Insolvency is when a person or a business does not have enough money to pay back debts they owe. Insolvency, bankruptcy and liquidation are all confusing subjects that involve a lot of technical jargon, strict rules and legal obligations. Insolvency is a difficult and often humiliating process to have to go through but with the right advice and support put in place, you might be able to save your finances without having to declare bankruptcy or force your business into liquidation.
Having a healthy, profitable business does not make you immune to insolvency. If that profit is tied up in assets or unpaid invoices when the time comes to repay loans, then you will be officially insolvent and required to find ways to improve your cash-flow.
Remember, insolvency does not necessarily spell the end for you or your business. By acting quickly and enlisting the help of an accountant to produce a forecast, as well as an insolvency practitioner to help with legal proceedings, you could find other ways to repay your debtors without compromising your business, personal possessions, or reputation.
Why do businesses become insolvent?
Insolvency can occur for two different reasons:
1. Cash-flow Insolvency - You are unable to pay debts when they become due.
2. Balance Sheet Insolvency - Your liabilities are worth more than your assets.
Insolvency can happen to anyone if care isn't taken to keep an eye on finances. Some of the most common reasons businesses become insolvent include:
- Not invoicing promptly - Letting contractors get away with late payments is a sure-fire way of falling into insolvency. Make sure you negotiate regular payments from long-term contractors.
- Overtrading - Turning orders down might seem like the last thing you want to do when you're trying to run a profitable business, but if you don't have the stock or resources to fulfil those orders, then you will run into serious financial problems.
- Ignoring stock - Leaving capital tied up in unnecessary stock can hold up cash-flow.
- Not hiring a bookkeeper or accountant - Bookkeeping lies at the heart of all business. Without a good bookkeeper, detrimental mistakes will slip by unnoticed. Keeping your accounts in order will help you to predict any future problems and allow you to take preventative action immediately.
What is an insolvency practitioner?
An insolvency practitioner (IP) is a professional licensed to act on behalf of, or in relation to an insolvent company, partnership or individual. An IP's job is to:
- sell the assets of an insolvent company or individual
- collect money owed to the company or individual
- negotiate with creditors
- distribute money collected after paying costs.
What is the difference between insolvency, liquidation and bankruptcy?
Insolvency, liquidation and bankruptcy are all complicated subjects governed by dense government legislation which can seem overwhelming at times. Getting to grips with all the different rules can be a challenge - especially when your business, possessions, or family home is at risk and the pressure is on to make some crucial decisions.
So, first and foremost, what is the difference between insolvency, liquidation and bankruptcy?
Insolvency: Insolvency is the state an individual or business falls into if they cannot pay back money they owe within the time agreed with creditors.
Liquidation: Liquidation is the legal process of terminating a business and distributing its assets among creditors (those demanding debt repayments).
Bankruptcy: Bankruptcy is, like liquidation, a way of dealing with unpaid debts. While insolvent businesses go through liquidation, insolvent individuals are required to file for bankruptcy. During bankruptcy proceedings, a debtor's assets will be shared out fairly to creditors to free them from their debt and allow them to make a fresh start.
So, in summary, insolvency is the state of not being able to repay debts, liquidation is a formal way for a business to distribute its assets to pay off its debts and bankruptcy is a formal way for an individual to distribute their assets to pay off their debts.
Hiring an accountant as soon as you become, or think you are about to become insolvent could help you to raise funds without having to file for bankruptcy, or terminate your business.
What to do when your business becomes insolvent
There are a number of steps you need to take as soon as your business becomes insolvent. The first thing you should do is enlist the help of a qualified accountant to help you prepare a cash-flow forecast. If your forecast looks good, you are advised to improve your cash-flow by:
1. Finding ways to obtain more finance.
2. Revising the way you manage your working capital.
3. Leasing the assets you need and selling the ones you don't.
If your forecast looks bad and it seems unlikely that your business will survive, you are advised to:
1. Stop trading immediately - trading while insolvent (known as insolvent trading) breaches a number of sections of the Insolvency Act 1986, which can make company directors personally liable for any debts.
2. Consult an insolvency practitioner.
3. Try to pay off as much of your debt as possible.
Recovering from insolvency
If you or your business becomes insolvent, your main aim will be to try to pay off as much of your debts as you feasibly can. There are a number of ways you can do this:
- company voluntary arrangement (CVA) or individual voluntary arrangement (IVA)
- liquidation or bankruptcy.
Company voluntary arrangement (CVA) or individual voluntary arrangement (IVA)
You will need to enlist the help of an insolvency practitioner before taking the CVA route. Your insolvency practitioner will help you to prepare a proposal setting out exactly how you aim to repay your debts. You will then take this proposal to a meeting with your creditors to negotiate the terms of your repayment. If at least 75% of the creditors present at the meeting accept your proposal, then all creditors will be bound by the agreement. Your insolvency practitioner will then collect and distribute your agreed funds until the agreement ends. The IVA works in exactly the same way except the debtor at hand is an individual, not a company.
Administration is a route you can take if recovery looks likely. Firstly, you will need to appoint an insolvency practitioner as administrator. They will take over the running of your business and negotiation with creditors into their own hands. Although the aim of the administrator is to rescue the business, if selling up seems like the better option then they will do this.
During administration, you will be protected by any further action by creditors to recover debts. Administration usually lasts no longer than a year but end dates are negotiable between creditors, debtors and the court.
Liquidation or bankruptcy
If there is absolutely no hope for your business, you may be forced to wind it up via the process of liquidation. Liquidation can occur via two different ways:
- Creditor's voluntary liquidation - When directors of a company decide together that there is no way they can continue without selling off all of the business's assets and drawing it to a close.
- Compulsory winding up - When a creditor owed £750 or more sends an application to court for the debtors to be wound up.
Tips for protecting against insolvency
There are steps you can take to protect your business from insolvency. These include:
1. Bookkeeping - Stay in control of your cash-flow by hiring a bookkeeper to keep accounts in order.
2. Impress your creditors - Build a good relationship with creditors so they are less likely to initiate court proceedings against you if you do ever run into financial difficulties.
3. Know your marketplace - Keep up-to-date with the condition of your marketplace e.g. is it shrinking? Are you losing business to new competitors? Are your suppliers running into trouble? Have you missed out on a technological advancement? Doing your research and being on the ball will help you to forecast any financial difficulties looming, so you can take early measures to protect your business.
4. Business ownership structure - You can reduce the risk of insolvency before you even start your business, by choosing the appropriate business ownership structure.
Starting a limited company offers the highest level of protection against personal bankruptcy out of all the options. This is because:
No directors or shareholders are personally liable for the company's debts.
You can take out Directors and Officers Liability insurance for even more personal protection. Although an attractive option for larger companies, the limitations on cover provided and the cost of premiums can put directors of smaller companies off.
If you wish to start as a partnership, registering as a limited liability partnership (LLP) will give you the protection of a limited company along with the control of a regular partnership.
When you start either a limited company or a limited partnership, you may be asked to sign a personal guarantee with your creditor (the organisation or individual who has loaned you money).
A personal guarantee is a promise you make to personally repay any debts your business fails to pay back. Where possible, avoid signing a personal guarantee as you could end up having to sell off your family home and possessions to pay off your business's debts. However, if the only way to raise necessary funds for your business is to sign a personal guarantee (common in the case of bank loans), then you will need to be very careful indeed. Even if a fixed rate is agreed, the final amount to pay back can as be as much as double your original agreement once fees and interest has been added on.
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