Knowing When To Bite The Bankruptcy Bullet

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Hitting the reset button is never easy. It can feel like you’re blowing up everything you’ve built, and it’s hard to focus on anything but the loss.

But when things have taken a turn for the worse, and what you’ve built has already imploded for reasons beyond your control, there comes a time to stop fishing and cut bait.

The simple truth is this: Sometimes bankruptcy can be a good thing.

Outswimming The Sunk Cost Fallac

You’ve likely heard of the sunk cost fallacy, which is a fancy way of saying, “throwing good money after bad.” It’s the psychologically understandable — but financially irrational — decision to keep pouring resources into projects that aren’t delivering a return, simply because you’ve devoted so many resources already that you don’t want to stop.

It’s a dilemma many small-business owners face, and it typically affects both their business and their personal finances. That can make the bankruptcy decision all that much harder, especially if it looks like liquidation — a Chapter 7 bankruptcy — is your only option. Selling much of what you (and your business) own might feel like a major step backward, even if it does wipe out your debt

But when your situation won’t realistically allow you to meet your future debt obligations, most of what you own is likely in jeopardy anyway. In that scenario, I believe bankruptcy is your best option.

The problem with throwing good money after bad is that the only thing you gain is debt. Continue to pour money and time into a business that won’t be able to sustain itself, and in six months, you might be stuck selling assets to pay off creditors regardless. With a Chapter 7 bankruptcy, you sell things now and you are able to settle your debts, typically for a fraction of what you owe

Predicting Your Future In Business And Bankruptcy

“That’s all well and good,” you might be thinking, “but none of that tells me when it’s time to decide my business is done.” And that’s a fair point.

The decision to file for bankruptcy is intensely personal. By this, I mean it is both a personal decision related to your risk tolerance and your family’s situation (including financial and non-financial components), and it is personal in that it varies considerably from person to person and situation to situation. No two small businesses, small-business owners or bankruptcy decisions are alike.

This is where I mention the importance of speaking to your accountant and an experienced bankruptcy lawyer in your state, both of whom are vital resources in making this decision and in seeing the process through. But there are some preliminaries you can consider on your own to prepare yourself for those conversations and help your professionals give you the best advice possible.

First, there’s Chapter 7 eligibility. If your business is tied up with your personal finances, or if you have things arranged such that personal bankruptcy might allow your business to continue until good times return, then you’ll need to declare Chapter 7 bankruptcy as an individual. That means passing a “means” test.

You’ll generally pass this means test if your income is below your state’s median. Determining your income can be complex, though, especially if some or all of it comes from a business you own, so even this seemingly simple test might require your accountant’s assistance.

If your income is higher than your state’s median, you can still qualify for Chapter 7 bankruptcy by taking a more detailed look at your income and expenses and possibly certain assets. If expenses outweigh the income/cash you can reasonably make available, you may qualify for a personal Chapter 7 bankruptcy. Even if you qualify under the below-median-income test, a more detailed look at your financial situation can help you determine if things are dire enough to warrant bankruptcy, or if other options are still realistically on the table.

Filing Chapter 7 bankruptcy as a business entity rather than an individual doesn’t require a means test exactly, but the process will involve a detailed accounting of income, expenses, debts and assets. A preliminary review of these items is worthwhile before you decide how to proceed.

Second, you’ll want to try to look six months to a year ahead and predict — as best as you or anyone can these days — what things will look like. If you know your current financial situation was caused by a temporary hiccup and that business will be picking up soon, bankruptcy might not be right for you. If there’s only a slim chance you’ll be able to catch up on your debt payments within 12 months, bankruptcy might be far more attractive.

And if things are just too uncertain to make any prediction, as is frequently the case, you’ll need to do some soul-searching into your risk tolerance, the other opportunities you have available and how well you could handle things (emotionally, psychologically and financially) if you risk spending more on your business but still shut down in the end.

Don’t be overwhelmed by the big picture: Focus on the details.

I wish I could give you a quick checklist that would make the bankruptcy decision for you. As I said above, however, the decision is intensely personal, and every situation is unique.

The key is not to become so overwhelmed by the enormity of the decision that you simply fail to act, letting things crumble around you — a trap all too many small business owners fall into. Instead, take control of what you can, which at this point is information. Gather the data, one line item at a time, and put it together so it gives you a clear picture of where you are right now.

You’ll be better equipped to speak to your professional advisers and feel more confident in the decisions you make for your future.

And you’ll make better decisions, too.

The information provided here is not investment, tax, or financial advice. You should consult with a licensed professional for advice concerning your specific situation.