This blog is all about my story of going from broke (and almost bankrupt) to the path of financial independence. I love sharing ideas for saving, investing, and winning with money. I hope that somehow my story will help others avoid the terrible mistakes I have made in the past. I also want readers to see that it is entirely possible to recover from bad money mistakes and become financially independent! However, today, I am going to talk about the opposite problem — going from millionaire status to bankrupt. Believe it or not, it happens all the time. I make a living representing businesses and business owners in bankruptcy cases. I have routinely witnessed the destruction of great wealth, and in this article I am going to share with you 7 reasons people go from millionaire status to bankrupt. Hopefully, these examples will help you keep and protect your hard-earned success!
1. Failure To Utilize Asset Protection Options.
I have written a separate blog post, entitled Asset Protect Your FI, so I won’t repeat the article here. However, failure to be mindful of available asset protection options is commonly the downfall of my formerly wealthy client. As discussed in my earlier article, there are a number of tools available to legally hold your assets in “protected buckets” that are not subject to creditor attack in the event that you become involved in an unanticipated legal situation. Bottom line: don’t leave your assets unnecessarily exposed when there are many ways to hold assets that will keep you protected from an unforeseen legal liability.
2. Investing in Risky Ventures.
This one is all too common. You’re probably thinking, “thank you captain obvious.” But in reality many of my really smart clients became the victims of risky ventures and lost their fortunes as a result. How does this happen? I call it the cocktail party scenario. When you are standing around with your buddies at a party comparing each other’s successes, you are often asked about your investments. For some reason, no one wants to say, “I invest in low-cost, diversified index funds.” No, that is just not sexy enough. Instead, people want to brag about how their investment choice is super-secret, really complicated, or only available to the elite members of society. What kind of investments am I talking about? Here are a few:
- Illiquid Real Estate Investments: These are usually deals with no pre-defined end game or proper risk evaluation. This might involve speculating on a piece of undeveloped real estate with the empty hope that it is will shoot up in value because some market “expert” told you it would. As you probably guessed, the real estate investment often doesn’t escalate in value and, even worse, the investor borrowed money to keep the deal going. Eventually, the loan comes up for renewal and the bank fails to renew the loan due to a deteriorating real estate market. When the bank calls the loan, the investor doesn’t have the cash to pay and the bank pursues collection against all of the personal assets of the investor.
- Start-Up Ventures: Everyone wants to get in on the hot tech company that has the latest software that is going to make all the ground floor investors rich. You don’t really understand the investment at all, but you certainly don’t want to miss out on the excitement. I have certainly had clients fall in this trap. They cash in their IRAs, borrow against their homes, and go “all-in” on this “once in a lifetime opportunity”. When the spectacular venture goes bust, they lose it all.
- Partnerships: I see these all the time. Ten doctors who may not even know each other are invited to join together in an exclusive opportunity to purchase an office building that is guaranteed to be profitable. They routinely jump at this really cool opportunity and appoint someone they don’t even know as the sole manager of the venture because they heard through the grapevine that the proposed manager has been very successful in the past. When the office building is unsuccessful and all of the tenants move down the street to the hottest new building, they are unable to pay the bank. What follows is a terrible scene — a room full of doctors with lawyers in tow trying to remember why they thought it was smart to invest hundreds of thousands of dollars in the deal and sign a personal guaranty with the bank.
- Business ownership: I am a huge fan of owning a business. I believe it is one of the absolute best ways to build wealth and achieve financial independence. That said, I have witnessed countless businesses fail because the owners are really great at being doctors, lawyers, dentists, architects, plumbers, etc. but really horrible at running a business. Never assume that because your are very knowledgeable regarding a certain professional skill (i.e. medicine) that you will automatically be a great business owner. In some cases, it is simply best to take a paycheck and let someone else manage the financial side of things.
Bottom Line: The best investments are not always the complicated ones. You should never invest in something you don’t understand. Don’t chase complicated, illiquid investment that promise you a fast path to wealth. Instead, continually increase your savings rate (something you can control) and diversify your investments using such vehicles as low-cost index funds.
I commonly hear how really savvy investors use leverage to multiply their success. Leverage is an investment strategy whereby you use borrowed money to increase the potential return on an investment. For example, if you had $100,000 to invest, you could purchase one house with cash, then later sell the house for $110,000, resulting in a 10% return on the investment. Alternatively, you can use leverage to multiply your return by using the same $100,000 to put a $10,000 down payment on 10 homes with a value of $100,000 each and borrow the rest. If you sold all of the homes for $110,000 each, then your profit would total $100,000 — a 100% return on your investment!!
Unfortunately, the use of leverage causes 90% of my clients’ bankruptcy filings. I call it the “musical chairs” effect. If the real estate market is good, then banks are handing out money like candy. In that environment, the investor will develop a neighborhood consisting of 100 residential lots, sell them all, then use the profits to leverage many other real estate acquisitions. This works wonderfully until a 2007/2008 environment strikes, real estate values tank, and the banks call in all of the loans. When that happens, the investor loses virtually all of his net worth to the banks and the purchasers of the lots are hurt because they are stuck with a lot in an unfinished residential subdivision that doesn’t have completed roads, utilities, and amenities. You get the picture.
Leverage is not limited to complex real estate ventures. Every time a consumer purchases a vehicle with 10% down they are using a 10 to one (10:1) leverage arrangement. However, many of my clients apply this form of leverage to acquire homes, second homes, luxury cars, boats, etc. When the “musical chairs” game induced by the current bull market ends, they find themselves with insufficient cash reserves to keep up the shell game and they lose everything. Bottom Line: Don’t abuse leverage. It is a great tool that allows a family to purchase a reasonably priced home, but can destroy your financial success quickly when you abuse it.
Margin is a form of leverage used to invest in the stock market. Similar to my real estate example, a stock market investor can use Margin to control a larger block of securities than they can afford to purchase with cash. Instead of purchasing 20 shares of a company with cash, an investor might use Margin to control 200 shares of stock with the same amount of money using an option contract. One of my clients ended up in bankruptcy after the Margin-based investment crashed and he was faced with a $700,000 margin call! Bottom Line: Don’t use Margin accounts as an investment vehicle unless you have significant cash reserves that allow you to absorb the downside. I prefer that you avoid them altogether.
Another common cause of bankruptcy is growing a business to quickly. The thinking here is understandable. If you have a construction company that makes you $500,000 in profit per year, surely you should be able to increase your profit to $2,000,000 if you open 3 more locations and drastically increase the size of your operation. This works sometimes, but in many cases the cash drain associated with increased debt, equipment and overhead necessary to grow the operation outpaces the profit realization. When that happens, the company simply does not have sufficient cash to fund operations long enough to realize the increased profitability, and a bankruptcy filing ensues. Bottom Line: Bigger is not always better. Find the sweet spot for your industry and stay there. If you have sufficient capital reserves and want to increase the size of your operation, then use a controlled, steady pace of growth that allows you to face the challenges that come along with a bigger business while maintaining adequate cash.
6. Guaranty Agreements.
I cannot stress the importance of understanding this type of agreement. A Guaranty Agreement is an agreement whereby you promise to pay the bank monies owed by a third-party. For example, your LLC business may borrow $2,000,000 to facilitate the construction of a manufacturing plant and pledge all of its assets to secure the loan. However, in virtually all cases, the bank will require that the owners of the business (and sometimes their spouses) to sign a Guaranty Agreement, promising to pay the debt of the business in the event that the business is unable to pay. Many of my clients have guaranteed tens of millions of dollars for companies they own, which led to their financial downfall. Here are a few common misunderstandings about Guaranty Agreements that destroy wealth:
- The bank/creditor can’t go after me because I incorporated my business. FALSE. Although incorporating your business is a great idea and does provide some measure of asset protection, when you sign a Guaranty Agreement you destroy the protection created by the corporate shield. Essentially, you allow the lender to side step the shield and go after your personal assets.
- The bank/creditor can’t go after my assets until all of the business assets are sold. FALSE. Most guaranty agreements allow the lender to pursue the borrower/corporation or the owner/guarantor in any order the bank chooses to proceed. For example, in one case the bank pursued my wealthy guarantor client before looking to the airplane collateral owned by the business and forced him into bankruptcy.
- The bank/creditor will sell the business assets for fair value so my exposure will be minimal. FALSE. Banks and other creditors notoriously fire sale the business assets, resulting in very large deficiency exposure for the guarantors.
- I didn’t understand what I was signing so I can’t be responsible. FALSE. You are held responsible for reading and understanding a Guaranty Agreement when you sign it as part of a business loan transaction. It is your responsibility to have a lawyer review the agreement and explain it to you before signing it.
- I only signed the credit agreement as an officer so they can’t hold me personally responsible. FALSE. Most business credit agreements contain small print that makes you personally responsible, along with the business, for the credit account.
Bottom Line: Avoid signing Guaranty Agreements if at all possible. If you absolutely must sign one, please pay an attorney for an hour of his/her time before signing such a powerful and potentially devastating agreement.
7. Insufficient Cash.
This final issue is a common thread in many of the above-referenced bankruptcy-inducing scenarios. Cash is King. Post it on your wall and read it every day. Many people say “cash is trash” but nothing could be further from the truth. Most bankruptcies could be avoided if the individuals or business owners made it a conscious effort to always maintain adequate cash reserves. If the cash reserve causes you to miss out on a hot investment opportunity so be it. If you can’t finance that second home, then go without. If you have to skip the vacation to somewhere south of the border then stay home. Whatever you do, you must always have cash on hand and lots of it. If you always maintain a healthy stockpile of cash you can survive the loss of a job, a business cycle downturn, or a bad investment outcome. Without adequate cash, you are living in a house of cards. If one things goes wrong, you are risking it all. Bottom Line: Treat cash reserves as your number one priority so that you can always survive a rough patch in the road.
You’ve worked so hard to achieve financial succeed in this world! You’ve saved and invested to provide a secure future for your family. Please avoid the above 7 pitfalls and hopefully you will never land in my office for a consultation.
Have a great weekend!