5 Signs You Need to File for Bankruptcy

Updated on January 31, 2020
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In your earliest days as a business owner, you probably never imagined that you might someday file for bankruptcy. You had big plans and dreams for your business! You were so optimistic about the future, and you had every intention of building a profitable, successful company. Isn’t that what every entrepreneur aims for?

Yet despite these best-laid plans, changes in the marketplace, threats from competition, and miscalculated business strategies force thousands of business owners per year to file for bankruptcy. The American Bankruptcy Institute reports that over 24,000 businesses filed for bankruptcy last year.

But before you start envisioning the worst case scenario for your own business, take a few minutes to evaluate your circumstances objectively. Because while bankruptcy really is the best available option for a business in some scenarios, there are plenty of cases where, despite the presence of real financial challenges, filing for bankruptcy would be the wrong choice.

If you suspect that your business might need to file for bankruptcy, read on to consider whether your situation fits all of the below criteria.

1. Your Cash Flow Crisis Is Long Term

Though cash flow challenges are typically the first warning sign that a business bankruptcy filing could be imminent, it’s important to remember that bankruptcies are rarely the result of just one or even a few late paying clients or missed vendor payments.

If you’re having a bad month, a bad quarter, or even a bad fiscal year—but you can still see light at the end of the tunnel—now is the time to get your business’s cash flow back on track by any means necessary. This will probably involve some hard choices, such as cutting expenses, personnel, and even your own salary in the short term. You might need to make major management changes or engage a new marketing push so that you can get your revenue streams up to where they need to be.

Regardless of the exact reasons contributing to your cash flow challenges, if you’ve spotted the warning sides of trouble early on, you might still have time to correct your cash flow before the problem gets out of hand.

On the other hand, if you’re behind on multiple payments with several suppliers and can’t foresee at least one realistic solution to your business’s cash flow crisis, you might be long past making internal changes to fix the problem. Businesses that have been behind on payments for more than six months with no end in sight would be wise to start considering a more drastic solution to their ongoing financial problems.

2. Your Personal Assets Are at Risk

Ultimately, the only real reason to file for bankruptcy is to protect as many of your personal assets as possible from being overtaken by creditors. That means, of course, that there is no need to file for bankruptcy unless your personal assets are at risk.

If you’ve adequately protected your personal assets through your business’s structure and financial management, you might be able to simply close up shop and walk away without worrying about a bankruptcy filing. On the other hand, if you’ve in any way implicated your personal savings or property into your business’s liabilities, filing for bankruptcy might be your best chance to salvage what you own.

Let’s take a look at the three primary scenarios in which you might need to file for bankruptcy in order to protect your personal assets:

When your business structure makes you personally liable: To some extent, the need to file for bankruptcy depends on how your business is structured. If you are a sole proprietor or a member of a general partnership, there is no legal separation between you and your business. You are personally liable for the full extent of your business debts, and your personal assets—including your life savings, retirement accounts, children’s college funds, and your family home—are fair game for creditors seeking to satisfy business debts.

As a result, while a limited-liability business facing cash flow challenges might be able to just close up shop and move on, sole proprietors or general partners often have a greater need to file bankruptcy in order to protect their personal assets.

When you’ve intermingled your personal and business finances: That said, structuring your business as a corporation or LLC doesn’t necessarily guarantee that your personal assets are safe from creditors. If you’ve fallen into the bad habit of improperly mixing your business and personal finances, a court could potentially nullify your corporate structure and declare you personally liable for your business’s debts.

When you’ve signed a personal guarantee: If the financing of your struggling business has included a business loan or some other form of major startup capital, you need to determine whether you’ve ever signed what’s called a “personal guarantee.” Many banks and alternative lenders require personal guarantees in order to finance newer small businesses—particularly those who aren’t able to put up solid collateral for their financing.

Unfortunately, too many small business owners sign personal guarantees without fully understanding the implications, leaving their personal assets totally vulnerable in the event of a business failure. If you’ve signed a personal guarantee on any financing, you as the business owner can and will be held personally liable for the repayment of that loan regardless of your business structure. This creates another scenario in which even corporations or LLCs need to file for bankruptcy in order to protect the personal assets of the owner—and even a business bankruptcy might not fully erase your personal liability.

If you have signed a personal guarantee on any business loan and are considering filing for bankruptcy or closing your business, consult with a knowledgeable bankruptcy attorney as early as possible to identify your best options for protecting your personal finances.

Hindsight Is Always 20-20

Sadly, if you’re already at the point of considering a business bankruptcy, there’s likely little you can do about the above three scenarios. Either you incorporated your business early on, kept your business and personal finances separate, and avoided signing personal guarantees on any loans—or you didn’t.

While there’s little you can do to change what’s already happened, understanding how these markers of personal liability impact your current business should help you to determine whether filing for bankruptcy may be the best path forward.

3. You’ve Researched Other Options

Even in the midst of a long-term cash flow crisis—and even if your personal assets are tied up in your business—you could have other options for avoiding a business bankruptcy. While these alternatives may not necessarily save your business, they might help you avoid many of the legal costs and credit ramifications of a true bankruptcy filing.

Before you decide to file for bankruptcy, consider whether one of these three alternatives may be a better choice for your business:

Negotiating With Creditors

When cash flow challenges arise, your first line of defense should almost always be with the vendors and creditors your business works with most regularly.

In many cases, if you’re honest and forthcoming about your challenges from the beginning, vendors with whom you have developed a strong relationship over time will do their best to work with you on a manageable payment plan as you navigate your business’s cash flow ups and downs. After all, you’ve been a good customer for a long time—and ideally, they want to continue doing business with you (while receiving on-time payments) over the long term.

If a deadline extension from a trusted supplier could make the difference in your business’s ability to tread water, don’t be afraid to have that conversation before jumping straight to the worst possible scenario. And remember—your fellow vendors are business owners, just like you! They’ve likely been there before, and they want to see you succeed.

Debt Consolidation or Refinancing

Even if your creditors or vendors aren’t open to a more informal negotiation, you might still have a financial recourse to manage your debts while you get out of your cash flow hole. Several online alternative lenders offer options for debt consolidation (to combine multiple debts into a single, manageable payment) or refinancing (to extend the payment terms of a debt) that can give you a little more breathing room while you figure out your business’s finances.

In each case, this new financing typically takes the form of new a short-term loan. The concept is that you would use the capital from the short-term loan to pay off your existing debt or debts, then make payments on your new loan according to the established schedule.

However, though business debt consolidation or refinancing might sound like your dream-come-true alternative, it’s important to note the downsides. These loans are typically short-term, giving you only about a year of space to regain control of your business’s finances and maintain the new payment schedule. In addition, the interest rates on refinanced loans can be quite steep, which for some business owners only compacts the problem.

What’s more, debt refinancing loans almost always require either significant collateral or an unlimited personal guarantee. So, if your personal assets aren’t already implicated in your business debt, this is probably not the right choice for your business.

Assignment for the Benefit of Creditors

Finally, even if your business is beyond negotiation or refinancing and you’re ready to close the doors, you might still be able to keep your credit issues out of the court system through what’s called an Assignment for the Benefit of Creditors (ABC).

Though the regulations for ABCs vary slightly from state to state, this process, in essence, offers an out-of-court alternative to Chapter 7 bankruptcy (also known as business liquidation) in order to save the time and cost of a formalized court filing.

Most creditors are willing to comply with ABC’s instead of formalized bankruptcies because they know that fewer legal expenses ultimately mean a greater final payment on their outstanding debts. And though an ABC may do little to save money for the business owner as compared to a formalized bankruptcy filing (since any money saved would go straight to the creditors), avoiding the tarnish of a bankruptcy filing on your credit report can make it easier to move forward with your financial and business life.

4. You’ve Identified the Right Bankruptcy Filing for Your Business

If you’ve investigated the alternatives but still believe your business should file for bankruptcy, you need to understand which type of bankruptcy filing makes the most sense for your circumstances. Your most appropriate filing depends on your business’s structure as well as your future plans for the organization.

While you should always consult your own legal counsel to before following through with a bankruptcy filing, you can prepare for those conversations by learning the differences between the three forms of business bankruptcy detailed below:

Chapter 7: Going through the process of a Chapter 7 bankruptcy involves forfeiting all the assets of the business to a trustee appointed by the bankruptcy court who then liquidates those assets and distributes their value among the creditors as repayment for the business’s debts. Once all assets have been distributed and the trustee has been paid, the court issues a discharge to the business’s owner, meaning the owner is no longer obliged to pay up their remaining debts.

Chapter 7 bankruptcy is typically the best filing choice for small businesses that have no future prospects and are on their way to closing up shop, because it offers a clear exit strategy while limiting the owner’s personal liability. This scenario typically occurs when the business’s debts are so overwhelming that they have no reasonable hope of restructuring the debts and moving forward.

Chapter 13: Reserved for sole proprietors facing a personal and business bankruptcy simultaneously, Chapter 13 bankruptcy is often seen as a preferable option for those business owners facing significant personal loss—such as the loss of the family home—due to loan collateral or some other intermingling of business and personal finances.

With a Chapter 13 filing, you as the business owner would work with the court to come up with a reasonable debt repayment plan that satisfies creditors while minimizing the impact on your personal finances to every extent possible. Though a Chapter 13 bankruptcy does not guarantee the protection of your home or your life savings, in certain situations, it may be your best case scenario.

Chapter 11: Chapter 11 is often the most commonly imagined form of business bankruptcy, but it’s rarely the best choice for small businesses.

Under this form of bankruptcy, businesses with some potential to continue operating after a bankruptcy undergo a reorganization process with the help of a court-appointed trustee, which may even be the owner of the company. Once the company submits a plan of reorganization to be voted on by the major creditors, the court determines whether the plan is fair and equitable in its intended repayment structure for existing creditors.

Chapter 11 bankruptcies are complex, they often don’t succeed, and in the case of small businesses, most creditors are going to be more eager to liquidate the business and obtain their payments owed than to await the hassle and expense of a reorganization. As a result, Chapter 11 bankruptcies are most commonly reserved for large corporations.

In addition to these three most common types of bankruptcy, a small subset of business owners might need to consider Chapter 12—which is for farm-related businesses—or Chapter 15, which covers companies that operate internationally. Because of the many nuances involved in the decision between bankruptcy filing types, be sure to consult an experienced bankruptcy attorney to determine your most appropriate option.

5. You Have a Plan to Move Forward

As monumental as filing for bankruptcy might feel, it actually won’t be the end of the world or even the end of your financial life. So, before you make the decision to file for bankruptcy, you want to have at least some idea of what life will look like after this season passes.

Rebuilding Your Credit

Unless your business was structured as a corporation, any bankruptcy you file will typically show up on your personal credit report for about seven years. That means any time a creditor, vendor, property manager, or anyone else checks your credit report for those seven years, they will learn of your previous bankruptcy, and it will significantly impact your eligibility for new credit.

In general, the longer you wait after your bankruptcy to apply for credit, the easier it will be to obtain—though interest rates and terms will still be less favorable than before your bankruptcy filing. It’s critical during this period that you take special care to manage your business and personal finances wisely in order to rebuild your reputation with creditors. That means never taking on more debt than you can afford and making payments on any debts on time, every time.

Negotiating New Vendor Contracts and Financing Options

As you can imagine, vendors and lenders that pull your credit report and learn of a bankruptcy will likely be reticent to offer you a new loan or supplier contract. From their perspective, knowing that you struggled to pay your debts in the past makes it more likely that the same could happen again! Even so, the information that leads to your potential creditors’ decisions doesn’t have to be completely out of your hands.

When first applying for new forms of business or personal financing, take the time to include with your application an explanation of the circumstances that led to your business bankruptcy. This shouldn’t be an emotional plea, but merely a summary of the facts that led to your past financial circumstances—particularly if this includes health problems, a natural disaster, or other causes outside of your control. At the end of the day, lenders are human beings, and many will be willing to consider special circumstances.

While you might go through several, even dozens of applications before you find the right creditor to work with, all you need is that first supplier to give you a chance. Over time, one yes will become several, and little by little, you will rebuild your relationships and your financial life.

Letting Go of the Emotional Baggage

For many small business owners, the logistical and financial aftermath of a business bankruptcy is only one piece of the recovery process. Equally important and often even more difficult for entrepreneurs is the process of overcoming the emotional impact of having seen a business fail.

Your pride has likely taken a big hit, and you may be questioning your competence to run a business in the future. It’s not uncommon for entrepreneurs to feel shell-shocked, or to become so risk averse that they’re unable to allow their businesses any room for growth.

If you find your bankruptcy filing is taking a psychological toll, talking to a mentor, a business coach, or even a mental health professional might help you to gain some perspective. Remember, you’re not the first entrepreneur to ever face a bankruptcy, and you certainly won’t be the last. Kodak, Eddie Bauer, and Marvel Comics have all faced a business bankruptcy; even President Donald Trump has filed for bankruptcy on four separate occasions!

Dealing with a business bankruptcy is always a tough road to travel. But in the end, it’s up to you whether this will spell the end of your entrepreneurial journey. The lessons learned through this experience will be hard won—but if you can learn from this experience while letting go of the emotional baggage, you’ll be well on your way to becoming a better, smarter entrepreneur as your business life moves forward.

Meredith Wood

Meredith Wood is the founding editor of the Fundera Ledger and a vice president at Fundera. She launched the Fundera Ledger in 2014 and has specialized in financial advice for small business owners for almost a decade. Meredith is frequently sought out for her expertise in small business lending. She is a monthly columnist for AllBusiness, and her advice has appeared in the SBA, SCORE, Yahoo, Amex OPEN Forum, Fox Business, American Banker, Small Business Trends, MyCorporation, Small Biz Daily, StartupNation, and more. Email: meredith@fundera.com.
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