Tuesday, June 01, 2010
Examining Small Business Financial Distress

University of Illinois Law School Professor Robert Lawless’ recent research into small business owners in Chapter 13 was the topic of an American Bankruptcy Institute podcast (www.abiworld.org).  Lawless notes that we always hear about the “heroic risk-takers” who succeed in their entrepreneurial ventures.  After the fact, we applaud their success stories, but we hear little about those who fail and end up in a Chapter 13 bankruptcy. The code defines a Chapter 13 filer as a debtor who incurs trade credit in the production of income from such employment, and has a regular source of income.

For the year ending 12/31/2007, Lawless finds that 1 out of 7 Chapter 13 filers (14%) are self-employed, and the typical self-employed Chapter 13 filer has no regular source of income.  Further, these self-employed filers are much worse off than other Chapter 13 filers. For example:

  • At 5.8:1, their debt-to-income ratios are almost twice as high as non-self-employed Chapter 13 filers. This ratio means that it will take the debtor almost 6 years worth of income to retire the existing debt.
  • The most common financing mechanisms for these self-employed filers are credit cards and second mortgages. 30% of 2007 filers were underwater on their mortgages.

As Lawless notes, because these businesses may not be incorporated, or if they are, lenders have extracted personal guarantees on the debt, the big financial bets made by these owners often result in a Chapter 13 filing.  The 2005 Bankruptcy Act was written to rein in overspending consumers, but this data show that 1 in 7 of those consumers max out trying to finance their business – and this data reflect conditions before the 2008 financial crisis.

As a nation, we laud entrepreneurship and small business as the economic growth engine.  Simultaneously we admonish lenders for their failure to lend to small businesses.  Lenders can’t be faulted for not lending to risky enterprises and business owners in need of working capital will continue to self-finance with credit cards and second mortgages.  So what’s the solution?  What many small business owners really need is not easier access to capital.  Rather, they need to know the practical tools of  turnaround management and put them to use daily:  identify and track the early warning signs; manage cash with weekly cash budgets; and wring the maximum value from existing working capital.  Wishful thinking is not a strategy and a flawed business model will always fail, regardless of where the capital comes from.

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