Here's What Happens When a Company You've Invested in Goes Bankrupt

Not every investment is going to be a success. Some companies may end up falling in value after you invest in them. In a worst-case scenario, it's also possible that a company you've invested in goes bankrupt. Bed Bath & Beyond is one of the most recent examples, but there have been plenty of companies throughout the years that went from being successful to shutting down.

If you own shares in a business that filed bankruptcy, you're probably wondering what happens next. Although this is never good news, the potential outcomes will depend on the type of bankruptcy filed. Businesses normally declare either:

• Chapter 11 bankruptcy
• Chapter 7 bankruptcy

Your stock broker will forward information to you from the company about what's going on. Here's what you can expect to happen and how you can protect yourself from these kinds of situations.

If it's Chapter 11 bankruptcy, there's a small chance your shares survive

A Chapter 11 bankruptcy allows for reorganization and potentially rehabilitation of the business. Most publicly held companies file this type of bankruptcy because they can continue operating their businesses and control the bankruptcy process, according to the SEC. The company will need to file a plan with the bankruptcy court about how it plans to recover.

When a company files Chapter 11 bankruptcy, its shares may continue to trade. They will likely lose a large portion of their value, and they could be delisted from the major stock exchanges.

There are a few potential outcomes if a company you've invested in files Chapter 11 bankruptcy:

• The company cancels its old shares and issues new ones. Your old shares would then become worthless.
• The company continues using its old shares. They may increase in value if it's able to recover.
• The company isn't able to recover. Common stock shareholders will be the last in line to get their money back.

The bottom line is that there's a slim chance the company recovers and continues using its old shares. But it's far more likely that it doesn't recover, or if it does, it issues new shares. Here's what the SEC says on its website about this: "In most instances, the company's plan of reorganization will cancel the existing equity shares."

If it's Chapter 7 bankruptcy, your shares are most likely worthless

Chapter 7 is a liquidation bankruptcy. The business ceases operations, and a trustee is appointed to liquidate its assets and pay off as much of its debt as possible. The payment order is based on bankruptcy laws, with secured creditors taking priority over everyone else.

Unfortunately for shareholders, they're last on the list of who gets paid. It makes sense, because when you invest in a company, you effectively own a share of it. As such, you benefit much more than its creditors if the company is successful. This also means you take on more risk.

While it's theoretically possible that you get some money back, it's highly unlikely. The SEC says that "Stockholders do not have to be notified of the Chapter 7 case because they generally don't receive anything in return for their investment."

Diversification is key

If a company you've invested in goes bankrupt, you could lose most or all of your investment. That's why financial advice always preaches the importance of a diversified portfolio and not investing too heavily in a single company.

A good rule of thumb is to have at least 25 to 30 companies in your portfolio to reduce risk. It's never fun when a company in your portfolio declares bankruptcy. But it's much easier to handle if that's 1 of 30 companies and not 1 of 4 or 5 companies.

Building a diversified portfolio can be time-consuming, and that's why many people choose investment funds. These invest your money in a large number of stocks for you. Instead of needing to pick stocks yourself, you can pick one fund that invests in hundreds of them. A few of the most popular types of investment funds are:

• Exchange-traded funds (ETFs)
• Mutual funds
• Target-date retirement funds

You can find plenty of these investment fund options at any highly rated stock broker. They're an easy way to invest, and a great way to ensure that even if a company goes bankrupt, it won't have too much of an impact on your portfolio.