Business and risk are two sides of the same coin. The risk of unpredictable loss and failure being omnipresent in every enterprise. However, the thing to be noted here is that, there are far reaching ramifications whenever a business goes bust.
Economically perhaps, there is a figure that can be put to it. However, the social impact i.e. the loss of livelihood, the uncertainty, the stigma and the emotional stress individuals, whole families or working communities undergo, is beyond mere numbers and statistics. To know more about the inherent challenges in the corporate world and update yourself on current business information, subscribe to CoffeeMug.
So what actually is bankruptcy and what happens when business goes bankrupt?
Simply explained: when an organization is unable to honor any of its financial obligations or pay off its creditors, it declares bankruptcy. To do this, it files a petition in the court of law. Then the said court, after considering the value of the outstanding debts, directs the same to be paid out, in part or full, from the sale proceeds of the company’s assets.
Here we also need to clear the confusion between insolvency and bankruptcy. Insolvency is a temporary phase due to the inability to immediately pay off matured debts. But when an entity continues to remain insolvent after all possible steps for recovery, it files for bankruptcy.
Bankruptcy is a bitter pill to swallow. The reasons for company bankruptcies is actually an outcome of a variety of business decisions, business environment and a whole lot of varied reasons.
However, the deeper causes of bankruptcies or the larger picture of what happens when a business goes bankrupt needs to be examined in a different light. Outlined ahead are some of the larger causes of bankruptcy:
1. An opaque or unsustainable business model that fizzled out when faced with real time business challenges.
2. Poor financial planning and outlay which resulted in funds being misallocated or important trenches receiving inadequate or late funding.
3. Misinterpretation of customer behavior and market trends which led to inaccurate demand forecast, poor production readiness and over estimation of revenue inflow.
4. Lack of innovation which made the company and its products become obsolete in the face of smarter and more agile competitors.
5. Absence of transparent and open communication channels which led to confusion and misdirected efforts, hampering movement towards the larger goal of profitability and growth.
6. Poor focus on core competencies which led to the drifting of growth and revenue priorities, messing up short and long term plans.
7. Mismatched product and market fit which means that either the product performance was poor or the customer expectations were different, translating into poor or no demand, in turn leading to losses accumulating.
8. Leadership gaps which left the company floundering in competitive waters and eventually leading it to unfortunately sink.
9. Poor response to customer needs and market trends which very quickly slammed the brakes on growth and eventually led to a downward spiral in revenue.
10. Falling for the valuation trap when entrepreneurs get too focused on getting higher valuations which in turn raises investor expectations. Promoters then chase faster growth requiring more cash burn. This can prove fatal in case of a sudden market correction.
If these are the reasons for company bankruptcies we also need to understand the implications of what happens to investors if a startup goes bankrupt. Because, at times the issue of what happens to the investor i.e. the shareholder in case of bankruptcy filing, is largely ignored in the scheme of things, during the entire bankruptcy redressal process.
The investor and the investment is directly impacted in the following manner:
Value of shareholder equity gets wiped out
A company will file for bankruptcy only when it is left with equity that has no value. It logically follows that the value of shareholders’ investments gets massively eroded or completely wiped out.
Dilution of equity
Any company going through bankruptcy proceedings, converts a substantial portion of its debt into equity. This can severely dilute the equity and the newly created equity may or may not have voting rights too.
Payment of dividends are completely and immediately stopped
The Companies Law states that a company does not have any obligation of sorts to pay its shareholders. In case of bankruptcy, debt holders will be the first to be compensated. Hence, all dividend payments are stopped.
New shares less in number and value are issued
With the old shares of the bankrupt company now worthless, a new class of equity shares are issued to creditors and existing shareholders. However, the number of shares or their value is significantly reduced which is actually a loss to a shareholder.
Total relinquishing of management rights
Until filing for bankruptcy, the shareholder appointed management controls the company. Once bankruptcy proceedings are filed the management is given to a trust whose first priority are the creditors and not the equity shareholders.
Conclusion
There are several reasons why startups fail, the most common of which is a lack of mentorship. Proper guidance from the start of the funding process can help to avoid any potential problems. Connecting with CoffeeMug experts will not only provide you with industry knowledge, but will also assist you in dealing with difficult issues and finding a viable solution.
FAQs
Q. What percentage of startup businesses fail?
A. Around 90% of businesses fail. Within the first year, 10% of startups fail. Startup failure rates appear to be similar across all industries. Startup failure is most common in years two through five, with 70% of them falling into this category.
Q. What are the top 5 reasons businesses fail?
A. Poor cash flow management, lack of strategy, poor planning, lack of leadership skills, overdependence on a small number of employees are the top five reasons why startups fail.
Q. What can be done to avoid business failure?
A. To avoid business failure, you must monitor the cash flow, avoid getting into debt, have a strong business plan, provide excellent customer service and learn from your business rivals.
Q. Who gets paid first when a company goes bankrupt?
When a business becomes bankrupt, its assets are divided among its creditors. Secured creditors have priority. Unsecured creditors, come next while stockholders are the last one to receive payment.
