Bankruptcy is not uncommon among construction businesses. Construction companies often pay for much of a project’s costs up front, with the expectation of being paid in a timely fashion by their clients. But this doesn’t always happen — construction payments are notoriously slow, and payment delays can wreak financial havoc on a business’s cash flow.
Even a construction company that is profitable on paper may be forced into bankruptcy if they’re unable to manage their cash flow. If your construction business in the unenviable position of considering bankruptcy, read this article first —some of the industry’s most experienced construction attorneys weigh in with considerations before filing.
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What does bankruptcy mean?
Not all companies are the same, and not all bankruptcies are the same. There are three main chapters of bankruptcy: Chapters 7, 11, and 13.
A Chapter 7 bankruptcy is also known as a liquidation. What does that mean? The important thing to remember with a Chapter 7 bankruptcy is your property and possessions can be seized and sold to repay your debts. Some essential property like clothing (provided it’s not expensive) and household goods will fall into the exempt category. But it’s still a serious consequence to consider, and many businesses who wish to remain open may want to examine other bankruptcy options first.
A Chapter 11 bankruptcy is also known as a reorganization bankruptcy. Business affairs, debts, and assets are typically restructured, allowing the company to repay their creditors over time while they remain in business. However, certain business decisions cannot be made without court approval. This is an option many businesses choose if they hope to remain open, but it is an expensive and complicated form of bankruptcy that should not be entered into lightly.
A Chapter 13 bankruptcy is also known as a wage earner’s plan. It allows individuals — typically sole proprietors — to keep their property and repay their debts over time, usually a period of three to five years. Homeowners can keep their homes and avoid foreclosure under this plan. Individuals who are self-employed or running an unincorporated business are eligible for Chapter 13 as long as the unsecured debts are less than $394,725 and the secured debts are less than $1,184,200. If those amounts seem oddly specific, it’s because they are adjusted from time to time to reflect changes in the consumer price index.
Why would a contractor declare bankruptcy?
There isn’t one singular reason why a contractor would declare bankruptcy. In some cases, it may be through no fault of their own. They could be the victim of late payments — or being stiffed altogether — on a job.
Bankruptcy is almost exclusively the result of cash flow problems. Such problems are caused all too often by partial or delinquent payments, made worse by the failure to implement an effective credit and collections policy. But they can also come from other factors, like an over-reliance on debt, financial fraud, or simply a drop in sales.
Many contractors run into cash flow problems when they fail to budget for retainage. Also known as retention, retainage is the practice of withholding some payment until the end of a project to make sure it is completed according to specifications. Contractors should always budget for this in a cash flow projection report to ensure they can continue operating until they are able to collect retained funds.
A poor debt-to-asset ratio can also be a reason a contractor might declare bankruptcy. How much of the company’s assets are being financed by debt and how much of them are being financed by the owners’ equity?
Two steps contractors should take before bankruptcy
Every business is different, so what worked for one business might not work for another. Bankruptcy is not an option any business should pursue impulsively.
In many cases, there are other steps you can take to resolve cash flow issues. Before a contractor files for bankruptcy, they should take a hard look at two elements of their business: Accounts Receivable (the money owed to you by customers) and Accounts Payable (the money you owe your subs, suppliers, and other vendors).
1. Take action to collect accounts receivable
If you have any amount of money sitting in accounts receivable, take action to collect it. If you still have the right to do so, filing a mechanics lien is the most effective tool that contractors have to collect outstanding payments in most cases.
“Some business owners give up too early instead of retaining legal counsel to assist them in collecting unpaid bills and executing construction liens,” says Cesar Mejia-Duenas, a construction attorney with experience in Florida, New York, and Washington, D.C.
If the lien deadline has already passed or you failed to protect your rights, you may need to hire a construction attorney, file suit in small claims court, or send outstanding accounts to a collection agency.
Regardless of the path you take, some action will be necessary to bring money in the door to cover payroll, bills, and vendor payments.
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2. Negotiate accounts payable
No matter how old your accounts payable are, there is always room for negotiation. Get in touch with the rep for your past due accounts. They will very likely be willing to negotiate, even if it’s only to extend the payment deadline while you resolve the underlying cash flow problem.
Once you file for bankruptcy, it will likely be much harder for your creditors to collect the funds you owe them. They have a vested interest in ensuring that you stay in business.
Should you file for bankruptcy?
At the end of the day, bankruptcy is one option — but it’s not the only one.
“Consider all alternatives and how it might affect the future of your business,” said California attorney George Wolff.
Business owners should never be afraid to seek advice from an experienced attorney, especially one with deep knowledge of both construction and bankruptcy law.
“Although bankruptcy may sometimes appear to be the best possible outcome from a financial viewpoint, it is very important to seek the advice of a bankruptcy attorney that is familiar with construction issues before filing for bankruptcy,” said Bruce A. Inosencio, Jr., an attorney with experience in Michigan and Florida. “There may be a chance, for example, that your company may not ‘qualify’ for bankruptcy because of actions it took before filing. Not all bankruptcy attorneys have the same level of expertise – make sure your bankruptcy attorney has experience with clients in the construction industry.”
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While you can start another business after filing for bankruptcy, a bankruptcy filing can affect your credit rating, which can affect your ability to get loans to start a business. Also, if your new business is too similar to your old and bankrupt one, creditors can attempt to collect from the new business. Talking to a lawyer can answer these questions in greater detail based on your specific case.
“Be aware of the future impact a bankruptcy will have on opening a business in the future,” said Scott Grier, an attorney with experience in Kansas, Missouri, and Oklahoma.
Even if bankruptcy seems like it is your only option, there may be other avenues to consider and a lawyer can help in that regard. Florida attorney David Adlestein says a bankruptcy lawyer is best suited to discuss every available option with you, and help you find the one that’s ideal for your specific business.
Cesar Mejia-Duenas advises business owners to first familiarize themselves with bankruptcy requirements and perform a thorough financial analysis to see if their business is truly bankrupt.
“I would not recommend bankruptcy unless it is the only card on the table, not only because of the legal consequences but also because it leaves the client with the sour taste of failure,” says Mejia-Duenas.
Bankruptcy should also be a part of a business owner’s larger plan. It should not be viewed as a silver bullet that will magically solve all problems. Every owner should ask themselves: What is the long-term plan to keep the business alive and what goal will the bankruptcy accomplish?
“Bankruptcy is expensive and does not always provide the protection that one is seeking,” says Illinois attorney Samuel H. Levine. “This is especially the case if the contractor does not have a viable plan for keeping the company in business.”
Aside from the cost of hiring accountants and lawyers to consult on bankruptcies, it costs money to file them, too. For Chapter 11 bankruptcies, the court charges a $1,167 case filing fee and a $550 miscellaneous administrative fee. Costs are lower for other types of bankruptcy: $235 and $75 for Chapter 13, and $245 and $75 for Chapter 7, respectively.
As long as you understand the risks, Texas-based attorney E. Aaron Cartwright, III offers a different view on bankruptcy.
“Do it —bankruptcy is a tool that all businesses and individuals have access to,” says Cartwright. “If things have gotten absolutely insane in your business life, bankruptcy will provide you a break from the collections efforts, will allow you to settle with some creditors for small amounts of money, and will generally just give you the beginnings of peace of mind. It’s just another tool — not a reflection of you personally.”
Bankruptcy can be a risk — especially in construction
Construction companies can often face unique challenges during bankruptcy proceedings. Carol Sigmond, an attorney with experience in New York, Washington D.C., Maryland and Virginia, said business owners should first evaluate whether the business or the owner should file for bankruptcy. She said, from her experience, most construction bankruptcies fail and become Chapter 7 bankruptcies.
“Construction companies are not good candidates for reorganization,” said Sigmond. “There is generally no good will, no work on the books or other assets to sell. Equipment generally does not generate enough cash to solve problems. Owners and higher tier contractors will find reasons not to pay for work performed. Often, there is debt to workers in the form of back wages or money due to tax authorities that may not be dischargeable. Liquidating 11’s sometimes succeed if either the bank or the surety will back the contractor while it battles with deadbeat owners, but generally, this is not the case.”
Consult professional help
While attorneys are helpful in bankruptcy proceedings as mentioned above, talking to an accountant is also essential before filing for bankruptcy. A qualified tax accountant can help you determine if you are eligible for any tax discharges and when exactly you should file for them.
Accountants can also provide a fair and accurate valuation of a debtor’s assets. If bankruptcy proceedings take place, they can also manage the affairs of businesses during the process to make sure assets are not misappropriated or embezzled.