Surprisingly, despite a bankruptcy filing, small businesses are still able to reorganize and become profitable.  The major difference between those who have filed vs. those who have not, according to a recent report released by the USSBA, appears to be their ability to qualify for future loans and the percentage rates if they do.  Many business owners with a bankruptcy filing in their history, would not even attempt to borrow, most likely for fear of being denied.  This begs the question, does a filing provide a “fresh start” or present a challenge?

Source: Bloomburg Business News, by Karen E. Klein, April 18, 2011

Small business owners who declare personal or business bankruptcy face restricted access to credit and higher interest rates for years. But those who persist with a new or reorganized company can become just as large and profitable as counterparts who have never declared bankruptcy. That’s according to a new report released by the U.S.Small Business Administration, “Beyond Bankruptcy: Does the Bankruptcy Code Provide a Fresh Start to Entrepreneurs?” The research was done by Aparna Mathur, a resident scholar at the American Enterprise Institute, a conservative think tank based in Washington. Mathur, who specializes in economic research on small business, bankruptcy, and tax policy, spoke recently to Smart Answers columnist Karen E. Klein. Edited excerpts of their conversation follow.

Karen E. Klein: Why did you choose to study small companies that had declared bankruptcy?

Aparna Mathur: I had studied bankruptcy and small business as a PhD student. I realized that no one had studied entrepreneurs in a post-bankruptcy scenario. I wanted to know: How do companies that have gone through a bankruptcy compare with those who have not?

How did you do the research?

I used data from the National Survey of Small Business Finances, which was conducted by the Federal Reserve Board in 1993, 1998, and 2003. The survey only questions businesses that have fewer than 500 employees and it contains information about profitability, issues the business is facing, and demographic information about the owners.

The survey asks: Did you file for bankruptcy in the previous seven years? The data is not very precise because it doesn’t ask when they filed. But I found that between 2 percent and 2.8 percent of the businesses in each survey reported a prior bankruptcy.

So you compared those who hadn’t filed with those who had?

Yes, and I found that the bankruptcy system does somewhat of a good job of allowing businesses to come back after a prior bankruptcy. For instance, I did not see significant differences in the two groups on all the big things that concern small businesses: profitability, size of the business by employment, cash flow, health insurance costs, taxes.

The businesses that had filed for bankruptcy were just as large and just as profitable up to seven years later as those who hadn’t.

But they did suffer some negative consequences?

The ones that had a bankruptcy in their past were about 12 percent more likely to be denied a loan than those who had not filed for bankruptcy. Also, the interest rates they are charged were about 1 percent to 1.6 percent higher on all types of financing, including trade credit and credit cards.

The entrepreneurs who reported a bankruptcy were nearly 16 percent more likely to say they would not even apply for a loan, which suggests that we are creating a class of discouraged borrowers who think it is futile to go to the commercial loan market to get these loans, probably because they had been denied so often.

What did you conclude about that?

It makes you question whether the fresh start is achieving its objective fully. It seems these small companies are not recovering or getting back on their feet as fast as the bankruptcy system wants because the market response is to charge them more and be more risk-averse about lending to them.

And yet they seem to overcome those hurdles over time. How do they do it?

We don’t see long-term effects on profitability and firm size. So they might be overcoming it through nontraditional forms of financing. For instance, if they’re unable to access the loan market or they don’t have equity, venture capital firms might be more willing to fund them if they believe in them.

Serial entrepreneurship is a huge phenomenon in the U.S. Entrepreneurs start and fail and they start another business and they fail and they start again. Many of them do end up becoming entrepreneurs one way or another.

Where does this notion of bankruptcy as a “fresh start” originate?

Bankruptcy law facilitates the process of filing and allows individuals or companies that file to recover. For instance, most sole proprietors file for personal bankruptcy, which is Chapter 7. Many states provide generous exemptions so the entrepreneur’s assets are not used to pay off the business debts, including things like cars, jewelry, and other personal property. Other states like Florida and Texas have unlimited homestead exemptions. So even if you own a million-dollar home, it does not have to be used to pay the company debts.

Chapters 11 and 13 are structured around reorganization, so they allow you to come up with a repayment plan and continue with the business. And again, the amount of debt that can be discharged is substantial—similar to Chapter 7.

How does our system compare to other countries?

Places like Europe and Japan are much stricter when it comes to bankruptcy filing. For instance, in the U.S., bankruptcy is purely voluntary. An entrepreneur can decide to get out of a business if it’s not going well and they can file for bankruptcy, even if they have assets. In Europe, bankruptcy is more involuntary; it’s something imposed on you by your creditors.

There’s also much more stigma attached to bankruptcy there and the entrepreneurial climate is not as dynamic because people are more risk-averse. They know that if they fail, there’s little chance they could restart in business with the markets and the people turned against them.

So bankruptcy laws that are considered pro-debtor in many states actually have a positive effect on rates of entrepreneurship?

Yes. Of course, there are pros and cons. The benefit is that they encourage business entry. The costs show up in states with generous bankruptcy protections, where creditors tend to charge higher interest rates and credit is more restrictive in general.