Most business owners think if their business partner files bankruptcy, they aren’t affected. The partner was supposed to shoulder 50% of the business risk, and his personal guaranty is meant to support 50% of the outstanding loan balance, right? Wrong.
When creating a business with a partner, few entrepreneurs truly understand how that act intertwines the financial positions of both partners, especially when debt is involved. No one ever thinks about this at the formation of the partnership or while the business is doing well, but what happens if things go south? Can your partner’s personal bankruptcy affect your business partnership?
Many owners create their company, establish partnerships, obtain a loan and enter the market without further thought. They believe that simply incorporating their business protects them from liability. Furthermore, because the company bylaws state that losses are shared among partners, they assume the risks are proportionate. While incorporating your business does limit some of your liability, and a good operating agreement helps to mitigate risk, the consequences of filing personal bankruptcy are far too often overlooked, as are plans for how to handle the debt if this occurs.
A common misconception is that if both partners guarantee a loan and then one partner files bankruptcy, the other partner shouldn’t be affected. That insolvent partner was supposed to shoulder 50% of the business risk, and his personal guaranty is meant to support 50% of the outstanding loan balance, right? Wrong.
In the world of SBA loans and most other commercial loans, the personal guarantors are “individually and severally liable.” What that means is that each guarantor has guaranteed the entire outstanding loan balance, regardless of the other party. So if your business partner files personal bankruptcy, the likely outcome is that her personal guaranty will be discharged (assuming she has no assets). This leaves you as the sole guarantor for the entire outstanding balance.
In other words, if you have a $500,000 business loan with your partner, you are each responsible for $500,000, as opposed to merely being responsible for $250,000. Your partner might pay $1,000 of the loan while you pay $499,000 of it. The banks don’t care about your partnership, they just want to see the loan repaid by someone.
Yikes!
So what can you do if you find yourself in this situation? Here are your best options.
Stay in Business and Be Profitable
A personal bankruptcy filing of one business partner does not need to affect the ongoing operations of the business. It typically only affects the individual and his “stock” or “interest value” in the entity. In most scenarios, his bankruptcy won’t reach the company assets. So if your business is performing profitably, it has the potential to make the note payments as originally agreed.
Nonetheless, you should check your loan documents, as some loans state that a guarantor filing for bankruptcy protection is an act of default. If that is the case, the remainder of the loan may be demanded right after your partner’s bankruptcy proceedings conclude. In this event, try one of the following solutions.
Buy Out Your Partner
When your partner files for bankruptcy, her 50% ownership in the company is considered an asset to the bankruptcy estate. But a 50% equity position in a privately held company is hard to sell; there just is no market for it—unless yours is a very large company. Therefore, the only logical buyer is you. This is an excellent opportunity to buy out your partner affordably and get him out of the business cleanly.
Request a Loan Modification
If your business is profitable, you can apply for a loan modification. This will change the terms and conditions of the loan, allowing you to avoid defaulting and removing your partner from the loan altogether.
Pursue a Debt Workout
If your business is struggling to honor its debt payments or is in default at the time of your partner’s bankruptcy filing, our business debt elimination services can help strip the debt from your company as well as allowing you to settle your outstanding personal guaranties.
File Bankruptcy
If you’re unable to honor your debt payments and are not a suitable candidate for a debt workout, you can file bankruptcy and wind down the company. The business will get liquidated, and your personal guaranties will be discharged (assuming you have no assets). However, before filing bankruptcy, it is advised that you meet with a local bankruptcy attorney to assess the risks of bankruptcy. Filing for bankruptcy may result in the loss of some or all of your personal assets.
In short, if your business partner files bankruptcy, she has left you responsible for all of what remains on your business loan. Your personal guaranty and the business collateral are now all that remain to secure the outstanding loan balance.
Remember, no one plans to file bankruptcy. When starting a partnership, it is impossible to account for all possibilities that may result in one or more of the partners filing for personal bankruptcy protection. Personal credit card debt, medical bills, underwater real estate and divorce are all possible reasons for someone to file bankruptcy—and none of them have to do with the ongoing relationship you and your partner have. Understanding this as well as your options can allow you to create a plan that ensures your survival and the protection of your business and personal assets.