October 4, 2022

Most early-stage businesses get started because the owner manager has a good idea, which is linked to a specific capability or area of expertise. With a natural enthusiasm for what they are doing, they secure funding for their business, win their first contract, and only then start to realise that they need to develop a wide set of skills to deal with areas such as recruitment, contract negotiations and lender management, as well as putting in place the right systems and processes for managing the finances, especially cash.

Few business plans go as far as including details of how and when directors might decide to exit, and what action needs to be taken if the business starts to experience cashflow difficulties. However, including this type of detail from the start can make it easier for business owners – typically the named directors of a limited company – to manage challenging financial situations if they arise. It’s always good practice to have a plan B.

>See also: Nearly 17% of small businesses at risk of insolvency

Before starting up a business it makes sense for entrepreneurial founders to model the growth trajectory and ensure that pricing levels will deliver a healthy return. The model should be fed with accurate cost data and capital expenditure requirements. The current high rate of inflation, as well as wage inflation, should be factored in. Running viability tests at an early stage of a new operation can also help to draw attention to financial issues that may need to be addressed as the business grows.

Early warning signs

There are likely to be some early warning signs if the business finds itself on the wrong course. For example, if sales targets are missed this could result in the business not generating sufficient revenues, leading to loan repayments being made late. This could mean that a cashflow crisis is looming. Alternatively, customer debts may be mounting up, causing a negative impact on cashflow, but the only intervention needed is a more efficient approach to credit management. Small businesses may lack the bandwidth to maintain a 360-degree view of the business, but this could be crucial to their success.

Business owners should be able to recognise the difference between a temporary cashflow challenge and an insolvent business, so they can seek relevant advice at the earliest opportunity.

>See also: Why the Government’s new insolvency bill is bad news for sole traders

The Insolvency Act

The Insolvency Act broadly defines insolvency as a situation whereby liabilities are exceeded by assets or there is an inability to pay debts when they fall due. Well before the business gets to this point, directors should seek the advice of a professional insolvency practitioner, who will explain the options. One of the most common misconceptions is that the directors of a limited liability company entering into an insolvency process will be disqualified. This is not the case and often the individuals involved go on to pursue successful business careers.

Creditors’ Voluntary Liquidation

By far the most common outcome for an insolvent business is a Creditors’ Voluntary Liquidation (CVL), where the insolvency process is initiated by the directors and shareholders.

In this scenario, the business has reached a point of no return and the only option is to wind up the business.

However, there are other options that could lead to a more positive outcome. For example, financially challenged businesses are sometimes placed into administration, with the appointed administrators exploring opportunities to sell the business as a going concern or sell some of its tangible or non-tangible assets, including intellectual property rights.

From the owner manager’s viewpoint, insolvency might be something which is easier to ignore rather than to address head on. However, taking steps at an early stage to understand the insolvency options is a painless and sensible move that could help them to formulate the right solution at the right time. Early intervention can minimise the financial fallout and help owner managers to take their next entrepreneurial career move with confidence.

Simon Underwood is a business recovery partner at accountancy firm, Menzies LLP

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