Tips to wind down your startup
Companies and their investors start with great enthusiasm. But in the life cycle of some companies, the enthusiasm (and funding) dissipates before the company has achieved an attractive sale or IPO. In these instances, as the cash-out date looms, companies and their boards face difficult decisions about how and when to wind down operations.
What follows is a summary of the options that should be considered for the wind down, ranging from an informal winding up to a bankruptcy filing involving a court appointed trustee:
Informal winding up: A state-law wind-down refers to an orderly disposition of assets under applicable state laws, administered by the company itself. The process is quick, non-judicial, and inexpensive. If a company has enough cash to pay all of its outstanding debts, this approach may make sense. The company must dispose of all assets, even those with minimal value, and should evaluate whether any claims against the company could arise in the future. If a company is satisfied that all outstanding issues are resolved, it may file final tax returns, make final payments, and file articles of dissolution with the Secretary of State. However, the company will receive no discharge, and it remains subject to the attacks of creditors unhappy with the process or the distribution. Creditors may commence an involuntary bankruptcy case against the company.
Assignment for the benefit of creditors: An assignment for the benefit of creditors (ABC) is an out-of-court process whereby all remaining assets are transferred to a third-party in trust, to distribute the proceeds of the assets to creditors. The advantages of this process are that the company selects the assignee and then the company’s management is out of the picture, leaving the assignee to address the sale of assets and payment of debts. The assignee is required to pay creditors according to state law. However, the use and statutory protections of ABCs vary widely by state (for example, ABCs are prevalent in California, but not in South Carolina). In some states, like Florida, the state courts oversee ABCs, leading to a slower process and potentially more expensive process than states with less court oversight. Generally, no final court order results from an ABC, leaving the parties at risk of litigation threats by creditors, and nothing prevents creditors from commencing an involuntary bankruptcy case.
Chapter 7 bankruptcy: A Chapter 7 bankruptcy case is meant to liquidate any remaining assets through a court-appointed trustee. The advantages are that, upon filing the bankruptcy case, it provides an official “end” date for the company, and it relieves the company of management duties through the automatic appointment of a trustee. Creditors with questions and claims will approach the trustee and the court, rather than the company, and the bankruptcy binds all creditors through the court’s process. However, this loss of control could be viewed as a disadvantage, and the court involvement provides a ready mechanism for review of the company’s dealings.
Chapter 11 bankruptcy: A Chapter 11 bankruptcy is a comprehensive process for reorganizing or liquidating a company’s assets. The process is expensive, but it allows a company’s management to maintain control (subject to court approval) and to shield itself from creditors as it determines how to reshape the entity. The process can also be used to sell a company’s assets “free and clear” of all liens and encumbrances, so it provides an attractive forum for a buyer.
If a company has secured debt, any decisions concerning the wind down will be made as part of a negotiation with its creditors and driven by the perceived value of the remaining assets.
Overlaying these wind down decisions are the fiduciary duties that officers and directors owe to their stockholders. For purposes of this discussion, we’ll focus on Delaware law given it is the predominate jurisdiction for incorporation.
In USA, and under Delaware law, officers and directors owe a fiduciary duty to the company and its stockholders. These fiduciary duties consist of a duty of care and a duty of loyalty. The duty of care requires directors to adhere to a standard of reasonable care to avoid making business decisions that put the company at risk. The duty of loyalty requires directors to put the company’s interests ahead of their own.
Once a company is insolvent, however, a board must start to take into account other corporate constituencies, most notably its creditors. In broad terms, insolvency occurs when a corporation cannot pay its creditors in full.
Once a company is insolvent, the fiduciary duties for officers and directors shift to maximizing enterprise value. How this objective is achieved can vary from spending the remaining cash in order to achieve a sale as a going concern to ceasing operations immediately and distributing all assets. If a company becomes insolvent and fails to act to maximize enterprise value, its creditors may sue the officers and directors in a derivative action in the name of the company for a breach of their fiduciary duties.
Having a clean and orderly wind down can help to preserve the reputation of a company’s officers and directors, protect relationships, maximize value for the creditors and investors and allow the officers and directors to walk away without lingering loose ends, entanglements or lawsuits.