What To Do When You Can't Pay All Your Creditors

Even in the best of times, small businesses have trouble with liquidity. As you expect customers to pay you for goods and services, business creditors lend capital with the expectation that you will service your borrowing. According to the Small Business Administration, 50 percent of small businesses fail within five years, primarily because they are undercapitalized.

During a recession, liquidity problems often arise if sales or revenues lag before you have a chance to ratchet down expenses. It’s easy to be caught in a cash squeeze, where you have more existing debts than you have money to pay for. What do you do? How do your prioritize who to pay? Here are some simple rules to help you when you can’t pay all your business creditors:

1. If you can, partially pay everyone.  Revolving credit cards, like VISA or MasterCard, already have this provision built in, as long as you make your minimum payment, you aren’t in default. Other business creditors, including trade creditors, probably don’t have this mechanism built in, but that doesn’t mean you can’t talk with them and arrange to pay over time or in installments. If you can do this, you’ll avoid default while preserving good will.
2. Prioritize your own debts or debts you have personally guaranteed.  If you have an LLC or a corporation, you’re usually insulated from most business debts, other than those you’ve personally guaranteed or put on your own credit. One of the reasons you set up an LLC or corporation in the first place is to protect your personal assets. Don’t throw that protection away by defaulting on debts you’ve guaranteed or taken out yourself.
3. Pay business creditors that include acceleration or penalty clauses.  Some debt, such as some bank loans, may become immediately due in full if you miss a payment. Other debt, like credit card debt, includes late fees and/or an increase in interest if you default. Don’t make a bad situation worse by defaulting in a way that will increase what you owe or how quickly you have to pay it back.
4. Avoid cross or universal default.  Some debt instruments, especially some bank debt and some credit cards, have terms stating that if you default on certain other debt(s), it will be considered a default on that instrument too, even if you haven’t missed any payments. Examine your debt for any cross or universal default terms, identify the triggering events, and then avoid them.
5. Keep the big companies happy.  Large, well-established creditors, like banks or the phone company, are more likely to report payment problems to credit rating companies than individual contractors or local businesses. Since cross or universal default (see above) is only triggered when a late payment or default is reported, by keeping the creditors who are most likely to file a report, you can avoid triggering other defaults.
6. Pay for the services you really need.  You can run your business without a water cooler, you can’t run it without phone service. Pay for the mission-critical services before paying for the ones that are indulgences.
7. Pay the people you need the most.  Would you work for someone who doesn’t pay you? If there are vendors or freelance employees you need on an ongoing basis, pay them first. Creditors with whom you had one-time transactions can wait. It’s not that their legal claim is less, but if you can only pay one of two creditors, pay the one you need to keep working with or for you.
8. Pay the people who need you the most.  Especially if you use smaller vendors and independent contractors, they may need your payments to meet their own costs and obligations. First pay attention to rules 1 through 7. You have to keep your own business intact. After doing so, prioritize paying the people who need it the most. After all, you’re a small business, too. You know where they’re coming from.

Getting back to rule 1, you should realize that most people and businesses are reasonable, and they appreciate honesty. If you’re having trouble paying your debts, don’t try to hide it or tough it out. Be open with your business creditors and treat them as partners. They’ll be more likely to work something out with you, and you may find yourself sleeping better, too.