Insolvency: What It Is, How It Affects You, and What You Can Do to Fix the Problem

When you start a new business venture, you probably think about all kinds of things—market demand, costs involved, profit margins, and so on. But the likelihood of your company going bankrupt isn’t usually at the top of your list. Yet in the U.S., businesses fail every day. And it’s not just small mom-and-pop shops that go bankrupt; large corporations such as Toys ‘R’ Us have also filed for bankruptcy recently.

The good news is that many businesses rebound from insolvency and often come out stronger after restructuring their debt and assets. But if you operate a small business or are thinking about starting one, you need to understand how insolvency can impact you as an individual – even if your business isn’t big enough to qualify for formal protection under the Bankruptcy Code.

 

What is insolvency?

In the simplest of terms, insolvency is when your company cannot repay its current or future liabilities. Insolvency can be triggered by a variety of situations that either negatively affect your company’s operations or reduce the value of its assets. An unexpected event such as a natural disaster or a significant drop in sales can put your company into insolvency as it struggles to meet its financial obligations.

 Insolvency can also happen if you get too aggressive with your business’s growth strategy, spending too much money on capital expenditures and other assets. In other words, you may end up spending more than the value of your assets without realizing it.

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What happens during bankruptcy?

If you have a business that’s been struggling to make ends meet, you may have to file for bankruptcy to restructure your company’s debt. The goal of a bankruptcy filing is to reduce your company’s overall debt and give you breathing room to get back on your feet financially. If your business is incorporated, the process is known as a chapter 11 bankruptcy.

If it’s a sole proprietorship, you’ll file under chapter 7 or chapter 13. If your company is a corporation, you’ll file under chapter 11. A chapter 7 bankruptcy is known as a liquidation. All of your company’s assets are sold off and the proceeds are distributed to creditors. Chapter 13 bankruptcy is known as a wage earner’s plan. You’ll still have to repay your creditors, but it gives you more time to do so and lets you retain your assets.

 

Why does business insolvency happen?

The circumstances that lead to business insolvency are as varied as the businesses themselves. The 2008 financial crisis hit many industries hard, and some companies that survived the downturn struggled to recover from the blow to their bottom line. Poorly managed businesses are often insolvent.

Management may not be paying close enough attention to the company’s day-to-day finances to notice a cash flow problem until it’s too late. Poor management also often results in unprofitable business decisions, such as failing to achieve economies of scale or engaging in predatory pricing that leads to a long-term loss of profits.

 

How does insolvency affect you as an individual?

If your business goes bankrupt or becomes insolvent, there’s a chance you’ll lose your personal assets as well. Creditors are likely to come after your personal property and bank accounts so they can make a claim against the money they’re owed by the company. While the exact rules vary in each state, it’s not uncommon for creditors to use the “subordination of lien” principle to go after your personal assets first.

It’s important to understand that there are no guarantees when it comes to bankruptcy proceedings. If the company that’s owed the money has enough legal standing to make a claim, there’s no way to prevent it from happening. If you’re personally liable for a business debt, you risk losing your personal assets to satisfy the debt.

 

Options if your business goes bankrupt

If your business goes bankrupt and you’re personally liable for debts incurred by the company, there are a few things you can do to protect your personal assets while you try to get the company back on its feet again. You can try to negotiate a payment plan with the creditors. You can find a new investor to inject cash into the company. You can work with the company’s bank to ask for more time to make payments.

You can try to find a merger partner. It’s important to know that there are no guarantees any of these strategies will work. Creditors are likely to refuse a payment plan unless they think it’s enough to make back the money they’re owed. Finding new investors or a merger partner is difficult in a struggling economy. And it may be impossible to find an extension from the bank that issued a line of credit to your company.

 

Strategies for recovering from insolvency

The best way to avoid insolvency is to keep a close eye on your company’s finances. If you see a red flag, such as a sharp drop in sales or an increase in your company’s expenses, you need to take action as soon as possible. And if your business deals with any type of financial risk, such as a drop in demand for your products or services, you need to have a contingency plan in place so that you can scale back your operations without putting the company at risk.

If your company is already in a state of insolvency, you may be able to negotiate with your creditors to pay off what you owe over time instead of all at once. Creditors are often willing to work with distressed businesses on payment plans as long as they feel like they’ll get their money in the end.

 

Final Words: Takeaway

When it comes to starting a business, there’s no shortage of challenges. One of the most important things you can do to ensure your company’s success is to minimize the risk of insolvency. While it’s impossible to predict exactly when a business is going to run into financial trouble, taking the right precautions and keeping a close eye on your company’s finances can go a long way towards minimizing the risk of insolvency.

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Date
2022-08-26