When creating a business with a partner, few entrepreneurs truly understand how that act intertwines the financial positions of the partners, especially when debt is involved. No one ever thinks about this when business is going well or at the formation of the partnership, but what happens if your business is performing poorly or your business partner files bankruptcy? Where does this leave you?
Many owners create their company, establish partnerships, go to a bank for a loan, and enter the market without further thought. Many believe that just incorporating their business protects them from liability (corporate shield) and because their company bylaws state losses are shared among partners, they will not be left with an unfair proportion of the risk associated with the business. While incorporating your business does limit some business liability, and a good operating agreement or bylaws can mitigate risks also, what these things often do not prevent is personal bankruptcy filings or how debts are handled if your business partner filed bankruptcy.
Most business owner’s think if you created a 50/50 partnership with someone, obtained a loan that you both guaranteed, and then later down the line your business partner filed bankruptcy, that it shouldn’t affect you. That person was supposed to shoulder 50% of the business risk, and their 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. This is irrespective of that happens with the other guarantor(s). So if your business partner filed personal bankruptcy, the likely outcome of that bankruptcy is that the personal guaranty associated with the business loan in question was discharged (assuming they have no assets), leaving you as the sole guarantor for the entire outstanding balance.
In other words, if you have a $500,000 business loan with your business partner, you are each responsible for $500,000, not $250,000 each. Your partner might pay $1,000 of the loan while you pay $499,000 of it. The banks do not care about your partnership. You guaranteed the entire loan!
So, if your business partner filed bankruptcy, your choices are as follows:
- Business Success – This option is pretty obvious. A personal bankruptcy filing of a business partner should not affect the ongoing operations of the business. It will typically only affect the individual and their “stock” or “interest value” in the entity and shouldn’t reach the assets of the company. If the business can still perform profitably, it still has a chance to pay the note payments as originally agreed. However, before making this assumption, you should check your loan documents. Some loans state that a guarantor filing for bankruptcy protection is an act of default under the loan. If that is the case, the loan may be demanded right after the bankruptcy proceedings for your business partner conclude. In that event, options 2-4 are available.
- Buy out the partner – When your partner files for bankruptcy, their 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 this is a large company. The only logical buyer would be you. There might be an excellent opportunity to buy out your partner’s shares for very cheap and get him out of the business. You might as well since you are guaranteeing all the debts, right?
- Loan Modification – If the underlying business is still profitable despite the bankruptcy of the business partner, you can apply for a loan modification to change the terms and conditions of the loan, removing the previous partner all together and assuring the loan gets called into default.
- Debt Workout – If the business is struggling to honor the debt payments or is in default at the time of the bankruptcy filing, a debt workout could strip the debt from the business and allow you to settle your outstanding personal guaranty as well.
- File Bankruptcy – If the business is not able to honor the debt payments and is not a suitable candidate for a workout, you as the remaining partner can file bankruptcy and wind down the company. The business will get liquidated, and your personal guaranty 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 filed bankruptcy, they have left you responsible for all of the remaining shortfall under your business loan. If you are not able to manage your business successfully to pay the loan off as agreed or are not able to negotiate a loan modification intending to avoiding a technical default, your personal guaranty, and the business collateral will be all that remains securing the outstanding loan balance. After liquidating the business collateral, the bank will pursue you for the entire loan balance, even though you once had a 50% partner who was supposed to shoulder some of the losses. Despite what you might hope, the bank and SBA will not write down 50% of your loan because of this and 50% of the obligation is not discharged in bankruptcy. The only thing that gets discharged through the bankruptcy is your partner’s personal obligation under the note.
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, other failed business loans, and divorce are all possible and shared reasons for someone to file bankruptcy – and none of them have to do with the ongoing relationship you and your partner have. Understanding this and understanding your options can allow you to create a plan for such an event which assures your survival and the protection of your business and personal assets.