The last resort of bankruptcy is rising among Main Street businesses across America

Small business bankruptcies are on the rise.

Subchapter V filings — which most small businesses these days are using to reorganize a floundering business — have outpaced filings from 2022. There were 1,659 Subchapter V filings through October, compared with 1,553 for the full year earlier, according to the American Bankruptcy Institute.

It’s become easier in recent years to use bankruptcy as a business owner under financial duress. The Small Business Reorganization Act of 2019 (SBRA) introduced Subchapter V to Chapter 11 of the U.S. Bankruptcy Code. The intention was to offer a simpler and more cost-effective way for small companies to reorganize their debts and get back on their feet. Since then, it has become an increasingly popular tool for troubled small businesses. But knowing whether it’s the right move for your business can mean the difference between a successful repositioning or an epic failure.

Bankruptcy, through Subchapter V or otherwise, may not be the best move for every business feeling a pinch. Here’s what business owners need to know about potential next steps.

Timing is key in declaring bankruptcy

Small businesses shouldn’t wait until the lights are about to be shut off, or assets repossessed, before seeking help from professionals.

“You always hope you can pull a rabbit out of a hat, but knowing when you can’t is pivotal,” said James Mohs, associate professor in the accounting, taxation, and law department at Pompea College of Business at the University of New Haven. 

The first step in moving forward is speaking to a bankruptcy attorney who can help you work through your options, including which type of bankruptcy may be right for your business, based on all the varying factors, Mohs said. 

“The right time to declare bankruptcy is after you’ve exhausted all your other options,” Mohs said.

For instance, is there an option to refinance or issue stock? Do you have friends and family you can turn to or other products you can offer to bring in money? Is a merger or sale of the business an option? What other avenues can you explore without taking on significant risk?

Be wary of short-term funding options

Access to capital for small businesses is at an economic cycle low. After the most aggressive Federal Reserve rate hike campaign in forty years, from zero to above 5% in its benchmark rate in roughly a year, business loans are now in the double-digit percentages. A recent Goldman Sachs survey found that 78% of small business owners are concerned about their ability to access capital, while 53% say they can’t afford to take out a loan in the current interest rate environment. Maybe most alarming, 21% said they would close their business if the credit market doesn’t become less restrictive — the Fed is not currently forecast to consider a rate cut before the middle of next year at the earliest.

Some businesses may be tempted to take a type of funding known as merchant cash advance for short-term funding needs, but piling these on can be a mistake because of the high cost of capital.

With a merchant cash advance, business owners receive a lump sum and repay from future sales, but this can be risky if the business is in a downward spiral. Maxing out your credit cards is also a bad idea.

“You don’t want your business bankruptcy to force a personal bankruptcy because that will ruin you for a long time,” Mohs said.

Protect your assets before it is too late

Bruce Levitt, a partner with law firm Levitt & Slafkes, has gotten calls the day before or after something happens in court, like a landlord-tenant action. Even if a bankruptcy is filed after that, it might not stop an eviction, he said. 

It’s also a good idea to seek advice before spending personal assets such as retirement funds to keep the business afloat, Levitt said. Retirement assets are essentially beyond the reach of creditors, so owners do themselves a disservice by dipping into their retirement funds, he said.

Debt and the costs of business reorganization

Businesses may have several options when it comes to filing for bankruptcy, and the right course to charter will depend on the business, the scope of its troubles, the owner’s intentions for continuing on in business and other factors.

Subchapter V tends to work best for businesses with debts that are mostly straightforward. Using this option, eligible businesses can spread debt repayment over three to five years, a relatively lenient timeline. But there are restrictions. For instance, businesses can’t exceed certain aggregate debt levels, currently $7.5 million.

Subchapter V is quicker and less expensive than a traditional Chapter 11, but there are still costs involved, said Megan Murray, a founding shareholder of Underwood Murray, a law firm that focuses on commercial bankruptcy. It’s not like you throw your business into bankruptcy and avoid legal and administrative fees. “You can’t just walk away,” she said.

It’s also important to consider whether the bankruptcy has a good chance of being successful, Levitt said. If customers have all run for the hills, with little chance of returning, reorganizing the business might not make sense and a Chapter 7 liquidation might be a better option. A Chapter 11 liquidation may also be an option if the owner is trying to sell a business as a going concern, so the company can remain open for purposes of sale, Levitt said.

The downsides of bankruptcy

Owners might be tempted to file for bankruptcy to avoid paying their debts, but there are drawbacks.

Depending on how the business is structured, it could go against your personal credit, which could impact any future loans you want to take out. “If your credit rating is low because of a bankruptcy, it can be hard for you to get credit,” Mohs said.

Also, owners may not realize that details such as your liabilities, including any litigation you’re in, your creditors and your financials, become public. “When businesses file for bankruptcy you have to show and tell. There may be some warts you don’t want the world to know,” Murray said.

Of course, bankruptcy can also be a red flag for customers, vendors and suppliers.

Use bankruptcy only as a last resort

Donald Swanson, a shareholder with the law firm Koley Jessen, said he’s helped hundreds of businesses work through financial challenges, but only put dozens in bankruptcy because there can be better ways to help owners recover.

He offered the hypothetical example of a business owner with $12 million in debt who owns property worth about $10 million and other assets he doesn’t want to sell. Selling the land would still leave the owner with a sizable heap of debt, but if the owner could raise money from friends and family and convince the bank to accept a cash deal, it might be preferable to bankruptcy.

“Once you file for bankruptcy, you are kind of playing your last card,” Swanson said.