What is the difference between a Chapter 7 liquidation and a Chapter 11 reorganization?
Takeaway: Chapter 7 is a corporate death sentence—a total liquidation of all assets—while Chapter 11 is a "reorganization" that provides a struggling company with a legal shield to restructure its debts and attempt to emerge as a viable business.
When a company is facing severe financial distress, the U.S. Bankruptcy Code provides two primary paths for resolving its situation: Chapter 7 and Chapter 11. The difference between them is profound. One is a process for liquidating a business that is beyond saving, while the other is a process for giving a struggling business a second chance at life.
Chapter 7: The Liquidation
A Chapter 7 bankruptcy is the end of the road. It is a formal, court-supervised process for conducting a complete liquidation of the company.
How it Works: The company ceases all operations. A court-appointed bankruptcy trustee takes control of all the company's assets. The trustee's job is to sell off (liquidate) all of those assets for cash.
The Payout: The cash proceeds are then distributed to the company's creditors in a strict order of priority defined by the bankruptcy code. Secured creditors (like a bank with a lien on the company's assets) are paid first, followed by unsecured creditors. The stockholders are last in line and, in a Chapter 7 liquidation of an insolvent startup, they almost never receive anything.
The Outcome: After all the assets have been liquidated and the proceeds distributed, the corporate entity is effectively dead.
Chapter 11: The Reorganization
A Chapter 11 bankruptcy is a much more complex and hopeful process. It is a reorganization, not a liquidation. The goal of Chapter 11 is to give a company that is still fundamentally viable but is burdened by too much debt a chance to restructure its finances and emerge as a healthy, operating business.
How it Works: When a company files for Chapter 11, it is immediately protected from its creditors by an "automatic stay." This freezes all lawsuits and collection efforts, giving the company breathing room to work out a plan.
The "Debtor-in-Possession": Unlike in Chapter 7, a trustee is not usually appointed. The company's existing management team remains in control of the business, a status known as the "debtor-in-possession."
The Plan of Reorganization: The company, working with its creditors, develops a formal Plan of Reorganization. This plan details how the company will restructure its business and pay back its debts over time. The plan must be approved by the creditors and confirmed by the bankruptcy court.
The Outcome: If the company can successfully implement its plan, it can emerge from Chapter 11 as a new, financially healthy company, often with its old equity wiped out and a new ownership structure controlled by its former creditors.
For most venture-backed startups that have run out of money and have no immediate path to profitability, a Chapter 7 liquidation is the more common outcome. A Chapter 11 is typically only a viable option for a more mature company that has real revenue and a fundamentally sound underlying business that is simply over-leveraged.
Disclaimer: This post is for general informational purposes only and does not constitute legal, tax, or financial advice. Reading or relying on this content does not create an attorney–client relationship. Every startup’s situation is unique, and you should consult qualified legal or tax professionals before making decisions that may affect your business.