed for an orderly closing of the business .
There are some drawbacks:
- The sale of the assets may not bring top dollar.
- Insiders may be prohibited from buying technology, intellectual property, or projects in development.
- Trustee's fees and expenses are paid off the top.
- The bankruptcy process can be slow.
- Claims are paid according to priorities in the Bankruptcy Code.
The better choice is not always obvious. Consult with a certified bankruptcy law specialist to determine the best course of action to take.