Bankruptcy – A Business Owner’s Guide to Avoiding the Problems that lead to Bankruptcy
by Steven R. Neuner, Esq.
Over the last 25 or so years, I have seen, both as a bankruptcy Trustee and as a bankruptcy lawyer, many failed businesses. Remarkably, aside from bad luck, these failures stemmed from certain commonly repeated mistakes. This article distills those mistakes for you, in the hope you will avoid them.
Start or run your business without a business plan.
More times than I can count, I see businesses in trouble where the owners cannot answer basic questions, like “How much does it cost you to produce or sell each unit of the goods or service you sell” or “Who are your most profitable and least profitable customers, and what is the profit margin for each of them?”
This inability can usually be traced to mistakes that began when the business started up. People who have experienced a business failure (or success) know the importance of having a road map, and of keeping track what the business is doing. Time and again, I see people who start businesses spending hundreds of dollars to form a corporation or limited liability company, without spending any time or money to write a formal business plan. They start a business that they think will be successful without any thought or research. They have no idea what their costs are going to be or what they can expect in the way of sales. They haven’t researched who their competition is, and where it is located. They have no idea what similar businesses have succeeded or failed at the location where they propose to set up shop. They have no budget. I am constantly recommending that these people meet with an accountant to create a business plan.
You would be amazed how much can be brought to light when you put onto paper the goals, objectives and dollars and cents of a business. There is software that can do this. There are statistics available that can help even the most inexperienced new business owner project what their costs are likely to be. There are well-written books how to prepare a business plan, and websites with templates, advice and assistance. Several of them can be found on the “resource links” page of this website. Your business plan is your critical first step.
This initial lack of planning starts a pattern that often proves the undoing of the business. Usually, the business fails after the owners have sunk countless hours and a great deal of personal wealth into trying to make it succeed. You wouldn’t build a house without a set of plans. Why build a business without them?
Don’t pay attention to your costs or keep tabs on your finances.
Next, business owners don’t devote the time and effort to set up careful financial record keeping systems and financial controls. They may open up a checkbook and work out of the checkbook register. They may not even balance the checkbook regularly. What is needed is an accounting system the keeps track of each category of income and expense, so that, at any time, you the owner can see what is going on in detail. At first, with relatively few sales or expenses, this doesn’t seem to be a big deal-when business is slow, it’s easy to keep track. However, as the business grows, and the owners get more busy and pre-occupied with the day to day details, things get harder. With less spare time, bookkeeping gets sloppy. Sloppy bookkeeping is financial blindness.
This is so easy to avoid. Computer programs like one of the versions of Quicken®, or Quickbooks ® are easy to set up and use. They can make the process of tracking all income and expenses easy. We usually recommend they be set up with the help of an accountant. More importantly, the time to set up these key systems and learn to use them is right at the outset, when you have the time. That way, when you grow and get busy, the systems and tools you will then need are already in place, ready to go. You will be prepared for the demands of business with the tools you need already in place. For some sample budget spreadsheets, the basic budget form, or the rolling expense forecast. (Always consult an accountant about business finances. Offered as samples only. Requires Microsoft Excel)
Don’t pay attention to the competition and the marketplace.
I have seen successful and well-established businesses go under because the world changed around them and they did not change with it. Before they knew it, their competition was undercutting them, or marketing better and taking away their customers. Newer products or changes in what customers need or demand have to be spotted early, and adapted to. Otherwise, your business can go the way of the buggy-whip manufacturer.
If you aren’t paying attention to what your competition is doing, and paying attention to your marketplace, you are driving blind, and looking for trouble.
Borrow from the tax man.
Everyone knows you have to pay your taxes, and that if you don’t, substantial interest and penalties can result. Bankruptcy will not avoid having to pay most taxes. Tax liens can be placed on nearly all income and property of the business. For payroll and sales taxes, the individual owners can and usually will be held individually liable.
Time and again, I have seen business owners using the money withheld from employees to operate their business. Maybe they think the business will generate the profits to make up the shortfall before anyone notices. It usually doesn’t.
If you can’t pay the taxes, you can’t meet the payroll. At a minimum, this should be a big red flashing-light warning that something is wrong! If you don’t know what the problem is and how you are going to deal with it right away, you should be talking to your accountant, financial advisers, or an experienced attorney.
Consider whether in this situation you would be better off closing shop and cutting your losses. Many are the times I have seen business owners struggle on for months or years to keep the business afloat, when they would have been better off closing the doors and working for someone else. Meanwhile they end up working for free and running up mounting personal and business debts before ultimately shutting down.
Being unable to stay current on taxes doesn’t have to mean the end of a business. It does require careful and immediate analysis (with professional advice) to prevent the downward spiral that can easily follow.
Borrow from yourself or relatives without proper loan documentation.
It amazes me that people who take the time to protect their personal assets by forming a corporation, or limited liability company then willy-nilly go on to lend their money to the business or borrow family members, without proper documentation.. When the business starts experiencing financial problems, one of their first concerns is getting this money paid back. This creates a host of problems and potential lawsuits down the road (which are beyond the scope of this article). However, I always caution that when a business needs a loan, the owners and their families should always “think like a bank”. Banks insist on all the proper loan papers being signed beforehand. They insist on collateral. Take the extra effort to do the same. Especially if the loan is coming from other family members, the business ought to give those lenders a security interest in the business assets, backed up by a recorded mortgage or financing statement. Careful documentation should be kept of when, where and how the loan was funded. The loan should be kept on the books of the business as a separate loan, no different than if the loan had come from a commercial lender. This can prevent substantial problems if these loans are paid off and the business later fails.
Again, this is an area where advice of an experienced attorney is essential and money well spent.
A common objection is that this would interfere with the business’s ability to borrow money from banks or other third parties. If this is a problem, it can be readily dealt with through a Subordination Agreement. “Think like a Bank” when you or your family lend money to keep your business going.
Mix business and personal finances together.
Just as important is maintaining the financial separation between the business and the personal finances of the owners. Even where one person or a husband and wife are the only owners of the business, if they have taken steps to create a corporation or limited liability company to own the business, that separation should be strictly maintained. All documents signed for the business should be signed in a representative capacity with the signer’s title clearly displayed (i.e., “John Jones, President”). This goes for everything, including signatures on checks. Any payments between the business and its owners should be separately and consistently recorded on the business’s books with back-up documentation wherever possible.
Doing this preserves the likelihood that the business, if it fails, will not take down the owners with it (although personal guarantees required by many banks might have the same effect). Not doing this creates an opportunity for creditors or a bankruptcy trustee to go after the owners individually to require them to pay all of the debts of the business, not just those they personally guaranteed.
This is another example of the importance and benefits of setting things up right at the outset, and obtaining advice from competent accountants and attorneys.
If things go wrong, don’t seek qualified advice early. Delay filing bankruptcy until things are hopeless.
If you woke up sick and weak enough that you couldn’t stand or walk, you’d see the doctor, right? When businesses get in trouble, I have seen the owners, time and again, waiting “until the patient was on death’s door” before seeking help.
If your business is having financial problems, you need to find out why. Whether or not you know why, you need to develop a plan to deal with it. Under these circumstances, you are personally involved and probably will not be objective, even if you have the financial and business knowledge needed. Whatever you do, you need to know and be able to carefully weigh all your choices. You need to know about your special obligations to creditors when a business is in the “zone of insolvency”. You need advisers with knowledge, experience, who can provide hard-headed objective analysis. Your accountant, in conjunction with an experienced bankruptcy professional, can provide this for you at a critical time.
I suspect people do not want to go to a bankruptcy lawyer for advice because they see that as inevitably leading to bankruptcy. This is not so. We regularly help our clients develop a plan where, as the preferred choice, bankruptcy is avoided. However, these clients, having looked at all the options, have made their decision with a clear-eyed view of all the alternatives, and their respective risks, costs and benefits.
Most importantly, such clients develop, often too late, a keen sense of the importance of priorities and timing. Too often, businesses end up in a Chapter 11 reorganization after the owners have waited too long or spent too much of their resources or energy. The result is failure when an earlier resort to Chapter 11 would have saved the business.
In part, this may be caused by viewing bankruptcy as meaning failure, rather than viewing it for what it really can be. Used properly, a bankruptcy is a financial and business planning tool that can save a business from the worst consequences of past mistakes or bad luck. Properly applied, a Chapter 11 reorganization results in all creditors receiving more than they would be getting any other way. Where Chapter 11 is appropriate and successful, the business lives on to generate a valuable product or service, to continue paying taxes, and to generate profit for its owners.
It is never too early to get help planning and thinking about alternatives, even bankruptcy. We do not sell bankruptcy. We sell advice to help you make the right decision for you and your business. Please feel free to call us at (856) 596-2828 or email me if you think we can be of help.
We are New Jersey bankruptcy lawyers. We help people obtain debt relief under the Bankruptcy Code.