Small Business Franchise Bankruptcy by mdv94274


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                           Don B. Bradley III, University of Central Arkansas

                           Homer L. Saunders, University of Central Arkansas


It is recognized that certain well-known disadvantages present a strong element of vulnerability for the
small business firm. The disadvantages are generally referred to as poor or inept management. These
terms include many symptomatic problems or immediate reasons faced by the owner and often leading
into the bankruptcy action. Very little information has been obtained from those who have filed action
under the process of bankruptcy in citing their reasons for their business failure.

The researchers felt that owners of firms undergoing bankruptcy action during this study were there
because of failure to create and implement a business plan initially (or the franchise business plan did
not work) that would considerably reduce or eliminate the well-known disadvantages facing the small
business owner.


Small business is a vital force in the economy. However, the rapidly growing number of small business
firms during the past decade has brought increasingly higher numbers of small business failures. The
American Bankruptcy Institute stated recently that the number of bankruptcies is increasing at a record
pace soon to exceed a million annual filings [2]. Most small business closures are of the type called
"discontinuance." This type has little traceable information regarding the firm's history. The firm may be
sold, merged with another firm, or simply sell the real and personal property items and close the
business without leaving unpaid bills or obligations. Closures through bankruptcy are those where the
small business owner closes the business leaving unpaid obligations, or closure of the firm to avoid
unpaid obligations. Closure through bankruptcy represents only three or four percent of total business
closures [5]. Filing for bankruptcy protection, once fraught with shame and disgrace, has become so
common that some experts are calling it the "growth industry of the decade" [6]. Chapter 11 type of
bankruptcy allows top management to get the firm out of trouble by drawing up a reorganization or
rescue plan, under the direction of the court, that involves restructuring the firm and writing down
(reducing) creditors' claims on its assets [8].

Bankruptcy penalizes everyone including employees and families losing wages and benefits; owners
and/or stockholders losing their investment; trade suppliers losing their investment in products sold to
the failed firm; lenders losing loan investments made to the company; and city, county, state, and federal
tax agencies losing future tax revenues [9].

Mark Alpert refers to the process of bankruptcy as creating a further penalty within the industry because
"a tolerance for failure encourages bad management." The "tolerance for failure" refers to the changes
brought about by the Reform Act of 1978 which allows a firm to "short-change its creditors while
enjoying the protection of federal courts" (1). When companies found that they could engage in
bankruptcy without destroying their business, while consumers were becoming less fearful of
patronizing them, a relaxing attitude developed toward bankruptcy. It was this relaxed attitude that
Sharon Meadows, a restructuring expert at First Boston, said caused "people to borrow a lot of money

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that they had no prospect of paying back" [1]. This left a number of firms with a very unstable capital
structure for their firm. Scarborough and Zimmerman cite a condition called "Resource Poverty" as a
major cause of business mortality. Resource poverty is explained as a lack of adequate capital, business
experience, outside advice, omission of management specialists, as well as a poor location and
inadequate market demand [7]. These cited causes of small business failure fall under the commonly
used terms of "poor" or "inept" management. There seems to be little uniformity when reviewing past
studies reflecting a disarray of suspected reasons for the firm's demise.

Documented reasons for small business failure are difficult to obtain. Facing an increasing number of
suspected reasons stated for small business failure, the over-riding similarity of circumstances found in a
large number of bankruptcy cases seems to point toward the lack of having developed and used a well
thought out business plan. Such a plan should have minimized the number of small business firms
forced into bankruptcy.


This study sought information from the owners of small business firms who had filed action under the
process of bankruptcy. Of course, it is difficult for some owners to discuss their previous business
venture or the problems leading up to the need to file bankruptcy proceedings. A questionnaire was used
as the method of collecting information because a larger sample could be contacted in a limited time
period. A cover letter explained our purpose of the study and assured the respondent that they would not
be identified as a part of the study. The survey sample was selected randomly from a list of firms
involved in bankruptcy obtained from Dun and Bradstreet. Some of the questions asked for demographic
data, as well as questions pertaining to the owners, perceived reasons for their firms' need to file
bankruptcy proceedings. Questionnaires were mailed to 600 owners of businesses who had filed
bankruptcy proceedings with 100 questionnaires mailed to the residents of each participating state
(Arkansas, Louisiana, Missouri, New Mexico, Oklahoma, and Texas). A total of 151 questionnaires
were returned for review. This represented a 25.2 percent return. A larger percentage returned would
have been desirable, yet even this percentage obtained is felt to be meaningful. It was felt that the
causative reasons for the business failure, as stated by the bankrupt owner might reflect greater insight
into the "real perceived reasons" for the business failure. It was felt that future "trouble spots" might be
identified and might be preventable or correctable in minimizing future small business mortality.


Only owners of small business firms that had completed the filing process of bankruptcy action were
considered in this study. Also, only those who were willing to give us the information about their
troubled businesses responded. Information is not available to explain why some of the owners of
business would reply while others would not. The respondents may or may not be truly representative of
the total population. This study was descriptive.

Discussion of Survey Questions:

1. Business origin:

Response Rawscore %

Started a new business 60 40 Purchased an old business 29 19 Bought a franchise 62 41

Total 151 100

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The researchers have been conducting research on bankruptcy for over 12 years, and this is the first time
that a significant number of bankrupt companies were franchises. This leads the researchers to believe
that there may be a number of unscrupulous franchise companies who are preying on people that have
lost their jobs, but received large settlements. The respondents indicated on their own that this was the
case. By looking at these statistics it would seem that it is safer to purchase an existing business than it is
to start a new business or a franchise. 2. What was the major reason for your business going bankrupt?

Response Rawscore %

Lack of capital 47 31 Poor planning 3 2 Lack of qualified workers 33 22 Recession 26 17 Bad location 6
4 Unable to collect bad accounts receivables 19 13 Insurance costs 17 11

Total 151 100

Lack of capital leads the list of reasons for going bankrupt. The new twist in this scenario is that many
of these people were cut off by their bank even though they had a good credit rating because they could
not secure lines of credit or other loans. Lack of qualified workers was second with a 22 percent
response. In this time of high unemployment, it is very disturbing to see small businesses going
bankrupt because they could not find adequate help. The third highest reason was the recession or
economic downturn that presently exists.

3. What percentage of your small business start-up cost was borrowed money?

% Response Borrowed Rawscore %

0 - 20 39 26 21 - 40 13 9 41 - 60 48 42 61 - 80 31 20 81 - 100 20 13

Total 151 100

The largest group was those borrowing 41 to 60 percent with 32 percent response. What is so ironic is
that 26 percent of the small businesses that went bankrupt borrowed from 0 to 20 percent. Sixty-five
percent of those small businesses who filed bankruptcy borrowed 41 percent or more of the money that
it took to start up the business. The researchers have found in past research that anyone who borrows
over 50 percent of the money that it takes to start a business has a much greater chance of bankruptcy.
"After seven-and-a-half years of study, the researchers recommend that a person not start a business
with less than 50 percent capitalization." [4] This research still supports that finding as being true.

4. Do you plan to start another business of your own?

Response Rawscore %

As soon as possible 63 42 Never 32 21 Maybe 13 8 In 3 to 5 years 7 5 Do not know 36 24

Total 151 100

Forty-two percent of those who have filed for bankruptcy intend to open another business as soon as
possible. Part of the reason for this could have been faulty questions designed by the researchers because
some of the people had filed for Chapter 11 or 13, which is reorganization rather than liquidation.
Although the overwhelming percentage of respondents had filed for Chapter 7, twenty-one percent
indicated that they would never reopen a small business again. The small business owners run the

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gambit from this being a very traumatic experience to one of "I could not care less."

5. Did you do any marketing research before the business was opened? Indicate how much.

Response Rawscore %

None 67 45 A great amount 20 13 Average amount 17 11 Very little 47 31

Total 151 100

One factor that has led to bankruptcy is very evident when 45 percent of the respondents indicated that
they did no marketing research at all before opening their business. Only 13 percent indicated that they
did a great amount of marketing research before opening. Also, very disturbing is that 31 percent of the
respondents did very little marketing research before opening. This means that 76 percent of those
responding did either no marketing research or very little.

6. Professional assistance prior to opening: (Check all that helped you prior to opening).

Response Rawscore %

Accountant 48 32 Attorney 38 25 Banker 143 95 Consultant 15 10 SBA 30 20 SBDC 25 17 SBI 3 2
SCORE 17 11 People in the business 95 63 None 4 3

Ninety-five percent of those who filed for bankruptcy had sought professional assistance from their
bankers. The second largest group were people in the business with a 63 percent response. The third was
accountants with 32 percent and lawyers finishing fourth with 25 percent. Evidently, to just consult your
banker or people in the business is not a large deterrent to staying out of bankruptcy.

7. How long did you think it would take for your small business to break even?

Response Years Rawscore %

1 or less 71 47 1 to 2 24 16 2 to 3 28 19 3 to 4 9 6 4 to 5 14 9 Over 5 3

Total 151 100

As has always been the case over our 12 years of researching bankruptcy, the largest number of
respondents were people who felt that they could break even within one year or less after opening their
small business. All experts have realized for years that it takes a minimum of two to three years for most
businesses to break even, but for some reason this knowledge has not filtered down to small business

8. Did you realize a profit on a consistent basis?

Response Rawscore %

No 73 48 Yes 78 52

Total 151 100

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A very interesting finding of this research is that 52 percent of the respondents did realize a profit on a
consistent basis. Unfortunately, many of them had one or two major problems that closed their
businesses. one of the foremost mentioned problems was banks cutting off their line of credit even
though they had always paid on time and had never missed a payment. Many of the small businesses had
unsecured loans turned into secured loans if which they did not have the assets or the capital to meet.

9. Did you do your own bookkeeping and accounting?

Response Rawscore %

No 62 41 Yes 89 59

Total 151 100

The majority of the small businesses that filed for bankruptcy kept their own books. The reason is not
clear to the researchers why 59 percent of these small businesses chose to do their own accounting.

10. Were your records kept current?

Response Rawscore %

No 81 54 Yes 70 46

Total 151 100

The majority of respondents indicated that their records were not kept current. A good indication of why
this happened may have been indicated in the previous question when 59 percent of the respondents
indicated they did their own bookkeeping and accounting.

11. Were you up-to-date with your taxes on your business?

Response Rawscore %

No 85 56 Yes 66 44

Total 151 100

Another indication of business financial problems is a small business' inability to not keep their taxes
up-to-date. It is very disturbing to think that 56 percent were delinquent on their taxes. This could be a
very strong warning sign to other businesses that they are in deep trouble when they cannot afford to
meet their tax obligations.

12. What sex are you?

Response Rawscore %

Male 63 42 Female 88 58

Total 151 100

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The largest response to this question was females, having a response rate of 58 percent. This may not be
an indication that women are more inclined to go bankrupt, but more of an indication that women are
inclined to complete survey forms. Although the researchers have found that over the 12 year period the
rate of women filing bankruptcy has tremendously increased, but so has women entering the small
business world.

13. What is your general age range?

Response Rawscore %

20 - 29 3 2 30 - 39 11 7 40 - 49 47 31 50 - 59 63 42 60 - 69 18 12 Over 69 9 6

Total 151 100

Sixty percent of the respondents to this survey were over the age of 50. This is a trend that is continued
over the 12 years of the researchers conducting this type of research. In our 1991 research we found that
"the largest group was people from the age of 50 to 59, representing 40 percent" of those going bankrupt
[3]. Increasingly, the age of small business people filing for bankruptcy has increased, but also at the
same time Americas has been graying. Even though the graying factor is a part of the increase, the
increase of older American declaring bankruptcy exceeds the aging process.


This study included responses only from owners of small businesses who had completed the filing to
initiate the bankruptcy process. It was felt that additional "perceived reasons" for the need to file
bankruptcy proceedings would be useful in helping other small businesses to avoid the same business
demise. The most commonly "perceived reasons" stated as leading to the filing of bankruptcy included
(1) an increasing number of franchise holders who felt they had not been treated fairly, (2) bank lending
requirements were harder to meet than in the past, (3) lenders were sometimes responsible for
encouraging or enticing borrowers to borrow more funds than they should, (4) lack of operating capital
just prior to filing the bankruptcy action, (5) stricter enforcement of federal regulations, and (6) the
inability to hire employees possessing the skills needed to be effective on the job. These additional
"Perceived reasons" for the need of filing bankruptcy action can also be included under the headings of
"poor" or "inept" management.

The franchise owner is included in this statement as they should have reviewed the business plan offered
by the franchisor more closely and noted areas of weakness or omissions that might directly lead to the
need for filing a bankruptcy action. Consequently, strategic preplanning followed by the early
recognition and correction of later developing obstacles facing the firm is vitally important in
minimizing the number of small businesses being forced annually into business closure.


[1] Alpert, Mark, "Bankruptcies Spreading Blight," Fortune, June 3, 1991, p. 123.

[2] "Bankruptcy Filings Likely to Hit One Million This Year," Associated Press, Arkansas Democrat,
Thursday, Sept. 5, 1991, section D, p. 1.

[3] Bradley III, Don B., and Saunders, Homer L., "Bankruptcy 1990 Style," SBIDA Proceedings, 1992,
p. 177.

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[4] Bradley III, Don B., and Saunders, Homer L., "Retail and Service Business Vulnerabilities That
Could Lead to Bankruptcy", The Journal of Business & Entrepreneurship, March 1989, p. 88.

[5] "Business Failure Records," New York: Business and Economic Division, Dun & Bradstreet, 1987,
p. 1.

[6] Harper, Peter Alan, "Bankruptcy: Era's Growth Industry" Associated Press, Arkansas Democrat-
Gazette, Sunday, August 16, 1992, section G, p. 6.

[7] Scarborough, Norman M., and Zimmerman, Thomas W., "Strategic Planning for the Small
Business," Business, April/June, 1987, p. 13.

[8] "The Kindness of Chapter 11" Finance Section, The Economist, May 25, 1991, p. 83.

[9] Woods, Dorman L. CCE, "Who Gets Hurt by Bankruptcy?" Business Credit, July/August, 1990, p.

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