How to Navigate Business Insolvency

Advice on bankruptcy, liquidation, reorganization, dealing with creditors, and financial insolvency.

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Most entrepreneurs fight valiantly to keep their companies afloat in the face of mounting expenses and declining revenue. But when finally forced to accept that they can't pay their bills, many simply throw up their hands and stop making rational decisions. That's a mistake -- because even after a business fails, an owner has important choices to make.

In general, a company can take one of three routes: reorganization, which allows it to stay in business; outright sale; or piecemeal liquidation of the assets. Each can happen in a formal bankruptcy process -- but doesn't need to.

That is crucial. Many people, even business owners, mistakenly equate insolvency and bankruptcy. The former means you are unable to pay debts as they come due; the latter is the formal and voluntary legal process of resolving insolvency in federal court. (Chapter 7 of the bankruptcy code covers liquidation; Chapter 11, reorganization.) Formal bankruptcy does stop the clock, giving you a temporary reprieve from creditors, but it also has negative consequences. In fact, for most small companies, it isn't a good option at all.

These pages offer guidelines for strategically closing out an unfortunate chapter of your business life. That's right: chapter. Running out of money doesn't mean that your entrepreneurial days are over. Most successful entrepreneurs have gone bust at some point. But the decisions you make at the time could have a great impact on your ability to start your next venture.

Resolving Insolvency

1. Own Up to the Problem

Entrepreneurs tend to be optimistic even in the face of real problems -- and as a corollary, they often have difficulty accepting defeat. (See "The Psychology of Insolvency," last page.) If your business is sinking, it's crucial to recognize it before opportunities for saving it -- or shutting it down efficiently -- have dwindled. The first and most basic warning sign is that you are not making money when you ought to be. Of course, some start-ups don't turn a profit early on. But in most cases, within a year or two, a company's revenue should support expenses and follow predictable trends. If not, consider winding down the business, or at least consult a trusted adviser.

Don't make a bad situation worse. Avoid measures that compound the problem -- financing inventory with a credit card, for instance, or through a factor. In addition to exposing you to high interest rates, credit cards usually leave the business owner, not the company, responsible for the debt.

Even more dangerous is skipping taxes to meet short-term obligations. The penalties on payroll taxes can be draconian, and interest alone can add another 5 percent to 8 percent a year. Worse, company officers can be held personally liable for the obligation, which never goes away, even in bankruptcy -- and exemptions that keep other creditors at bay don't apply to the state or federal government.

Keep your savings to yourself. Above all, never use personal savings, especially retirement funds, to meet your obligations. "The business leg of your financial stool is already weak; don't weaken the personal leg, too," says Donald Rhodes, area director at the University of Georgia Small Business Development Center in Macon. Moreover, if you have any chance to reorganize, you may need that money to recapitalize.

2. Prioritize Your Debts

If you do file for bankruptcy, the court will determine (or approve a plan for) how much creditors get. Until that point, be strategic about whom you pay and when.

Pay secured creditors first. Vendors may be more aggressive in demanding payment than your bank, but resist the temptation to satisfy the loudest voice first. Your bank loan is likely secured by company assets and possibly your own as well. Your bankers, not your suppliers, control your destiny.

Conserve cash. Businesses considering reorganization will need cash to finance operations during the process. Companies that don't anticipate outside financing should stop paying unsecured vendors as soon as possible, advises Suzanne Caplan, a turnaround consultant in Pittsburgh. On the other hand, you can't afford to alienate vendors altogether, because you will still need them to ship inventory.

Don't play favorites. It's better to pay all unsecured creditors something than to concentrate on a few. In formal bankruptcy, an appointed administrator may sue to recover and redistribute preferential payments, eating up cash that could satisfy your debts or fund your operations.

3. Try to Reorganize

From the entrepreneur's perspective, reorganization is usually the best outcome, because it keeps the business operating in his or her hands. This most commonly means negotiating with creditors to either lower the principal owed (perhaps in exchange for equity) or stretch out payments to lower the monthly bill. The negotiations typically involve convincing lenders that if they don't lighten your burden now, they are likely to get back much less later.

Works best when…you are breaking even or turning an operating profit but are hamstrung by debt.

In court or out? For many reasons, including the legal, accounting, and other professional costs of Chapter 11, it's best to negotiate a reorganization outside of court. (See "The Vanishing Chapter 11," last page.) But if you can't come to terms with all your creditors and have to seek shelter in court, you may still be able to save time (and money) with a prepackaged bankruptcy in which your biggest creditors preapprove your turnaround plan. "You herd the big cows together, then rope in the others in court," says Pittsburgh turnaround expert Maggie Good.

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