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Bankruptcy Options for Small Businesses

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Small-business owners should keep this paraphrased bit of poetry in mind: Even the best-laid plans go awry.

No matter how solid your business plan, the fact is bankruptcies happen. Any number of circumstances can tank a business despite the soundest plan or sharpest execution. That’s why owners should pay attention to signs their operation is troubled and know what their options are.

"Bankruptcy" isn’t a dirty word. It’s a valuable tool if wielded correctly.

“It allows a business to rise like a phoenix from the ashes,” says bankruptcy attorney David McGrail, a partner in McGrail & Bensinger in New York.

On the surface, the threatening signs may seem obvious. The organization doesn’t have enough cash, and it’s consistently having difficulty satisfying creditors. Simple or not, however, owners are often blind to the facts of their business, said McGrail, who has been helping debtors fix their finances for a decade.

William Holder, a University of Southern California accounting professor specializing in bankruptcy, said, “In my own experience, when problems begin to arise, they’re probably pretty notorious — everybody knows."

There are two paths to federal bankruptcy court. Businesses can voluntarily submit themselves to the bankruptcy process or a creditor can force the enterprise into bankruptcy.

“You want to be doing it on your terms. That’s the most important thing,” McGrail told BusinessNewsDaily. He explained it is critical to have a plan for exiting bankruptcy and avoid a “free-fall,” in which the legal process spins beyond the debtor’s control. McGrail said he has seen more cooperation between debtors and creditors lately, with favorable results for both.

Before a firm voluntarily enters bankruptcy, management should exhaust all possibilities.  A good attorney or consultant will review the options to determine if bankruptcy is the best road. Most local bar associations can recommend qualified bankruptcy attorneys.

There are three common types of bankruptcy.

In a Chapter 7 bankruptcy, or liquidation, the court appoints a trustee to evaluate the debtor’s assets (including personal assets) and then sell them. Certain types of assets, such as clothes or older cars, are exempt. The trustee distributes the proceeds to creditors according to both federal and state bankruptcy law.

Chapter 7 signals the end of an enterprise’s existence. McGrail warns firms against using Chapter 7 because it’s possible for an owner’s house to become part of the debtor’s assets, depending upon how the company is structured.

Chapter 11 bankruptcies, used primarily by businesses, have evolved in recent years.

“Chapter 11 is both a reorganization and a liquidation these days,” said McGrail. The goal is to restructure the debts so the company can remain a going concern, either for the debtor to keep operating or for a potential buyer, known as a “stalking horse,” to purchase. Chapter 11 ensures that buyers get a clean bill of goods.

Under Chapter 11, small businesses with no more than $2.19 million in unsecured debt face simpler filing requirements and may emerge from bankruptcy more quickly. The condensed schedule, though, can prove difficult for operations already in disarray.

Debtors should be prepared for a time-consuming and expensive process.

“It’s a fishbowl,” said McGrail. “Anything and everything you do has to be transparent.”

These new responsibilities will stretch organizations. “Smaller business enterprises can often have information systems that are much less formal,” said Holder. He explained that accounting and administrative positions will become very important even if  they’ve been slashed prior to bankruptcy.

Chapter 13 is a method of debt restructuring solely for individuals and those operating unincorporated businesses that have a steady source of income. The court sets out a plan over three to five years in which the debtor, under the close supervision of a trustee, uses all discretionary cash to pay back as much debt as possible. When the plan expires, the rest of the debt is wiped away.

Naturally, the best bankruptcy plan is to confront liquidity problems before they overwhelm an outfit.

Accounting systems are very important and, I think, underappreciated for being able to notice changes,” said Holder. “It’s like cancer. Early detection is the best method of preventing the disasters in people’s lives.”