Practical Ecommerce

Planning for failure

Among the initial tasks of starting a company is to organize a business plan. It’s the first of many plans in the life of a business. After all, a well-managed business is planned — for its future, for its growth, and for the unexpected.

There are marketing plans, investment plans, disaster recovery plans, and, for some, exit plans. There is one plan that is not frequently discussed, however. It is often overlooked.

What happens if the business goes bust?

No one wants to admit failure, nor would anyone want to plan for failure. Every business owner wants to succeed. So why take the time to consider failure?

Well, why not? A good business should have a disaster recovery plan, to minimize loss and disruption. That includes a financial disaster.

Business owners are typically the last to admit that their company is failing. By the time an owner acknowledges a problem, it is often too late to minimize the effects.

A business goes bust when it can no longer pay its bills on time. In the U.K., that means the business is insolvent. In many cases, debt builds up with suppliers and banks, whilst the company continues to trade in the hope that it can recover. Money put aside for taxes or rent gets used for immediate bills.

Business owners sometimes pay bills out of their own pockets to keep the company afloat. Personal loans are taken out. Occasionally, this can be a good idea if a known payment is due to arrive, or a large order is about to be signed. But, taking out loans or paying from personal accounts is often fueled by hope. The debts increase and personal reserves dwindle.

Personal liability

In the U.K. and other countries, companies that are incorporated protect their owners and directors from the business’s debts. However, there are three things that can breach this “corporate veil” and make the owners and directors personally liable.

  • Trading whilst insolvent. If the company is insolvent — there are technical measures for this — and continues to trade, the directors become liable for any debt from this point.
  • Loan guarantees. Some vendors — such as banks, landlords, and suppliers — require owners and directors to personally guarantee the loans of the business. This means that if the company cannot pay, the owners and directors are responsible.
  • Illegal dividends. In the U.K., many accountants advise directors and shareholders to pay themselves in the most tax efficient way. This usually means a small salary (about $13,000 per year) and taking the rest as dividends. This is because the first $13,000 of salary in the U.K. is tax-free and the dividends are taxed at a lower rate than salaries. The problem with this is dividends must come from accumulated profits. If a company becomes insolvent there are no accumulated profits, all dividends paid from that point become illegal. The director and shareholders have to repay such dividends to satisfy the company’s debts.

To avoid these circumstances, owners and directors first and foremost must be realistic and recognize when the company becomes insolvent. At that point, the company must stop trading. Don’t continue blindly in the hope that all will be well. Indeed, act before the company becomes insolvent, as financial options are limited afterwards and an improper response could get you in trouble.

Minimizing risk

As a company owner, minimize your financial and legal risk that comes with insolvency. First, draw up a list of all your suppliers and providers to whom you have provided a guarantee. Pay them first, always. You cannot do this preference if the company is insolvent.

Try to change suppliers to those that do not require a personal guarantee. Failing that, start reducing the credit levels on those suppliers.

If you have an overdraft with the bank that you have personally guaranteed, tell the bank if the company becomes insolvent. This will prompt the bank to apply any customer payment you receive to reducing the overdraft. This is a preferential payment being “forced” by the bank and you cannot be held accountable to other creditors.

Also, review the structure in which you pay yourself, as the owner. Take the tax hit and pay yourself a salary. Stop playing games with dividends. It’s morally responsible, as a citizen, and the salary payments cannot be clawed back by the creditors.

These actions to minimize risk would not affect the profitability of the company. They provide more latitude to trade out of any difficulty so the company can grow, and recover. But, if the worst happens and the company goes under, the actions will protect you as the owner and reduce the damage to your personal finances.

email-news-env

Sign up for our email newsletter

Comments ( 2 )

  1. Carlos Rivera March 9, 2017 Reply

    One of the reasons why I enjoy reading your articles so much is because you discuss important topics no one else is willing to talk about. Another gem! I learned a lot. Thank you!

    • richard stubbings March 9, 2017 Reply

      Thanks for your continued support. No-one wants to think of failure, but if the worst should happen, the way you have administered the business in the last few years may have a massive impact on what happens to your personal finances. Small changes that do not affect the business can have dramatic effect on your circumstances on a failure.