When a business is in trouble, the most critical question is usually “why?” In the answer, may be the solution to the problem. Even if all creditors cannot be paid in full, there might be a solution that allows the business to continue operating. And if there is no real prospect for reviving the business, perhaps the critical question is how best mitigate the damage from the business failure (for any owner having signed a personal guarantee, this may be at the forefront of his or her mind).
Can The Phoenix Rise From The Ashes?
In some instances, the business is in trouble simply because of sustained lack of profitability. In other situations the problem may arise elsewhere – something separate from the ongoing business operations. When it is the latter category, the opportunity for successfully restructure may exist. And even if creditors will not receive 100 cents on the dollar, a restructuring may still be preferable to shuttering the business and simply liquidating assets.
Common Causes For Business Distress:
- Past operating losses, whereas the business is now profitable;
- Accumulation of arrears on secured debt, even though ongoing payments can be made;
- Maturity of term debt, with inability to refinance;
- Delinquent income or payroll taxes;
- Extraordinary legal expenses or judgment against the business;
- An unsuccessful attempt to expand the business or open new locations;
- Temporary health issues experienced by the owner or operator;
- Personal financial distress of the owner causing excessive withdrawals from the business;
- Cross-collateralizing business debts with other non-business obligations.
Separating The Future From The Past
In many instances, while the business may be struggling, the cause of distress has nothing to do with current operations. In such instances, most creditors may be paid more if the business continues to operate. The business would be considered to have value as a “going concern,” and any liquidation would be less. When a business has the ability to either operate profitably or produce positive cash flow, there is real opportunity to reorganize the business and restructure the debts. The key in this instance is to prevent creditors from seizing assets of the business while a deal is hammered out.
Cash-Flow Danger: The Domino Effect
When a business starts running short on cash, the situation tends to unravel quickly. Suppliers may refuse to deliver inventory. Credit may dry up (if it hasn’t already). Lenders holding liens against business assets may start to seize and liquidate those assets, regardless of the impact on operations. Nothing cripples a business faster than having working capital seized, or critical assets sold.
Unfortunately, at this point many business owners simply throw up their hands. This is true, ironically, even if the business is showing a profit. The real tragedy is that simply closing the business is often the worst result for most parties, including the majority of creditors. If the business continues operating then the debtor can often pay more to creditors. To achieve this result, a business owner will need to quickly explore the benefits of either an out-of-court restructuring, or an actual chapter 11 bankruptcy filing. And waiting until the business has depleted all of its working capital will actually make it more difficult to fund the reorganization effort.
Two Tools: 1) Chapter 11 Filing; 2) Out of Court Restructuring
- Chapter 11. Chapter 11 is considered the business reorganization chapter within bankruptcy. When a business is in trouble, chapter 11 may be the only viable option to continue operations. If the business is anything other than a sole proprietorship (e.g. it is a corporation, or a partnership), and the goal is anything other than complete liquidation, then chapter 11 is the only chapter available. At its core, chapter 11 allows the business time to propose a plan to creditors, which should present a better option than simply liquidating the various business assets. At its very essence, chapter 11 is designed to avoid waste. To this end, chapter 11 creates a means for compromise between the business and its creditors. When functioning as intended, it can provide an alternative to the loss that would otherwise occur if business assets were simply sold off in a fire sale. When a business is in trouble, chapter 11 may present the means for greatest recovery by both the equity holders and creditors.
2. Out-Of-Court Restructuring. An out-of-court restructuring is designed to accomplish the same thing as a chapter 11 filing, however, it is missing some of the key tools otherwise available. First and foremost, there is no automatic stay, which in bankruptcy, prevents any collection activity by creditors. The business is relying entirely on the cooperation of the creditors. If there are only one or two primary creditors, this option may work, because cooperation is needed from a small number of parties. But this option to will typically fail if one or more creditors begin any aggressive collection activity. While this option may keep the business out of bankruptcy, it requires near complete cooperation from the business creditors.
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