Article By: James K. Baer & Caitlin D. Lalezari
8 Tips for Avoiding Insolvency Land Mines
As 2016 comes rushing in, the likelihood of a funding crunch or inslovency is growing and startup companies are having significant trouble securing ongoing financing. Whether or not you believe that this frailty of later-stage funding exists, experts are engaging in open dialogues about it. Charles Crumpley, editor of the Los Angeles Business Journal, recently wrote an article inquiring whether “a Bloodbath [is] coming to Silicon Beach.” Crumpley cited Mark Suster, a reputable Silicon Beach investor, remarking the difficulty in writing checks to tech companies “at later-stage valuations when you know you’ll have to exit into the public markets or sell to a public-market company, and the stocks are declining precipitously.”
The more pertinent issue in this economic landscape is not whether winter is coming, but when and how best to prepare yourself. Corporate directors and officers are facing difficult decisions of determining the future feasibility of their companies, and what to do when continuing on the same course is simply not an option.
Get a realistic picture
It is increasingly important for corporate boards, officers, and major stakeholders to not remain complacent and uphold the status quo when a potential crisis looms in the future. Choosing to be proactive is essential. This begins with the above key players honestly evaluating their company’s burn rates to get a realistic idea of its near term viability on a cash flow basis.
Suster commented that the general sentiment of early-stage investors is to urge companies to lower burn rates altogether and ensure that they have “18 to 24 months of cash.” Companies that have between six and twelve months of burn left in their corporate coffers, with no next-stage funding secured, need to seriously consider next steps.
CEOs understandably lack the desire to objectively cut salaries and to fire non-essential personnel. I have found that roles can often be combined and compensation, if not materially reduced, can be adjusted to include a lower base salary with a commensurate bonus, which tie to actual results. In essence, this creates the ability for a company to hedge and hold its team to actual results.
That which you most fervently desire, you most easily believe. That is to say, passionate immersion in one’s corporate environment may lead to considerable difficulty discerning relative hopes and opinions from objective reality. Where people have vested interests, the truth may be especially skewed. This principle is particularly accurate in the realm of corporate insolvency, where over-optimism reigns.
Whether intentional or out of sheer human nature, there is a tendency for those in management positions to misrepresent the dire realities of a company’s true state — especially when it’s not good news. It is critically important that corporate stakeholders inquire for themselves the rate at which their company is spending its cash and to determine how much longer it truly has before it may hit the wall. Without actively seeking the truth of the company’s financial position, directors, officers, and lenders risk exposing themselves to a loss of reputation, or worse, legal and financial liabilities.
Hire a Professional
In an effort to seek truer objectivity, hiring a consultant to ask the tough questions and get a candid assessment of your company’s state can be the distinguishing factor to avoid those land mines and big surprises. This will set an earnest tone for the company’s management that, while they will retain some flexibility with their decision-making, a vigilant eye is watching.
Hiring a consultant is an effective interim option to set boundaries and address mismanagement or inefficiencies. At the same time, this option also recognizes and can prevent creating strained relationships due to uncomfortable confrontations between management and significant stakeholders. The consultant would spend between five and fifteen hours and compensation for such services can range from $5,000 to $10,000.
Upon making his or her assessments, the professional will likely generate several recommendations, depending on the company’s particular situation. Generally, in the venture capital world, Chapter 7 Bankruptcy, Assignment for the Benefit of Creditors (ABC), consensual restructuring, Chapter 11 Bankruptcy Reorganization (for a company with significant debt and substantial assets), or an orderly shutdown are common recommendations.
Bankruptcy is often one of the least appealing options, as it is an expensive, complicated (at least in Chapter 11), and uncertain judicial process that, in some instances, may have stigma associated with it. In Chapter 7 Bankruptcy, the company has no control over the process, as a trustee is randomly appointed to administer the case and liquidate the company’s assets. Alternatively, in many situations, an ABC may be the best vehicle to accomplish the board’s goals and balance its fiduciary duties to the company. Through an ABC, the company can choose an independent third party as the assignee to whom all corporate assets are transferred in trust. Although a fiduciary to the company’s creditors, the assignee’s interests align with the board’s in that maximizing asset value is a key priority. Moreover, the process is fast, streamlined, and relatively flexible.
In preparing for the inevitable risk that your company might not survive, the following are ten landmines to look out for. While this list is not exhaustive, these are reoccurring issues that, in my experience, often come up, whether your company is restricting money, doing an ABC, or completely shutting down.
1) Budget for Future Payables
Although the general rule is that a company’s board of directors and shareholders are not liable for a company’s debts, the following are exceptions to this rule and other issues to consider. Payroll and payroll taxes, unfunded retirement accounts, and latent personal guarantees should all be areas of concern for potential personal liabilities.
While not personally liable, there are additional concerns regarding the company’s ability to pay D&O insurance and employee severance. Gray areas also arise with regards to accrued employee vacation. Although I have not seen the Labor Board enforce these as personal liabilities, that is not to say that they could not. At the very least, leaving these promised benefits and insurances unpaid would certainly damage the company’s public image and reputations of those associated with it.
A thorough and transparent analysis must be conducted to determine if there are sufficient funds to cover projected or extended costs. Boards of directors and investors need to meet with their company’s CEO and higher management to get an accurate portrayal of the company’s true payables, and make sure that all current and future expenses are accounted for in the event that a shut down is on the horizon.
2) Be Careful of Personal Guarantees
All corporate officers should be extremely aware of any personal guarantees for which they may be liable. It is common for credit card companies, such as American Express ™, to not issue a card to a startup company without requiring the social security number of the CEO, for instance. The CEO will be liable for corporate debts incurred on the card regardless of awareness.
On one hand, company boards and venture capitals do not want the company’s management to be stuck with these liabilities. On the other, this can lead to improper preferences in paying off the company’s liabilities. Not taking heed of hidden liabilities creates precarious situations that would best be avoided by paying attention and planning accordingly.
3) Notice Where Priorities Lie
As I have alluded, it is human nature for people to want to pay off those expenses most near and dear to their hearts. For instance, if there are loans to insiders or relatives, those obligations may be paid off first, even if those funds should ethically or legally be allocated proportionally to all creditors. This occurrence becomes especially true for companies where six months or less of burn remains and the prospect of next-stage funding is meager.
Boards and investors should examine where cash is flowing, particularly in those crucial final months. Hiring a consultant can be an especially valuable tool for such evaluations.
4) Pay Attention to Regulatory Issues
Stay informed of governmental rules and regulations. Such issues may include violations of state or federal law, such as the Worker Adjustment and Retraining Notification (WARN) Act, or federal securities laws.
The company should be aware of whether the advance notice requirement of the WARN Act has been complied with. If the company does not have enough cash to meet payroll, it may in effect be forced to violate the law.
Companies should also pay attention to bridge financing or other stopgap financing alternatives to ensure that adequate legal disclosure of objective risks have been provided. If a company cannot secure long-term financing, and only has a few months of burn left, it is not uncommon for the company to oversell its prospects in order to raise cash on an interim basis. Once those last investors realize the fragility of the company’s financial state down the line, problems may arise if they were led to believe others were amply investing.
For this reason, companies need to address the hazards associated with later-stage investing and disclose, both orally and in writing, all the related risks.
5) Get the Backing of Secured Creditors
If there is a secured creditor, the first question to ask is whether there is enough money for the company to pay off its debts in full. Always have a plan for dealing with your creditors.
Having the support of your secured creditors is crucial, regardless of the exit strategy your company may choose to implement. The company’s assets will not be sold free and clear of secured creditors’ liens if using an ABC. Secured creditors do, however, have an incentive to cooperate with an orderly process. An ABC will spare creditors the time and effort in foreclosing on the company themselves and facilitate a more efficient close out. At the same time, ABCs do not give rise to an automatic stay. This creates the risk of secured creditors foreclosing on their collateral if they do not approve of the exit vehicle.
Ultimately, engaging in open discussions and coordinating with your secured creditors will ensure that your company will be in the best position to allow for an organized and systematic close out process.
6) Avoiding Litigation
In the event that something goes awry, the company may be exposed to litigation. Without an orderly process, management will be left to their own devices. At best, they will not know what to say to creditors. At worst, management could give creditors the impression that they will get paid off in full when that simple is not feasible.
Overselling the company’s position, whether to creditors or late-stage investors, leads to resentment and distrust. The same creditors, who might have been inclined to cooperate with the smooth close out, may go so far as to bring a strike lawsuit out of sheer anger. Similarly, disgruntled employees may seek out legal recourse, whether their suits have merit or not.
Litigation is an expensive, time-consuming process that can have detrimental effects on the reputations of the company and individuals closely affiliated with it. Make sure that your company’s management is not overstating their ability to pay in order to avoid frivolous lawsuits.
7) Keep Records Orderly and Safeguarded
Whether the company’s officers and directors choose to shut down the company’s operations, sell, or mothball it, there are a variety of records that must be safeguarded.
When the ship is sinking, it is not unusual for computers, phones, and documents to start disappearing. Companies should be ahead of the curb, especially in terms of ensuring that records are properly protected. Such records include payrolls, taxes, employee records, and information that would be needed if litigation did arise. If a company is behind on its lease, arrangements can be made to transfer documents into digital form and move records or equipment into a storage facility.
Make sure that electronic and paper copies of documents are accounted for. Hiring an individual to safeguard these records and be a fiduciary to the company is a shrewd way to cover your bases.
8) Don’t Let Time Run Out
It’s easy to rely on internal projections. In my experience, I’ve rarely seen a company underestimate how much time is left. These underestimations are often material, though. Where your company is down to its last six to twelve months of burn, managing its interests in an organized fashion and being in a position to potentially restart in a meaningful way, means facing your realities sooner rather than later.
Companies may fail to consider additional payables, such as accrued vacations, or are overly optimistic that creditors will give them more time or discounts. They fail to appreciate that when a company is declining receivables also become harder to collect.
Ultimately, it is rare that an accurate assessment of shut down costs has been made for a small to medium size company. A general rule to consider is, after employee payroll, payroll taxes, D&O insurance, and secured creditors have all been paid off, the company will need at least $100,000 to fund an orderly shutdown process, such as through an ABC.
The sooner you assess your realistic position, the better off you will be.
About the Authors:
James K. Baer has been a corporate lawyer for thirty years. Big firm trained, he specializes in venture capital financing, among other areas. In that regard, Baer is president and owner of CMBG Advisers, Inc., a boutique firm specializing in restructuring and liquidation of tech companies and other small businesses. He is also of counsel at Glaser Weil. Baer has a unique perspective having been both a corporate venture capital attorney and a restructuring specialist.
Baer can be contacted at (310) 820-9900 or firstname.lastname@example.org.
Caitlin D. Lalezari, Esq. is an associate at Baer and Troff, LLP