When Should an Entrepreneur File for Bankruptcy?

Deciding to file for bankruptcy is a significant and complex decision for any entrepreneur. And while it might seem like waving the proverbial white flag, it can actually be a minor setback that leads to a major comeback.

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Bankruptcy is a tool that can provide a lifeline in situations where debt and financial challenges feel like they’re impossible to tackle. For some—not all—it’s a powerful step toward a fresh start. So, how do you know when to consider bankruptcy as an option?

Let’s explore some signs that bankruptcy may be the right choice, and review the types of bankruptcy filings available to you as an entrepreneur.

Sign #1: Persistent Cash Flow Issues

As an entrepreneur, you know cash flow is the heartbeat of your business. Without consistent income, covering daily operational expenses becomes difficult. Persistent cash flow issues can indicate a deeper problem. This can be especially the case if your income regularly falls short of what you need to pay your suppliers, employees, or operational expenses. If you’re constantly scrambling for funds, it’s a red flag that you may need to take significant action.

Cash flow problems don’t automatically mean it’s time to file for bankruptcy, however. But they’re a sign you need to reevaluate your finances. If cash flow challenges persist despite restructuring, cutting expenses, or increasing revenue efforts, it may be wise to speak with a financial advisor or bankruptcy attorney about your options.

Sign #2: Debts Surpassing Revenue and Profit

Accumulating debt is pretty normal in business, especially in the early stages of scaling. But when your debts consistently exceed your revenue and profit, it’s a serious sign that something is broken. In some cases, entrepreneurs take on more debt, thinking it will solve their financial issues. But if that debt just keeps growing and you’re not seeing profits, you might be in over your head.

Mounting debt can become a vicious cycle. At some point, you may need to evaluate the sustainability of your business. If you’re no longer able to make minimum payments or you’re using one line of credit to pay off another, it may be time to consider bankruptcy. This step can clear your slate of unsecured debt and help you focus your resources on remaining expenses.

As attorney Rowdy G. Williams points out, “The best part about bankruptcy is that your unsecured debts are going to be totally discharged—meaning they go away. That allows you to use your available resources to focus on the other debts and get out of this mess.”

Sign #3: Inability to Secure Additional Financing

When your business is in trouble, you may look to outside financing to stay afloat. But if you’re repeatedly denied financing because of your debt-to-income ratio, low credit score, or lack of collateral, it can be challenging to keep going. When creditors start seeing your business as too risky, this limits your options for moving forward. It may be time to file for bankruptcy.

Lenders look closely at an organization’s financial health before offering a loan. If you’re no longer able to secure additional financing, it may be an indication that your financial situation has deteriorated significantly.

In these cases, bankruptcy can offer relief by halting debt collection efforts, providing you time to reorganize. Bankruptcy could even discharge your debt.

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Types of Bankruptcy for Entrepreneurs Can File For

If you’re facing overwhelming debt, understanding the types of bankruptcy available to entrepreneurs is essential. Bankruptcy isn’t a one-size-fits-all solution, and your options for how you file depend on your business structure and goals.

Chapter 7 Bankruptcy is good for entrepreneurs who are ready to close their business. In Chapter 7, a trustee sells your business assets to pay off creditors. Once the assets are liquidated and debts are paid, any remaining unsecured debts are discharged, meaning you’re no longer responsible for them. This option is commonly used by sole proprietors and partnerships with few assets and minimal cash flow.
Chapter 11 Bankruptcy is often called “reorganization bankruptcy” because it allows businesses to restructure their debts and continue operations. This option is generally more suitable for larger businesses or entrepreneurs who wish to keep their business running. Under Chapter 11, you’ll propose a plan to repay creditors over time. This process requires court approval, and it can be costly and time-consuming. However, it allows you to maintain control over your operations and potentially regain financial stability.
Chapter 13 Bankruptcy is similar to Chapter 11 but is generally only available to individual filers or sole proprietors with a consistent income. It allows you to reorganize your debt and establish a three- to five-year repayment plan based on your income. Like Chapter 11, Chapter 13 lets you retain your assets and work toward debt repayment without shutting down operations.

Protecting Your Future Financial Health by Filing for Bankruptcy

Filing for bankruptcy can have a lasting effect on your financial record, but it doesn’t have to be the end of your entrepreneurial journey. Many successful entrepreneurs have filed for bankruptcy, only to come out on the other side much stronger, using the experience as a springboard to smarter business decisions. With time, you can rebuild your credit and even regain access to business financing.

If bankruptcy seems like a viable option, we’d encourage you to take action sooner rather than later. Waiting until your financial situation worsens can limit your options. When handled proactively, bankruptcy can give you the breathing room needed to reorganize and come back with a more sustainable approach to business.