When Should a Small Business Owner File for Bankruptcy?

For small business owners, the decision to file for bankruptcy is often scary, stressful, and intimidating. It’s a critical choice that can have far-reaching implications for both the business and the personal lives of the owners and any employees who work for the business. Sometimes, it’s 100 percent the right choice. But it all depends on how you approach it. 

Understanding the Truth of Bankruptcy

First off, let’s tackle the stigma. Bankruptcy often comes with a shadow of failure, but in reality, it’s a legal tool designed to provide a fresh start. It’s about making a strategic choice to protect what can be saved and to rebuild on a more solid foundation.

As bankruptcy attorney Rowdy G. Williams explains, “We need to get over the notion that bankruptcy is embarrassing or a black mark on who you are as a person. Bankruptcy is a legal and ethical tool that exists to help people escape bad financial situations. See it as a tool – not a mistake.”

When you see bankruptcy as a tool – much like debt can be a tool – it starts to open you up to the possibility that this could be something that provides relief for you, your business, and your family.

3 Common Types of Bankruptcy

For small businesses, there are three primary bankruptcy paths you can go down: Chapter 7, Chapter 11, and Chapter 13. Each serves a different purpose and suits different situations:

• Chapter 7: This is like hitting the reset button. It’s about liquidating assets to pay off debts, after which the business typically closes. It’s a path often chosen when there’s no viable way to keep the business running.
• Chapter 11: Think of this as a restructuring plan. It allows the business to keep operating while working out a plan to pay creditors over time. It’s complex but can be a lifeline for businesses with a solid core that just need some breathing room to reorganize.
• Chapter 13: This is more for sole proprietors who intertwine personal and business debts. It’s about setting up a repayment plan based on your income, giving you a chance to catch up without losing everything.

As you can see, each type of bankruptcy has different characteristics and purposes. It’s absolutely crucial that you do your research and understand each type. You also need a very clear picture of the circumstances you’re currently facing. Without knowing (a) the types of bankruptcy and (b) your situation, it’s impossible to make a smart choice.

Recognizing the Signs: When Bankruptcy is a Good Option

Deciding to file for bankruptcy isn’t about one bad month or a tough season. It’s for when the storm comes and it doesn’t seem to pass. Here are some signs that it might be time to consider it:

• You’ve Exhausted Other Options

Before considering bankruptcy, make sure you’ve carefully explored all other alternatives. This might include negotiating with creditors for more favorable payment terms, restructuring the business, reducing operational costs, or seeking additional financing. If these efforts have been exhausted or are not feasible, bankruptcy might be the next step to consider.

• You’re Drowning in Debt

If your business debts feel like a tidal wave you can’t escape, bankruptcy might offer a practical and realistic solution. It’s about facing the reality that the debts are beyond what the business can handle. This number will be different for every business and business owner, so don’t let someone give you a “number” to measure what it means to drown in debt. It’s more a question of overwhelm.

• You’re Experiencing a Cash Flow Crisis

When the business consistently spends more than it earns, leading to a perpetual state of financial emergency, it’s a red flag. If cutting costs and boosting sales haven’t got you back on track, consider that it might not ever get you back to a stable position. Bankruptcy could help clear the deck.

• Creditors are Threatening Legal Action

When creditors start taking legal action to recover debts, such as filing lawsuits or obtaining judgments that allow them to seize assets, it might be necessary to file for bankruptcy to protect the business. Bankruptcy can halt these legal actions, at least temporarily, providing some breathing room to reorganize or plan for debt repayment.

• There Are Restructuring Roadblocks

Sometimes, the path to recovery is clear, but obstacles block the way. If renegotiating terms with creditors or securing new financing isn’t possible, bankruptcy might offer the best option. If nothing else, it’s something to consider as you work through a plan to get out of debt and find a little financial breathing room.

• You Want to Protect Personal Assets

For sole proprietors and some partnerships, personal and business assets can be intertwined. If your business debts threaten your personal assets, such as your home or personal savings, filing for bankruptcy might be a way to protect those assets, depending on the bankruptcy chapter filed.

Bankruptcy can sometimes offer a fresh start, either by discharging certain debts that are impossible to pay off or by restructuring the business in a way that makes it work again. For businesses with a solid core but unsustainable debt, bankruptcy can provide a way to reset and begin fresh under more favorable conditions.

Having said this, you’ll have to consult with a bankruptcy attorney to understand the implications. In some cases, you might have to actually shut down the existing business and start fresh with a totally different company name. In other cases, you’ll be able to continue operating under the same name. These are things you’ll want to explore as you consider bankruptcy.

Making a Decision

If you’re seeing these signs, it’s time for a serious sit-down. Consult with a bankruptcy attorney to explore your options in detail. This decision should be a strategic move, informed by expert advice, not a panic-fueled leap.

Filing for bankruptcy is about shedding the weight that’s holding the business back and setting a course for a more sustainable future. And, to be honest, it’s just the start. The post-bankruptcy phase is where a lot of your challenges will come. it will require dedication, smart planning, and sometimes, a significant pivot in how you do business. But with the right mindset, it can lead to a stronger, more resilient venture.