One of the most rewarding experiences an individual can have is to start and grow his own business. Our economy depends on people deciding to become entrepreneurs. And people with a plan, good financing, attention to detail and a strong work ethic can position themselves to do well financially. But any successful entrepreneur will tell you besides all these attributes, the successful business owner needs a big helping of good luck. Good fortune does not visit every small business. And no matter how diligently a business owner follows processes designed to successfully start and grow a business, bad luck might dash all of the hopes and dreams the business owner had when she set out to start the business.
It’s not uncommon in my practice to meet with individuals who, despite their best efforts, now find themselves with a serious financial shortfall. They come to our office to see whether filing a MN Bankruptcy case can help them out of the financial circumstances they find themselves in. In this blog, I want to discuss the analysis that I use in advising business owners whether to stay open or close, and whether to file a bankruptcy case.
When I meet with business-owner clients, here’s what I look for:
Should the business stay open?
This is the very first thing we have to discuss. The small business owners I meet with share one characteristic: the business owner is extremely invested in the business - in terms of money, time and emotion. The majority, though certainly not all, of the business owners who meet with me tell me that if possible, they would like to keep operating the business. For most of the people I speak with, the difficulties with the business have to do with external factors - that is, that the business plan for establishing and growing the business makes sense and the market for the products or the services is there. Rather, the business owner can point to a short-term cash flow problem that blossomed into a long-term problem, a tax issue, an unexpected competitor in the market that has led them to the financial difficult he or she is facing.
So since the business owner perceives that it is not his or her “fault” that the business is not cash-flowing sufficiently, the business owner tends to want to make the business work, if the external problems can be resolved. While I understand a business owner’s loyalty to her business, assigning fault for the financial problems of the business is not the only job that has to be done to see whether closing the business is advised. I was working on a complex small business case many years ago, when the business attorney for the business met with the owners and me to discuss keeping the business open. He asked four simple questions of the business owners to form an opinion about the advisability of continuing to do business. The answer to these questions will usually lead us to the correct decision about keeping businesses open.
Question #1: Are you paying your employees.
A business owner’s primary responsibility is to pay the business’s employees the agreed-upon wage, in full and on time every pay period. Not meeting payroll, even if it seems like a temporary problem for a business owner, is a serious matter. Minnesota state law says that a business owner must, at a minimum pay the business’s employees the minimum wage for the number of hours the employee worked. Failing to do so exposes the business for a significant penalty. It also should go without saying that missing payroll is a guaranteed way to destroy employee morale and will result in employees at least looking for other positions, if in fact the employees don’t quit their jobs.
Question #2: Are you paying your taxes?
If you are operating your business, you will have to pay income tax, withholding taxes for the people you employ and (if you operate a business that has to pay sales tax) state and local sales taxes. Paying taxes in a timely matter can be financially challenging, but it is absolutely necessary in order to operate your business legally and effectively. Not being able to afford to pay income, withholding and/or sales tax in a timely matter is a serious sign that the business is not financially viable.
Question #3: Are you paying your trade payables?
This is a fairly simple question: is the business paying its bills? Every business needs to use credit periodically to keep current on its trade payables. But if the business is almost always borrowing money by using a line of credit or short-term loan to pay its vendors, that is a sign that the business may not be financially viable.
Question #4: Are you paying yourself?
Many small business owners that I meet with have gone a significant length of time without a paycheck from the business. It is a sign, I think, of the significant emotional investment business owners make in their businesses that individuals are willing to forego their own pay in order to keep the business operating, and keep their employees working for the business. But if you take the long view of this situation, it is easy to see that skipping paychecks is a sign that the business is in serious trouble. There are many non-financial rewards to operating a business. But for almost everyone, it is important that the operation of the business be profitable enough that the owners can support themselves. If this is not happening, it is a sign that the business is not financially viable.
When I meet with business owners and ask them these questions, if I get 3 or more “no” answers, I think it’s time for the owners to think about closing their business. Certainly if taxes and employees are not being paid, I think it is time for a business to close its doors. And trade creditors - the companies that the business pays to provide products and services for the business are typically not willing to indefinitely extend credit to businesses that have a difficult time paying bills on time. Last, at some point individuals who own businesses have to see financial compensation for their efforts, or at some point they will decide that operating a business without getting paid makes no sense when the alternative is to work for someone else and receive a regular paycheck.
Deciding to close a business
If a business owner tells me that he or she has reached the conclusion that continuing to
operate an unprofitable business makes no sense, and they decide to close the business, the first issue that has to be addressed is the timing of the closing. I tell clients there is no magic formula to closing a business, and, particularly in a case in which the business has employees other than the business owner, there isn’t a great way to closing the business. It does take some pre-planning to try to minimize the difficulties that go with closing.
The first thing for business owners to do is pick a date that the business will lock its doors. It’s important to set a date once the decision to close has been made, and depending on the business, that date can either be immediately or sometime in the future. A major voice in setting the date of closing comes from lenders, if the business has any - and particularly secured lenders. The business owner should communicate his or her intention to close the business with the business’s critical lenders once the decision to close has been made. If the lender has a security interest in equipment, inventory and fixtures of the business, it is likely that the lender will want the business to conduct an orderly liquidation of the assets, with the lender significantly involved in the liquidation.
Once the decision to close has been made, the business owner will need to analyze whether the owner has personal liability for the debts of the business. The first step in this analysis is understanding the business form the business used: was the business a sole proprietorship, a partnership, an LLC or a corporation? If the business was a sole proprietorship or a partnership, then all debts incurred by the business is the personal responsibility of the owner/partner. The question gets a little more complicated if the business was an LLC or a corporation. When companies are formed as LLCs or corporations, the obligations of the business are not always the personal responsibility of the owner of the business.
Some utility providers and vendors will create accounts only in the name of the business. The owner has no personal responsibility on the utility bills or on invoices for inventory, supplies or products that the business buys for business use or resale. If most or all of the obligations owed by a business are in the business name only, then when the business closes, the business creditors should be contacted and informed of the closing. In the case where there are assets of the business that when liquidated will produce cash, these cash amounts should be paid, on a pro-rata basis, to the trade creditors. I advise clients in this situation that I believe the owners of the business are entitled to some compensation for liquidating assets for the benefit of creditors; this should be discussed in advance of the sale of assets with both critical lenders and vendors to make sure there is no misunderstanding about whether the business owner will receive some compensation for closing the business and liquidating assets.
Is there personal liability for business debt?
It is very common, however, for business owners (particularly small business owners) to have signed personal guarantees on business obligations. This is routinely done in a situation where a business has a Small Business Administration loan, of if the business has a revolving line of credit, or if the business has credit cards in the business name.
In these situations, where owners have personally guaranteed the payment of business obligations, simply closing the doors and liquidating assets to pay as much as possible of business debt may not be enough to satisfy all of the business creditors who have personal guarantees supporting the debt owed by the business. So a business owner in this situation will have to take another step in the analysis of his or her finances: is the amount personally owed for business debt manageable enough that the owner can, either in one lump-sum, or by making payments, simply pay off the amount owed. If the business owner can make the financial arrangements to pay off the creditors to whom the owner is financially responsible, then the wrap-up of the business, while not easy or simple, is something that can be accomplished without creating a lot of financial strain on the owner.
The problem with many of these scenarios is that the business owner, particularly the owner who has not been receiving a regular paycheck from the business, has often been borrowing money to pay personal living expenses. The owner’s personal- and business-related debt becomes intertwined inasmuch as the unprofitability of the business results in the owner having to use credit cards or lines of credit to pay for housing, groceries, clothing, etc.
If the business owner has racked up personal debt because of the lack of cash flow of his or her business, it can be difficult for the owner to come up with sufficient cash to pay off trade creditors and pay personal living expenses at the same time. Couple that with the fact that many business owners who close a business often face a period of unemployment after the business closes, and it’s easy to see that the financial difficulties of the business can leak over and negatively effect the owner’s personal finances. If that happens, then business owners are smart to look at the possibility of filing a bankruptcy case to resolve the debt issues of the business, and, in many cases, the debt issues caused by the business downturn in the personal affairs of the business owner.
That’s the subject for next week’s blog: if you file a bankruptcy case, do you do so personally, or does the business file, or both?