Bankruptcy is a common method for business owners to exit a business venture. Technically, a business is bankruptcy when its liabilities exceed its assets. Most notably, however, when a business fails to produce sufficient profits to continue operations, the result may be the need to shut down the business or to restructure the business’s liabilities (debts).
Shutting down a profitable business is far easier than shutting down a business that has outstanding debts that it cannot pay. In such a case the debtors of the business often argue over who gets paid how much. The bankruptcy process is an orderly way of administering the assets (or cash) of the business to those who have the highest claim of right or priority.
Reorganizing the liabilities of the business is often fraught with disputes with creditors. Again, the bankruptcy process provides an orderly manner of distributing the available assets to those with the highest priority. Reorganization, unlike liquidation, allows the business to continue operations. After the reorganization, the business is treated similarly to a new business entity.
Types of Business Bankruptcy
There generally two types of bankruptcy Chapter 7 (liquidation) and Chapter 11 (reorganization) under the US Bankruptcy Code. All bankruptcy proceedings are federal in nature. As such, bankruptcy law and procedure is relatively uniform across all states (with limited exception for state exemptions).
Chapter 7 Bankruptcy – This is a liquidation of all of the assets of the business. It is an organized procedure whereby all the assets of the business are collected and sold. The value of the assets are distributed to the creditors in the order of their priority. Secured creditors must be either paid in full, or the collateral securing the loan is turned over to the creditor. Unsecured creditors are next in priority. Owners of the business will only receive value from the liquidation once all creditors are paid.
Chapter 11 Bankruptcy – This is a reorganization of the businesses liabilities. It requires the business to put for a plan for using all available profits from operations to pay toward its debts. Secured debts must be paid in full. Unsecured debts receive a payment toward the existing debt for a stated period of time. These payments are almost always less that the actual debt. Once the business makes payments on the debts for a stated period of time, any remaining debt is extinguished. The business is free to continue operations free of the pre-existing debts. The difficulty associated with a Chapter 11 bankruptcy is the ability to work out a payment plan with secured creditors and not have to surrender key business assets.
We discuss bankruptcy in greater detail in our Startup Legal Resources.