Bankruptcy laws are designed to protect you - the debtor - as well as your lenders. It wasn't long ago that people who couldn't pay their debts were locked away in prisons and forced to survive on a diet of bread and water until they could pay up. If your business fails nowadays you might not be able to afford much more than bread and water, but you can be assured that you won't be sent to jail and that your lenders will be reimbursed in the most fair and equitable manner possible.

Federal law generally allows for two different kinds of business bankruptcy: Chapter 7 and Chapter 11.

Chapter 7 Bankruptcy
Chapter 7 bankruptcy is the most common form of bankruptcy. It involves the total liquidation of the company's assets in order to repay debts owed to qualified lenders. An appointed trustee collects all of the assets that have been designated as non-exempt by the court, sells them, and distributes the proceeds to the creditors.

Chapter 11 Bankruptcy
While Chapter 7 bankruptcy can be described as a liquidation, Chapter 11 bankruptcy can best be described as a reorganization or rehabilitation of the business. The goal of Chapter 11 bankruptcy is to restructure the business and debt payments in such a way as to allow the business to meet its obligations from future earnings. As in the case of Chapter 7 bankruptcy, Chapter 11 reorganizations are also supervised by a court-appointed trustee.

Bankruptcy proceedings can be initiated either by the small business owner or by creditors. Once they have begun, however, both sides are subject to limitations. Business owners are restricted from selling or transferring assets and creditors are restricted from contacting the business owner for the purpose of collecting the debts.

In the event of a bankruptcy, secured creditors (creditors who have collateral for their loans) are paid before unsecured creditors. Typically, the secured creditor will be given the item(s) they have secured as collateral. If this does not fully repay the amount owed to them, the remaining debt will be transferred into the same category as the business' other unsecured debts such as credit cards, utility bills, etc.

Resist the temptation to buy into a scheme that promises to save money by helping you do your own bankruptcy. The stakes are too high and bankruptcy law is too complicated to take yourself on as a client.

Instead, look for a reputable bankruptcy attorney who has a proven track record of success with small businesses. A good attorney may not make it possible for you to avoid bankruptcy, but he might help you get through it with your checkbook - and your dignity - intact.