How Small Businesses Can Survive Bankruptcy
By Seattle Business Magazine August 21, 2008
Today, even traditionally strong businesses are having trouble staying afloat amid crashing waves of rising energy costs, cooling real-estate markets, recurring bad weather and the ever-growing financial market crisis. Banks and creditors are becoming more conservative, making it harder to borrow money and wait out the storm.
Despite the troubled economy, the number of business bankruptcy filings in Washington dipped to 477 in 2007, compared to an average of 629 the previous six years, according to the American Bankruptcy Institute (see chart below). Lawyers in Seattle and Bellevue attribute the dip to recent changes in federal regulations that make bankruptcies more expensive and cumbersome. More businesses are closing or renegotiating their debts outside of court. But if the bad times persist, more businesses will be forced into court.
William Bradford, professor of finance and business economics at the University of Washington and a member of several local bank boards, sees worrisome signs. Citing a statewide survey, Bradford says that about 30 percent of minority small-business owners and 40 percent of white small-business owners say their markets have been deterioratinga noticeable uptick since January. The survey indicates the uncertain economic environment will continue for as much as a year, maybe longer, Bradford says.
We are not at the bottom, he adds.
These may seem like chilling statistics, but with the right amount of planning, bankruptcy does not have to be the end of the line for a struggling entrepreneur. Bradford says every owner should think about bankruptcy as soon as possiblenot as a goal, but as something to plan for.
You … can and should believe the business will be profitable, but you should be aware and protect yourself if the business is not profitable and fails, he advises.
The good news: With a competent team, a responsive strategy and vigilance over records and discipline, a business can prevent a train wreck.
The basics
Bankruptcy occurs when you can no longer pay your debts or dont have enough assets to cover your liabilities. It often happens to small businesses because cash flow, market demand and access to credit can change rapidly. Lawsuits, natural disasters, ballooning costs or other misfortunes can sink a business despite an owners best intentions.
When someone chooses to file for bankruptcy, usually theres a problem that cant be fixed outside of bankruptcy court. For all its implications, bankruptcy court is an organized, public process, which might be a good antidote for a chaotic, stressful or suspicious situation, says Jay Kornfeld, partner at Seattles Bush, Strout and Kornfeld law firm.
For businesses, the two most common kinds of bankruptcies fall under Chapter 7 or Chapter 11 of the U.S Bankruptcy Code.
Chapter 7 is liquidation. The business owner turns everything over to a bankruptcy trustee and walks away. The trustee liquidates the assets and pays the creditors. The business owner knows his or her job is over and loses control of the liquidation. Chapter 11 is reorganization. The owner or manager stays in place and runs the company. If people think the manager is not doing a good job or is dishonest, a court-appointed trustee can run the business. The debtor discloses all details, drafts a new business plan and seeks majority approval from creditors and the judge. Some or all debt can be discharged or repayment extended and assets can be sold. The firms creditors can also object in court.
Family-farm owners have their own reorganization plan under Chapter 12. Sole proprietors can file for another option called Chapter 13. The rules for Chapters 12 and 13 are similar to Chapter 11, but they are strictly reserved for farm owners and individuals, respectively.
In case of emergency
Filing for bankruptcy may sound embarrassing and unpleasant, but it does not have to mean certain disaster. As with most problems, bankruptcies can be mitigated if the red flags are detected early. For those who are considering pressing the panic button, be sure to follow these three steps:
STEP 1: Recognize the warning signs. When bills go unpaid and creditors come knocking, people tend to run for cover and hide their heads in the sand, says Mary Jo Heston, a shareholder at the Lane Powell law firm in Seattle. By the time they come to us, its possibly too late. But if they had come to us six months earlier, a formal bankruptcy might have been avoided completely.
The warning signs are almost always in the records, specifically the cash-flow report, says Michael Franz, certified business adviser at Washington State Universitys Small Business Development Center in Seattle. About 90 percent of owners dont know financial statements are the key to reading a business like a book: pivotal decisions, growing problems, where money comes from and where money goes.
Its the overall trends we are looking for, Franz says. There can be volatility, but how many years can you keep operating with decreasing net worth, decreasing retained earnings and decreasing excess cash? … When is it going to turn positive?
STEP 2: Determine the root of the problem. Precision in this area is critical, Franz says. Is product pricing too low? Are customers ill served or are products or services obsolete? Then: What is required? Can the fix be applied in time?
Avoid personal liability issues, Kornfeld advises. When forced to choose whom to pay and whom to put off, a business might be tempted to defer paying wages, state sales taxes or federal payroll taxes until things get better. Bad idea, says Kornfelddelaying payment only creates more problems and penalties.
Bradford agrees: Its the worst thing an owner can do.
STEP 3: Call your lawyer. Find an attorney with expertise in bankruptcy and turnaround strategies. As soon as warning signs appear, its crucial to recruit outside professionals, certified public accountants and lawyers who specialize in turnarounds, workouts, restructurings and bankruptcies, Franz says. An owner can discreetly ask a current attorney, accountant, fellow business owner or bankruptcy industry professional for recommendations.
Consider someone with experience in your specific industry who also fits your personality. The American Board of Certification, which certifies attorneys as specialists in business bankruptcy, among other things, maintains a searchable database of certified lawyers on its website (see sidebar, page 40). Be picky, Franz adds, but pick someonefast.
Outside consultants are almost necessary because you [the owner] have emotional blinders or psychological blinders, says Franz.
Because of the emotional distress, owners will turn to bankruptcy as an exit, as a resolution, when they dont need to. Its the emotional distress that is driving it. They are burned out. They want out.
Not a solution
Just because you plan for the possibility of bankruptcy, dont think that filing for Chapter 11 will be an easy way out of your problems. Theres a reason why bankruptcy is usually a last-resort option: Its not easy to do.
Even if a business enters bankruptcy court with a solution and a strong will to reorganize, there are no guarantees. Filing is complicated, expensive, time consuming and, for many, emotionally upsetting. Any one of those factors might deliver the fatal blow.
A business bankruptcy can trigger a personal bankruptcy, says Bradford. In small business, the bank often requires the owner to give a personal signature, a personal guarantee that he or she will repay the loan. If the sale of assets falls short, the owners personal assetscars, houses or other propertymight be in jeopardy. An owner and any partners should read the contracts, consult an attorney and fully understand their personal liabilities, Bradford notes.
Regardless of outcome, the stigma of bankruptcy court will follow you for seven years and beyond, Franz says. Your credit score will go down, your insurance rates will go up and you will have to explain the bankruptcy in different venues for years to come. The question of whether the root cause will be a recurring problem will remain.
For some, the automatic stay is a compelling reason to file. As soon as a bankruptcy case is filed, all collection activities must stop, says Dillon Jackson, a lawyer with Seattles Foster Pepper PLLC. The automatic stay gives the debtor time to find solutions, Jackson adds.
Last year, Chapter 11 became more expensive because of changes in federal law, including more reporting requirements. There are certain provisions in Chapter 11 to alleviate costs for some small-business ownersask your attorney about these options, Jackson urges. But if you dont have enough money, a Chapter 11 is doomed from the start.
Whenever possible, consider alternatives to bankruptcy, such as the workout and the wind-down, both of which can be handled out of court. In a workout, a debtor arranges a payment schedule with creditors and lenders (see sidebars). Bankruptcy lawyers and accountants assist the negotiations, but its often less expensive. The results are often similar: debt renegotiations, liquidations, etc. A wind-down is a more informal type of bankruptcy. The owner negotiates a buyout or shutdown with creditors, liquidates the assets and pays creditors with whatever is left over.
If the business has been losing money for a while and you dont have a solution, Chapter 11 will not make the business profitable, Jackson adds. In Chapter 11, [the money] has to come out of somebody. If you do not keep your bills current from the day the case is filed forward, your case will be thrown out. You have to be at least treading water when you come in.
Plan for success
Once a company has declared bankruptcy, it should consider approaching its creditors with a plan for success.
Brian Budsberg, a National Association of Bankruptcy Trustees board member, is assigned to Washington Western District Court. As a court-appointed bankruptcy trustee, he liquidates or operates businesses during certain cases. In such instances, he advocates a straighforward approach for both bankrupt companies and creditors alike: Establish good communication, gain information, use good judgment and get your best people in the discussion.
When businesses struggle for the first time, they dont know how their vendors or banks will react, Kornfeld says. Most vendors or banks appreciate you coming to them earlier. If you come to them earlier, everyone will survive. You dont realize that other businesses can be accommodating. Its not that you have to be [either] a perfect business or a dead business.
Appearances do matter, Budsberg says. If your best software engineers, salespeople, machinists or suppliers sense trouble and leave, they might ruin everything because key personnel will talk to other employees about a financial problem, and those employees will start rumors or make comments that will cycle outside of the company.
On the other side of the negotiation table, Busdberg says, creditors have to accept that they are not going to get full payment. The question then becomes how to limit the loss and how to create future business opportunities to offset the loss with future earnings, he says. While creditors have every right to be firm, they have to be realistic.
End game
Sometimes, however, theres no way to save the ship, no matter how much negotiation has been attempted. An informal wind-down bankrutcy is often preferable, says Bradford.
In these cases, a business owner needs to acknowledge that the business is worth more dead than alive, Bradford says. If you invest more in a failing venture, you are giving up opportunities to go to other types of opportunities. The implications of that on ones family can be very serious.
From start to finish, bankruptcy is a long voyage, often stretching to a year or more. It requires discipline and tough decisions. Working it out or winding it down is just as challenging. But it is possible.
Its a significant decision to file. It is not a panacea, Kornfeld says. There are some valuable business tools, but you should be ready for some real work and be sure this is the right fit.