Small business failure.
October 20, 2009 3:36 PM   Subscribe

What happens to the owners when a small business fails?

Let's say that Mr. X started a small brick & mortar business. He had a reasonable business plan. He had a bit of savings, but also got an SBA loan as well as a bank loan to finance the rest.

Let's say that Mr. X sets up shop. He works hard preparing, he hires employees, he buys materials, he engages a marketer and advertises and markets the business, opens the doors and... customers just don't come. Let's say he gradually lets the staff go. Still few customers. He tries to find another business that will buy the business he set up. No takers. His hand is forced, and he liquidates the assets and closes the doors. Since he doesn't have a job, he can't repay the remainder of the SBA or bank loans.

What happens next to Mr. X? Does Mr. X lose his home, his car? Does he have to declare personal bankrupcy? Can his business be bankrupt without the risk of him losing his personal possessions?

How can someone wishing to start a small business insulate themselves against the risk of failure? Actual anecdotes about starting a small business and failing would be appreciated.

(Note: I don't own a business -- this is all purely hypothetical.)
posted by eschatfische to Work & Money (14 answers total) 6 users marked this as a favorite
Three words: Limited Liability Corporation.
posted by OldReliable at 3:49 PM on October 20, 2009 [1 favorite]

If Mr. X was wise and either incorporated his business when he set out, or formed a Limited Liability Company (LLC), his personal possessions are not at risk. The corporation or LLC will declare bankruptcy, but Mr. X himself will not.

If Mr. X did not do either of these, then yes, his personal possessions, house, car, etc. are all at risk, and he may have to declare personal bankruptcy.

How can someone wishing to start a small business insulate themselves against the risk of failure?

This is the entire point of incorporation or LLC formation.
posted by DevilsAdvocate at 3:57 PM on October 20, 2009

Mr. X is fine, as long as he formed a corporation. In our legal system, corporations are separate legal entities, and as long as he respected the corporate form (have meetings, keep separate books for business expenses, etc.) as required by his state, his business creditors can't get to his personal assets for business debts. It is very possible, and recommended, to do this even if your business is selling lemonade on the corner because of these limited liability benefits.

If, however, X didn't respect the corporate form; let's say he filed as a corporation but didn't keep separate books for business expenses, never had a board meeting, etc., then his creditors could pierce the corporate veil and get at his personal assets. U.S. corporate law is very form over function that way.

He could also get some of the same limited liability benefits of a corporation under some limited liability partnership agreements and the like, though that gets fairly complex.
posted by craven_morhead at 4:01 PM on October 20, 2009

Response by poster: OK, so let's say that Mr. X created an LLC, and he operated the business as an LLC in accordance with the laws of his state. Realistically, what then happened to the unpaid debts?
posted by eschatfische at 4:04 PM on October 20, 2009

Mr. X's corporation filed for bankruptcy and any assets from the business are used to partially pay back the debts. Most of the debt remains unpaid but the banks absorb the losses.

I'm no a lawyer, but this happened to my father.
posted by muddgirl at 4:09 PM on October 20, 2009

IANAL. Setting up a corporation is great, but in practice, if the corporation's assets are minimal, such as only a small initial investment of cash by a sole owner, then banks, vendors and other creditors are going to demand personal guarantees from the corporation's major stockholders/corporate officers, to be collateral for loans and lines of credit. And insurance companies will be unwilling to write essential types of coverage like key man life insurance policies, and errors and omissions or liability coverage, until they see solid financial performance and growing equity for at least a couple of years. Furthermore, most states' blue sky laws prohibit entrepreneurs from raising capital by selling shares in a new speculative venture to the general public.

In a tight credit environment such as we have today, there is no way that I know of, other than self-funding (or angel funding or VCs, which are alternative "self-funding" in practice), to start a small business without giving collateral or personal guarantees for loans and necessary credit.
posted by paulsc at 4:47 PM on October 20, 2009 [3 favorites]

The outcome of your hypo turns on whether or not Mr. X personally guaranteed the debt of the business. No sophisticated lender would lend to Mr. X in the situation you describe without some security beyond the business's (i.e., LLC's) promise to repay.

Lenders, including the SBA and banks, will require Mr. X to either put up personal collateral for the loan and/or personally guarantee it. Despite what others have said above, under the laws of most states in the US, collateral and personal guarantees are not affected by the form of entity the business has chosen (corp, LLC, etc.).

In your hypo, when the business liquidates with outstanding debt, the creditors will either take the collateral, if any, and/or attempt to collect from Mr. X personally.
posted by dbolll at 4:48 PM on October 20, 2009 [1 favorite]

in practice, if the corporation's assets are minimal... vendors and other creditors are going to demand personal guarantees from the corporation's major stockholders/corporate officers, to be collateral for loans and lines of credit

Yes, this is how lenders often get around the legal protection offered by the corporation. Anecdotally, before my father's small business went under, dogged negotiating got its line of credit extended several times, but essentially all of his personal assets were attached by the bank as non-negotiable conditions of those extensions. What fun.
posted by killdevil at 5:01 PM on October 20, 2009

As a non-hypothetical data point, I can say you're close to describing my situation, except for the failure part (fingers crossed). I'm buying an existing business, but had to form a new LLC to do so, and that LLC (obviously) has no history. So I've had to personally guarantee out the ass in order to get the loan needed to acquire. It specifically says in the bank's offer letter that if the LLC starts falling short on its obligations to them, it won't be long before they're raiding my personal Ameriprise account for repayment. In fact, I also had to allow them to essentially put a "freeze" on (X / .7) dollars, where X = the amount I'm borrowing. That frozen amount is still in Ameriprise, but I can't buy/sell securities. (I believe I'm allowed to reallocate, though.)

After a year or two, if there's a good, respectable pattern of paying down my loan each month, I can have a chat with the bank and request that they remove the personal guarantee, the idea being that by this point, the LLC will have established a good enough track record for them to work from.

All of this, however, applies to the specific bank that loaned me (or rather, the LLC) the money. I don't believe you can extrapolate it so easily to other creditors. For instance, if I screw a vendor out of money down the line, I don't really see what basis they would have to go after my personal Ameriprise assets, the way this bank, who I gave explicit permission to do so, can.

As a side note, in getting insurance coverage, I was never asked for a personal guarantee. That may be because they were content with the financials provided by the current owner, though. Things might be different for a pure startup.
posted by CommonSense at 5:02 PM on October 20, 2009

I wanted to add a comment and a question to Commensense.

The corporation can owe money to the small business owner, since they're legally separate persons. Therefore, the owner can become a creditor when the business declares bankruptcy. This happened with the company my aunt worked for -- she was owed severance and pay in lieu of notice, but that's an unsecured debt at the bottom of the list and the owners of the company had secured debts so even though they were the ones who failed (and re-opened the business under a new name), they were paid before the employees. This company was about 20 years old and had assets belonging to the business, so I guess they were past the stage when the owners would provide their own assets as collateral.

Second, the question to CommonSense, why does the bank freeze so much more money than you owe? Should the collateral be more or less the amount of the debt?
posted by If only I had a penguin... at 5:12 PM on October 20, 2009

It's not easy to get loans. Many people start a business and secure the loan with the equity in their home. If the business is unable to repay the loan, the house is at risk.

I owned a small business. I got a loan from the previous owner, who was anxious to sell, and a loan from a family member. I was able to pay back the loans, make a regular profit and pay my staff, rent and vendors. But my vendors all wanted credit reports. Because it was an established business, they didn't require me to provide a personally secured loan. But every time they sent me inventory, they took some risk. If the business failed, a bunch of vendors could have had a loss. On the other hand, they are happy to have a customer, so it's in their interest to ship me inventory.
posted by theora55 at 5:56 PM on October 20, 2009

if I only had a penguin: It's because the collateral was money market funds, securities, etc. and not just cash sitting in a savings account. They could be liquidated at a moment's notice, of course, but because they've got inherent volatility, the bank builds in a buffer of sorts.
posted by CommonSense at 7:47 PM on October 20, 2009

Can I chip in a bonus question here: What's to stop Mr. X from starting 10 crazy businesses, each failing, if he's personally protected from the risk? What's to stop him from just starting new businesses over and over?
posted by GilloD at 10:00 PM on October 20, 2009

See paulsc's comment above about banks requiring personal guarantees for new businesses with few assets. Banks don't just hand out startup loans for new businesses willy-nilly.
posted by DevilsAdvocate at 10:15 PM on October 20, 2009

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