Key Considerations to Avoid Bankruptcy in a New Company

New businesses should avoid falling into the pit of bankruptcy. Learn how.


Kick starting a business can be a big thing in one’s life. One can say it starts with growing pains to investment headaches, while some consider growing and developing a company is far from easy sailing. However, there is nothing much gratifying than running a successful business of your own.If entrepreneurs lack good ideas, credible insights or proper leadership, then they can nosedive or fall flat, and are also often forced to declare bankruptcy. As a result, this can raise a lot of concerns for the creditors, investors, employer and employees. Similarly, it can also affect a business’ reputation and ruin the trust among the peer group. Even a business built upon an original, solid idea can fail if your financial and managerial skills aren’t up to scratch. 

But then that also doesn’t mean the end of the world for the company or for the entrepreneur. If the bankruptcy is considered early, as soon as the first signs of trouble appear, the company and its assets can actually be benefited through the process. The process of bankruptcy effectively halts all investor and creditor collection against a start-up, while the company gets a second life to restructure or liquidate its assets to pay off the debts. Bankruptcy can also help the start-up to sell its assets without any liens, hindrances or claims. Similarly, it may also help the company by removing the office lease from the equation. 

One of the most preferred forms of conducting business is when the members of a company have the option of limiting their liabilities. A company is a registered association having perpetual succession, a separate legal entity, common seal whose shares are transferable having limited liability. In order to understand the Insolvency and Bankruptcy Code 2016 effectively and to analyse its implementation critically, it is important to understand the pre-existing legal framework on Insolvency and Bankruptcy.

Inception of the Insolvency and Bankruptcy Code 2016

Recognising that reforms in the bankruptcy and insolvency regime are critical for improving the business environment and alleviating distressed credit markets, the Government of India introduced the Insolvency and Bankruptcy Code Bill in November 2015, which was drafted by a specially constituted Bankruptcy Law Reforms Committee (BLRC) under the Ministry of Finance. Formal bankruptcy, particularly for reorganising, has long been out of reach for most small businesses, especially after a ‘reform’ 15 years ago gave creditors more power. 

After a public consultation process and recommendations from a joint committee of Parliament, both houses of Parliament passed the Insolvency and Bankruptcy Code, 2016 (Code). It got a Presidential assent in May 2016. The law was necessitated due to a huge pile-up of non-performing loans of banks and delay in debt resolution.

Insolvency resolution in India took over 4 years 3 months on an average against other countries such as the United Kingdom (1 year) and the United States of America (1 year 5 months), which is sought to be reduced besides facilitating the resolution of big-ticket loan accounts.

Insolvency and Bankruptcy finds a place in the concurrent list of the Indian Constitution (Seventh Schedule). Both State and Central governments can frame laws and regulations to govern Insolvency and Bankruptcy in their respective jurisdictions. The Coexisting List plays a central role in upholding the federal structure of the country. The United States shares a similar structure. Initially, in the United States, insolvency comes under the subject matter of the state, but then once the bankruptcy process commences, only federal laws become applicable. In spite of having dual control policies, there has not been a single case in post-independence India, in which states have practiced their legislative prowess in framing laws either for insolvency or bankruptcy and all responsibility regarding the subject has been left to the centre.

‘‘

If entrepreneurs lack good ideas, credible insights or proper leadership, then they can nosedive or fall flat, and are also often forced to declare bankruptcy.

Understanding Insolvency and Bankruptcy Better

Insolvency and Bankruptcy are two terms that are often used interchangeably but in fact, they are not identical. Insolvency, if defined legally, is a state where a company or individual’s liabilities exceed its or his assets and when the debts or obligations become due for payment, the company or individual is unable to raise sufficient cash for payment. In a common language, an insolvency is a form of financial distress for a company or an individual in which it is not able to pay its debts when due. A number of factors can lead to insolvency for a business concern. These include improper maintenance of accounts and human resource management, which may lead to an incorrect-figured budget, increase in input costs, and lawsuits filed against a company. 

A company can deal with insolvency by taking corrective actions like straightforwardly negotiating with the creditors and restructuring the company’s debt, creating a functional plan to bring down the overhead costs, and generating surplus cash, in which a situation of bankruptcy does not arise. Bankruptcy is a legalised procedure that companies, organisations, and individuals use to deal with insolvency. A company or a start-up files a petition to be declared bankrupt, so as to become qualified for getting government aid when it is unable to pay off its liabilities. 

The two most common types of bankruptcy are Reorganisation Bankruptcy and Liquidation Bankruptcy. Under Reorganisation Bankruptcy, the loan payable by the company is restructured to the debtor’s advantage. Debtors sell off their assets in order to collect money to repay their debt. This is called Liquidation Bankruptcy. All ‘bankrupt’ individuals and companies are ‘insolvent’, but all ‘insolvent’ individuals and companies are not necessarily ‘bankrupt’. Insolvency, most of the time is temporary and can be overcome by effective financial management.

Insolvency Resolution Process for Start-ups

First and foremost, filing a bankruptcy on behalf of your company does not protect you against creditors or investors collecting what they are owed by you personally if you provided them with a personal guarantee. If you operate as a company, LLC or Corporation, your liability is limited. Still, you need to be careful and separate personal from company finances, for example by keeping your bank account separate from the company’s one.  

However, even if you are extra careful to separate your finances, if you were not acting in good faith, the creditors and investors can still go after your personal assets. Start-up business owners may also face bankruptcy if a bank determines the owner is out of formula, meaning that your debt to asset ratio requires your bank to call in a loan. For start-ups or individuals and unlimited partnerships, the Code applies in all cases where the minimum default amount is Rs 1,000 ($15) and above. The Government of India may later revise the minimum amount of default to a higher threshold. The Code envisages two distinct processes in case of insolvencies: automatic fresh start and insolvency resolution.

Under the automatic fresh start process, eligible debtors (basis gross income) can apply to the Debt Recovery Tribunal for discharge from certain debts not exceeding a specified threshold, allowing them to start afresh.

The insolvency resolution process consists of preparation of a repayment plan by the debtor, for approval of creditors. If approved, the DRT passes an order binding the debtor and creditors to the repayment plan. If the plan is rejected or fails, the debtor or creditors may apply for a bankruptcy order.

Timeframe for Completion of the Exercise Under the Code

The Insolvency and Bankruptcy Code 2016 has chalked out the different bankruptcy settling procedures for companies, individuals, and other types of organisations. It allows both the debtors, as well as the creditors to initiate the procedure. The code sets out a maximum timeframe for finishing the insolvency resolution procedure for both individuals and corporates. As per the Code, companies are required to complete the entire insolvency exercise within 180 days. This can later be extended by 90 days just when a majority of the creditors license or do not raise objections on the extension. 

For smaller companies, which also include start-ups with an annual turnover of Rs 1 crore worth of assets, the whole exercise of insolvency must be completed in 90 days and the deadline can be extended by 45 days. However, this doesn’t include a partnership firm. If debt resolution doesn’t happen the company goes for liquidation. The Code has set up the Insolvency and Bankruptcy Board of India (IBBI) as a regulator. It supervises the procedures identified with insolvency in the country and furthermore controls every one of the associations that have been registered by the board. The IBBI has over 10 members, including the Ministry of Finance, the Ministry of Law, and the Reserve Bank of India.

The process of bankruptcy resolution will be administered by licensed insolvency professionals. They would likewise practice control on the debtor’s assets during the insolvency procedure. The Code has also presented two distinct courts for administering the procedure settling bankruptcy, for companies and individuals. These are (i) the National Company Law Tribunal for organisations and Limited Liability Partnership companies; as well as (ii) the Debt Recovery Tribunal for overseeing insolvency resolution for individuals as well as partnership firms. 

An insolvency plea is given to the relevant tribunal in a corporate account holder’s case; it is NCLT by the debtor or the creditor. The plea can be acknowledged or dismissed in at most a timeframe of 14 days. If the plea gets acknowledgment then the tribunal should rapidly appoint an Insolvency Resolution Professional for drafting a resolution plan within 180 days, which can be then extended by another 90 days. 

Along with this, the court would start the way toward settling corporate bankruptcy. For that specific period, the organisation’s directors will stay suspended and the promoters will have nothing to do with the organisation management. The Insolvency Resolution Professional can look for help from the management of the organisation for dealing with ordinary activities. In the cases in which the CIRP is unfit to revive the organisation, at that point the procedure of liquidation will be started.

‘‘

Insolvency and Bankruptcy are two terms that are often used interchangeably but in fact, they are not identical.

The Other side of Bankruptcy 

Of course, the process is not all sunshine and rainbows. There are many downsides to filing for bankruptcy. First of all, it takes a lot of time and money. The processes of liquidation and reorganisation are often lengthy and costly. The high costs in particular often discourage start-up owners from filing for bankruptcy. Obviously, declaring bankruptcy can help relieve you from your legal obligation to pay your debts and save your home, business, or ability to function financially, depending on which kind of bankruptcy petition you file. But it also can lower your credit rating, making it more difficult to get a loan, mortgage, or credit card, or to buy a home or business, or rent an apartment. So, plan your business in advance, learn from others’ failures so that you don’t have to go through these legal proceedings. 

Preeti Verma
Preeti Verma
An alumna of IIMC, Preeti writes on global and domestic business, life cycle of a business and its stages. Her fourteen years of stint includes The Economic Times, Business Standard, Financial Express, Tehelka, Businessworld and Times Internet.

Your View Matters

LEAVE A REPLY

Please enter your comment!
Please enter your name here

Disclaimer: The opinions expressed by columnists are their own, not those of Dutch Uncles

If you wish to contribute or have a story suggestion,
email to editor@dutchuncles.in

Also Read

Rules to Acquire – Mergers and Acquisitions...

Acquisitions and mergers are a major route for many...

Zomato is a Validation that India Can...

Talks of Zomato’s IPO (Initial Public Offering) have been...

Its raining IPOs, What This Means for...

Google is adamant on making it rain IPOs because...

stay abreast!

Never miss key developments & updates from your industry