There comes a time when it becomes clear that managing out-of-business debt is no longer feasible, or when creditors apply excessive pressure. In such situations, liquidation often appears as a practical solution.
Understanding the drawbacks of liquidation can help you avoid making costly decisions under already unfavourable conditions, or it may prompt you to consider alternative approaches.
What is liquidation?
Liquidation is the formal process of winding up a company’s affairs, whereby its assets are sold off and the proceeds are used to settle its debts.
Liquidation occurs when a company or individual is insolvent, meaning they cannot pay their debts as they fall due.
Insolvency can arise from various causes, such as decreased cash flow, increased expenses, poor cash management, excessive trading, natural disasters, or financial crises.
Liquidation typically involves several stages
Decision to Liquidate: If a company is unable to meet its financial obligations, the directors may decide that liquidation is the best course of action. This decision can be voluntary or may be prompted by creditors or the court.
Appointment of a Liquidator: A liquidator, often an insolvency practitioner, is appointed to take control of the company’s assets. The liquidator is responsible for selling the company’s assets and distributing the proceeds to creditors according to a legal priority.
Settlement of Debts: The liquidator collects and sells the company’s assets, uses the proceeds to pay off creditors, and ensures that any remaining legal and financial obligations are addressed.
Dissolution of the Company: Once all assets have been sold and debts settled, the company is formally dissolved, and its legal existence ends.
Types of liquidation
Creditors’ Voluntary Liquidation (CVL): Initiated by the company’s directors when they realize that the company cannot continue operations. The directors prefer this voluntary process over a court-ordered liquidation due to bankruptcy.
Compulsory liquidation- A “winding-up by the court” is a common term for compulsory liquidation. This action is the harshest penalty for a company that violates its fundamental debtor duties. The court normally grants the request of a creditor, the corporation, or its shareholders before ordering the compulsory liquidation.
Members’ voluntary liquidation- The official procedure to wind up a solvent firm is called a members’ voluntary liquidation (MVL). Only solvent businesses are eligible for MVLs, and the board of directors must swear under penalty of perjury that the business is financially stable and able to meet all its responsibilities, including its debts, taxes, and creditors.
Drawbacks of liquidation
- Loss of Control: Once a company enters liquidation, control shifts from the directors to the liquidator. The directors no longer have authority over the company’s operations or assets, which are managed by the liquidator in the interests of creditors.
- Potential for Increased Costs: The liquidator is usually paid based on the work they perform, which can lead to concerns about increased costs if the liquidator extends their workload. This can reduce the amount available to pay creditors and prolong the liquidation process.
- Impact on Creditors: Delays in the liquidation process can be detrimental to creditors, who may have invested substantial amounts or rely on the funds to cover their obligations. In cases where the process is lengthy, creditors might not receive full repayment, and some may not receive anything at all.
- Personal Liability for Directors: Directors who have personally guaranteed the company’s debts remain liable even after liquidation. Additionally, if the directors have overdrawn loans or paid dividends without sufficient profits, they might face further legal action.
- Irreversibility: Once liquidation begins, it cannot be halted. This means that the company must cease operations and sell off its assets, potentially making it difficult for the company to recover or for new businesses to secure loans and credit.
- Job Loss and Supplier Impact: Employees may lose their jobs, and suppliers may lose their contracts or face financial difficulties if the company’s liquidation impacts their business relationships.
- Restrictions on Company Name: Directors may face legal restrictions on using the company’s name or a similar name in future business ventures, limiting their ability to operate under a familiar brand.
- Investigation and Legal Risks: Liquidation often involves an investigation into the actions of the directors and the circumstances leading to the company’s downfall. Directors found to have acted improperly may face legal consequences, including bans from serving as directors or even criminal charges.
- Future Credit Implications: The company’s and directors’ credit histories will be adversely affected by the liquidation, potentially impacting future business ventures or personal creditworthiness.
Understanding these drawbacks is crucial when considering liquidation, as they can significantly impact both the company and its stakeholders. It’s important to weigh these factors carefully and explore alternative solutions where possible.