The last thing on an entrepreneur’s mind is business bankruptcy.
Heck, he is only focusing on the huge profits his new business could start raking-in, in a short time.
However, as we well know, statistics published by Bloomberg suggests that 8 out of 10 businesses fail or go bankrupt in their first 18 months.
That is, 80% of all new businesses launched in the US go bankrupt in their first 18 months!
This statistic is too scary to be ignored!
The questions that naturally arise from this statistic include: What is bankruptcy? What causes bankruptcy? how can a business avoid bankruptcy? etc.
This article will be answering these and more questions.
Let’s begin!
What is Bankruptcy?
Bankruptcy is a legal process through which an organization or individual that is unable to pay their outstanding debts, may file a petition in court, to seek relief from all or part of their debts.
Bankruptcy was defined by debt.org as a court proceeding in which a judge and court trustee examine the assets and liabilities of individuals, partnerships or businesses whose debts have become so overwhelming they don’t believe they can pay them.
On reviewing their assets and liabilities, if the court finds their debts overwhelming, the court could decide to give them relief (by declaring them bankrupt).
However, if the court finds after evaluation that their assets outweigh their liabilities or debts, it will most likely dismiss the application for bankruptcy.
If the application for bankruptcy is granted, the assets of the organization are sold and used to pay as much of the debts of the organization as it could cover.
Whatever debt that could not be paid, will be written off by the court, thereby giving relief to the debtor.
So, this process ensures that creditors recover some part or all of their capital.
It also protects debtors from having to struggle hopelessly with their debts. It gives them a second chance to start all over again.
Bankruptcy is handled by Federal Courts in the US, and they are guided by the rules spelt out in the Bankruptcy Code of the United States of America.
Types of Bankruptcy
There are several types of Bankruptcy spelt out in different chapters of the Bankruptcy Code of the United States of America. We will be reviewing the most popular ones in this section:
- Chapter Seven (7) Bankruptcy
This type of bankruptcy is sometimes known as Straight Bankruptcy. It is the most common bankruptcy application in the United States of America.
Private individuals and businesses with very few assets or a very low cash flow mostly use this type of bankruptcy.
It allows them to get relief from unsecured debts, like credit card balances, and medical bills
How does bankruptcy chapter 7 work?
If a business applies for bankruptcy under chapter 7 of the Bankruptcy law and its application is successful, the business shuts down.
All its employees are dismissed, and a federal court trustee supervisees the sale of all non-exempt assets, to pay off as many debts of the organization, as the sales can cover.
Under Chapter 7 of the bankruptcy law, the business ceases to operate, except in the case where the federal court trustee allows the business to remain in operation temporarily.
If a business has multiple creditors, the court trustee will divide the funds recovered from the sale of the business assets among the creditors.
Businesses such as Sole Proprietorships, Limited Liability Companies, Corporations, etc. can apply for bankruptcy under chapter 7 of the bankruptcy law.
However, this type of bankruptcy application is most common among Sole Proprietorship businesses.
After the sale of non-exempt assets, creditors get paid, while the debtor is discharged of all outstanding debt.
Under chapter 7 of the Bankruptcy law, exempt assets refer to assets belonging to the debtor that cannot be sold to repay debts. It is non-exempt assets that can be sold to repay debts in bankruptcy.
Exempt assets differ from state to state across the United States of America. Some of them include a home, personal car, personal clothing, pension account, relevant work tools, etc.
A major consequence of filing for bankruptcy under chapter 7 of the bankruptcy law is that it will remain on your credit report for 10 years.
This alone will reduce your chances of accessing any reasonable loan to start again.
2. Chapter 11 Bankruptcy
This type of bankruptcy is mostly used by businesses to reorganize, remain in business, and become profitable once more.
When a business files for a chapter 11 bankruptcy, the management of the business remains in control and could make decisions for the company, however, with the approval of the court.
This opportunity to reorganize will give the company a chance to emerge from bankruptcy, as a profitable company.
This bankruptcy allows the business to eliminate debts, restructure long term debts, sell non-performing assets, etc.
To qualify for a chapter 11 bankruptcy, a company must be generating revenue regularly.
They also must submit a reorganization plan to the court for consideration, clearly specifying how and when the company expects to repay all outstanding debts.
This plan must be approved by the court and the creditors before it can be implemented.
The goal of filing for a chapter 11 bankruptcy, is to give a business the chance to emerge from its debts and become profitable again.
J.C. Penny, Stein Mart, Hertz Rental Cars, etc. filed for this type of bankruptcy in 2020.
3. Chapter 13 Bankruptcy
This type of bankruptcy is for individuals and businesses that make too much money to apply for Chapter 7 bankruptcy.
It offers individuals and businesses who earn an income consistently, an opportunity to create a debt repayment plan.
This debt repayment plan is to last between three to five years, during which the debtor is to have paid all or the agreed part of the debt.
If the court approves this debt repayment plan (and by extension the bankruptcy application), the debtor is allowed to retain all of their assets, including non-exempt assets.
Seven years from the date of this bankruptcy application, the negative report of this bankruptcy application is cleared from the credit history of the debtor.
Bankruptcy Terms to Be Familiar With
Find below some terms you will come across as you proceed on any bankruptcy application:
Bankruptcy Trustee
A bankruptcy trustee is a person chosen by a bankruptcy court to act on behalf of the creditors, in a bankruptcy proceeding.
He or she is to review the debtor’s bankruptcy petition, supervise the sale of their assets (where necessary), and distribute the proceeds among the creditors.
The bankruptcy trustee also supervises the repayment plan of a debtor, in a chapter 13 bankruptcy petition. It is the trustee that receives the repayments and distributes them to the creditors.
Credit Counselling
This is the counselling session that a debtor is mandated to attend before their bankruptcy petition is approved.
The debtor is mandated to meet with a non-profit budget and credit counselling agency, to receive valuable financial advice that will help him make better financial decisions.
He or she will also be required to take a course in personal financial management before his petition is granted. All of these are aimed at helping him make better financial decisions.
Discharged Bankruptcy
After the bankruptcy petition of a debtor has been approved and his or her non-exempt assets have been sold and the funds distributed to the creditors, this can be described as discharged bankruptcy.
Under Chapter 13 where assets are not sold, a bankruptcy is described as discharged when a debtor has completed their repayment plan.
Exempt Property
In Bankruptcy law, exempt property refers to properties that cannot be sold to pay creditors in a bankruptcy proceeding.
Although exempt property varies from state to state across the United States of America, some properties are commonly regarded as exempt across the United States.
Such properties include your residence, personal car, some work tools, etc.
Lien
It is a legal action that permits a creditor to take, hold or sell a debtor’s real estate as repayment for their debt.
Liquidation
It refers to the sale of a debtor’s non-exempt assets to raise funds to pay their debts.
Means Test
This is the test a debtor applying for chapter 7 bankruptcy has to pass before his petition can be approved.
What is it all about?
This test examines the income, assets, expenses, and unsecured debts of the debtor, to find out if they are really in a bad financial situation, and are unable to pay their debts.
This test is to ensure that people do not abuse the privilege associated with chapter 7 bankruptcy.
If a debtor fails this test, his bankruptcy chapter 7 petition, may be dismissed or changed to a chapter 13 proceeding.
Reaffirmation / Reaffirmed debt
It is an agreement in which a debtor agrees to continue paying a debt that may be discharged in the bankruptcy proceedings.
The debtor may do this to be permitted to keep some assets that would have been sold in the bankruptcy proceedings.
A debtor may choose the path of reaffirmation to prevent the permanent loss of properties that holds sentimental value.
Secured Debts
A debt that is backed by assets of significant value can be described as secured debt. For instance, car loans are backed by the vehicles they were purchased with, mortgages are backed by the houses they purchased, etc.
Unsecured Loans
These are debts for which the creditor holds no collateral. Such debts include Credit cards, etc.
Debts That Cannot Be Cancelled Through Bankruptcy Petition
Although lots of debts can be written off via a bankruptcy proceeding, certain debts can never be written off by any type of bankruptcy application.
We will be listing such debts in this section:
- Court fines and penalties.
- Court-ordered alimony.
- Court-ordered child support
- Government fines and penalties.
- A Federal tax lien for taxes owed to the US Federal Government.
- Reaffirmed debt.
- Some student loans.
What Factors Can Lead a Business to bankruptcy?
Several factors can lead a business to bankruptcy. In this section, we will be reviewing some of those factors.
- Poor Market Conditions.
That a business goes bankrupt simply means that they are no longer making enough money to keep them in business.
One factor responsible for this is poor market condition. What does it mean?
It simply refers to a situation where consumers are no longer interested in paying for a product or service, because of prevailing economic, technological, etc., conditions.
One factor that can lead to poor market conditions is technological changes.
For instance, if the goods a business offers have been overtaken by technological advancements, they will inevitably face poor market conditions.
Nokia had to discontinue producing phones with Symbian OS (their operating system) as consumer preferences tilted towards Google’s Android, and Apples’ iOS.
They might have run into a difficult situation if they continued to produce all their phones strictly on the Symbian OS.
Another factor that could lead to bankruptcy is when there is a general downturn in the economy or industry in the economy.
For instance, several businesses across the United States went bankrupt in 2008, because of the global economic meltdown.
Other factors that could lead to poor market conditions include fierce competition from competitors, Increased cost of doing business, etc.
Poor Management
Have you ever wondered why staff in management positions are paid far more than other employees?
I believe one reason for this is because these organizations want to attract the brightest managers and keep them focused on making good decisions, that will help the organization remain profitable.
When the management of a business makes poor decisions, it runs the business into major problems, one of which is bankruptcy.
For instance, if the management of a small business compromises on quality, and it leads to a lawsuit that gulps millions of dollars, the business may never recover from it.
Other Causes
Beyond poor management and poor market condition, several other factors could lead an organization to bankruptcy. These factors include:
- Loss of key staff.
- Unforeseen disasters (like fire or flood disasters for an uninsured business).
- Lawsuits.
- Theft or fraud, etc.
How to avoid Bankruptcy
So, how does a business avoid bankruptcy?
Truth is, there is no hard and fast rule to apply here. To avoid bankruptcy, a business would have to avoid the factors that lead to bankruptcy.
Avoiding these factors starts when you are yet to launch your business. You have to study the industry you wish to operate in and come up with a plan on how to thrive there.
You must also study your numbers properly to ensure you will be able to generate enough revenue to pay whatever loans you took to launch the business.
What is our point here?
The steps to avoiding bankruptcy starts when you are still writing your business plan. You must ensure you cover all the basics, to ensure you don’t face any negative surprises.
Beyond starting on the right note, you must keep making the right decisions to keep your business afloat. A few mistakes along the line are enough to sink a business.
Read Also: How To Protect Yourself Against Rising Inflation
Conclusion
So here you go!
These are the major things you need to understand about Bankruptcy for businesses.
If you wish to apply for bankruptcy, see a bankruptcy attorney to guide you on how to go about it.
Wishing you all the best in your journey to bouncing back.
Cheers!
