The Financially Distressed Business

What should you do when your business is
experiencing tough times

Although business failure might not always be avoided, personal financial disaster for the owners should not always be the outcome. With careful planning and proper management, the proprietors of a financially troubled business can avoid a trip to the personal bankruptcy court.

Clinton W. Daley 

BizJump Quarterly, 2006

matter how much planning and experience that goes into your business, there is no guarantee of success. Business failure is not only painful and psychologically distressing, but it can lead to financial disaster for the proprietors. According to the Small Business Administration (SBA), each year over 10,000 businesses close their doors because of financial insolvency--in many cases leaving the owner (s) in personal financial ruins.

Although business failure might not always avoided, it should not result in personal financial disaster for the proprietors. With careful planning and proper management, the proprietors of a financial trouble business can avoid a trip to the personal bankruptcy court; Or in many cases, they can even turn around the fledging business. In fact, history is littered with incidents of great businesses that were at one point near the brink of bankruptcy--FeDex is one such example.

CAREFUL PLANNING

During the planning stages of a new venture, business owners can begin to minimize their personal financial exposure by: (1) Selecting the right legal form of business (2) Being careful in pledging collateral and personal guarantees to creditors and (3) Maintaining adequate business insurance. 

Selecting the best legal business form

In this case the best legal form of business is one that will limit the personal liabilities of its owners. If business owners select a partnership or sole proprietorship business form, they will be personally liable for business debts and law suits. On the other hand, by choosing the Corporation or and the Limited Liability Company (LLC) business form, entrepreneurs can minimize personal liability for business debts.

Personal Guarantee

In almost all cases lenders will require that the proprietors sign a personal guarantee for business loans. This personal guarantee allows the lender to liquidate the borrower's personal assets if the loan is in default (even if the business is incorporated). Additionally, most other major creditors, including landlords and leasing companies will require personal guarantees. Ideally, business owners should try to avoid signing personal guarantees whenever possible. However, most creditors are unwilling to waive the personal guarantee requirement for relatively new businesses. Still, new business owners can minimize personal liability by negotiating a cap on the amount of the personal guarantee. For example, if the total loan is $100, 000, the borrower may be able to negotiate for a personal guarantee of only $60,000. Another strategy is to request that the guarantee expires after a certain period. One client, who personally guaranteed a business lease for a building for 5 years, insisted that she would only personally guarantee the lease for 2 years. Unfortunately the business went bankrupt after only 18 months of operation. In this case the business owner was only personally liable for $6000 (The 6 months that was left on the lease, times the monthly rent of $1000) as appose to $42,000 if she had personally guarantee the lease for the entire 5 years. 

Collateral

Just like in the case of a personal guarantee, most banks will demand collateral from the borrower to secure the loan. In case of a default, the lender will liquidate the collateral to repay the loan. Common forms of collateral that lenders will require are real estate, stocks, bonds or any other forms of assets that can be easily converted to cash. Based on our firm's experience with lenders, it's very difficult to secure a loan of over $50,000 without pledging collateral. Even if the requested loan amount is under $50,000, most banks will still frown on a deal that is not supported by collateral. According to one banker, "Why should we take the risk, when you [the business owner] don't believe in your business enough to put up your house?" One alternative is to apply for a loan from a government backed micro lender or a SBA guaranteed loan. These institutions are more lax in the collateral requirements than a regular commercial bank.  

Maintain Adequate Insurance.

A fire, an employee mistake or a simple "slip and fall" by a customer can result in financial disaster for small businesses. Small business usually cannot afford a court battle; and even if they win, most small businesses could never stay solvent after a lawsuit. Therefore, it is necessary that business owners secure business insurance to protect them from the aforementioned disasters and other everyday risks of conducting business.

MANAGING THE FINANCIAL DISTRESED BUSINESS

Even if after careful planning, businesses can still get into financial problems. All is not done. It's not too late to turn things around. The following are several short and long term strategies that could be implemented to keep the business afloat: 

1.      Pay employees on time¾ A demoralized staff is arguably the most dangerous threat to an ailing business. One of the fastest way that a business can wreck employee moral is to not pay them on time. Not only will the business experience a decline in worker productivity, but also some employees might even sabotage the business. Of all its financial liabilities, a business must meet its payroll first. 

2.      Take care of "Uncle Sam"¾ Even if the business is incorporated, the Government can still hold you personally responsible for unpaid taxes. There is virtually no escape from tax authorities, even if business owners file for bankruptcy, it's difficult to discharge the business's tax obligations in court. Furthermore, a delay in paying taxes could result in hefty penalties and fines by tax authorities. In addition, not only are Government tax officials not as receptive as business creditors, but also they have the power to immediately shut down the business.  

3.      Don't lie about debts ¾ A knee jerk reaction to a business's inability to meet its financial obligation; usually the first decision that the proprietors make is to apply for a business loan. With creditors banging at their doors, business owners will be tempted to lie to the banker about the business's financial conditions. Business owners know that their chances of obtaining a loan would be slim if they say to banker "Our business is doing terrible" In addition, for the same reasons business owners may be tempted to omit some of their financial obligations from the loan application. However, whether or not the lender asks the owners to list all of their financial obligations, they are still required to do so. In fact, if later on the business file for bankruptcy, the courts may decide that the loan was obtained fraudulently and hold the proprietors personally liable for its repayment. Upon learning that he was about to lose his major customer due to a merger with another company, one client decided to apply for a business loan to offset the cash flow problem that this account loss would cause. Although, this was a proactive move on the part of the business owner, he left out one small detail-he forgot to tell his banker. If he defaults on this unsecured loan, the client may be held personally liable for its repayment. In addition, being under increased pressure to make loans, a common practice among some representatives of financial institutions is to tell borrowers that they should not worry about completing that part of the loan form that ask about debt. However, borrowers must be very careful. Since they will ultimately be responsible for whatever they do or do not disclose. 

4.      Negotiate, negotiate, negotiate¾ In times of financial distress, some very important stakeholders in a business may be the difference between success and failure. It's essential that the business owner negotiate with these very important stakeholders, who are the business's employees, customers and creditors.

Employees- with the job market getting tighter, employees will have a vested interest not to see the business go under. To save on expenses, a business can ask its employees to work less hours (hourly paid workers), or accept lower wages and benefits. Another strategy is to simply ask employees to cut back on routine expenses. Gone are the days when many Dotcoms had catered lunches for employees. In addition to cost savings, in some cases it is possible to raise financing by selling shares of the company to the employees. 

Customers- In cases where the goods and services of a business are indispensable to the operations of its customers, it is possible get customer to assist the business through difficult times. Proprietors can ask its customer to pay faster, for example in 15 days as oppose to 30. In some cases, a customer may be willing to provide financing for the ailing business. For example, a manufacturer of glass window panes was close to bankruptcy when the business was bailed out by his customer-a window manufacturer, which offered a long-term loan to the company.  

Creditors- this group is perhaps one of greatest threat to the solvency of a business. In most cases the ailing business can ask its creditors to delay payments or restructure the debt. One client had his bank convert a line of credit which he had to pay in full within one year, to a term loan, which was payable over a 5 year period. Most times, however, creditors will play hard ball. Some will flatly refuse to help. In this case the business owner should communicate to them that at this point it is something or nothing. If they give you time, you will eventually pay them. However, if they force the business into bankruptcy, then it's likely that everyone will lose. In fact, you can put psychological pressure on your creditors by filling out bankruptcy forms (available at most stationeries) along with other forms when you negotiate with them. 

5.      Manage Cash flow¾ In many cases a business's financial problems are the results of poor management of cash flow. By concentrating on the three major sources of cash flow problem, business owners can drastically turn around their cash crunch problem. These three major sources are accounts payable, accounts receivables and inventory.

Accounts payable- this is money that is owed to creditors- In this case the goal of the business is to pay its bills on or around the last day that payment is due.

Accounts receivable- this is a sale that the business made, but has not received payment. In this case the business must move quickly to collect the outstanding accounts. One strategy is to send out invoice earlier than usual. In addition, the business will have to be firmer with dead beat customers. Ironically, you might have to turn to collections agency or an attorney to collect from them.

Inventory- is usually a significant investment for a small business and can tie up a significant amount of the business's available cash. Typically small businesses not only have too much inventory, but they usually have too much of the wrong inventory. The key strategy for a financially distressed business is to purchase inventory as needed and to only purchase inventory that moves quickest off the shelves.  

6.      Get Help ¾ Unfortunately by the time business owners decide to seek help, it is usually too late. Stubbornness, among other factors result in business owners trying to solve their problems by themselves. However, they would be greatly help by getting the services of a business professional some of there are an experienced accountant, business consultant, the SBA and a business lawyer.  

7.      Protect your personal bank account-You probably did not read it, but the loan agreement (fine print) gives the bank the right to withdraw money from your personal bank account to clear your business debts. In times of financial distress, it is best to move your personal accounts to another bank that you don't do business with.  

If all fails

Albeit a bitter pill to swallow, at times bankruptcy is the only option available. In this case, you will need a lawyer to help you though this difficult phase. But, before you start to feel sorry for yourself, consider this: Many prominent entrepreneurs who have had initial business failures have live to establish and run very successful businesses later. What is important is that you learned from your mistakes for the next time around. And yes, there will be a next time - if you are truly the gutsy fellow entrepreneur that I know you are, there will be a next time.