In what order do I pay creditors, employees, taxes and investors when closing my startup?

Sometimes a new business has to close down completely and that can be for a whole host of reasons. For example, maybe the company raised one round of financing and just couldn’t get another one out the door; or the startup sold everything it owned in an asset sale and then needed to wind everything down. No one wants to think about shutting down while it’s all going good, so that’s usually how it goes.

This post is the first in a two-part series. Here are the main points on shutting down your company.

Not All Debts Are Created Equal

When the money runs out, your creditors line up for payment. They aren’t equal, and the guy at the front of the line is the one with the security interest. Maybe your business has debt; maybe you borrowed from a bank or a non-bank lender to get the shop up and running. If that loan was secured, which means tied to something the business owns, that lender will be able to take their collateral and maybe they’ll recover everything they’re owed. Secured lenders generally get repaid before the unsecured creditors, and before any shareholder receives any restitution. If you’ve got more than one secured loan, they get paid according to seniority. That means the senior (or first) loan gets paid first, then the next. And if you run out of money…? Good time to call an attorney, including a bankruptcy attorney.

The most special debt of all, apparently, is taxes. Taxes are generally the first priority after secured creditors. So that’s federal and state taxes, payroll tax withholding, sales and property taxes, Delaware franchise tax. That means if you don’t have a lot of money, you could end up paying payroll and other taxes (income tax, sales tax, Delaware franchise tax) and walking away with nothing left to settle creditors or to even dissolve the corporation (until the Delaware franchise tax is paid, Delaware won’t take a certificate of dissolution, so you might not even be able to dissolve). So get those government payments lined up and add them to the list.

If you have people who worked for you but didn’t get paid, they get repaid before shareholders do. Oh and the process to dissolve doesn’t end the liability, and managers can be personally liable for their employees’ wages too. State and federal wage laws let the employee go after you, even if the company dissolves. In California involved investors, like VCs, PEs, can be sued for unpaid wages. Look, I know no one can afford to pay the employees if no one else gets paid, so how is this going to help? Here’s the thing. If you aren’t paying employees, you’re behind the eight ball before you even decide to shut down. My advice is never to skimp on payroll to conserve money.

Now, it gets messy. There’s all those creditors that are totally unsecured that start emailing you about payment. Unsecured creditors are the rest of the list. Everyone you owe money to when you close up shop. That includes vendors, outside service providers, contractors, consultants, software subscriptions, and a lot of other lenders (like unsecured business loans). They’re owed whatever’s past-due, but any ongoing contract may be able to be renegotiated or canceled altogether. If you weren’t keeping up with the accounting, now’s the time to figure out where you stand: how much have I been paying you? What am I already owed? What am I going to owe? After you dissolve, the vendors usually can’t come after managers or shareholders personally. The only way to collect is from the dissolved entity. And if you paid the shareholders before you paid the vendors, and the vendors were owed money at the time, the vendor could potentially sue the dissolved entity. So pay vendors’ debts before shareholders’ distributions.

Convertible note investors - whose notes did not convert to stock and SAFE investors - are essentially unsecured creditors. Too often, they’re treated like shareholders by founders who “assume” SAFE investors and convertible notes share the same rights. They don’t. Even though they were promised shares they didn’t get any. They hold a promise that gets them paid if there’s any money left over after all the secured creditors get repaid and the government gets their cut, and all the employees (or managers) who go unpaid get the cash they’re owed, and the vendors, and, and, and. Unless otherwise stated in their agreements, these investors usually expect to be repaid before preferred and common shareholders get paid. They usually assume there’s money set aside for final dissolution costs. Don’t disburse the funds to the shareholders until after the investors are paid.

Back to vendors: most vendors (like SaaS vendors, third-party service providers, consultants) get paid after secured debt, taxes, wages and shutdown costs, and before shareholders and SAFE or note holders. So it’s worth trying to end the contracts. Don’t just stop paying to see what happens - contact an account manager to see what it takes to end contracts early. Often vendors will agree to a release or termination of service if you can show you filed the Certificate of Dissolution. Then there are customers, who may have purchased your product or service under the assumption it would stick around. How do you tell them you’re shutting down? What happens then? Who will they switch to instead? When’s the last day you’ll let people pay through the site? When will you redirect them to another vendor?

Non-cash Things

A new business’ other assets are the non-cash things, like trademarks, domains, patents, software, data, customer lists, laptops and furniture. “What about all the stuff that belongs to the company?” you’re asking. “What if I just want to keep it?” Well, my friend, good question. This is another place owners miss. The assets of the corporation do not revert to the founders. The company has an obligation to make best efforts to convert them into cash for the creditors. It can’t just give them away. Old laptops and furniture may not be worth trying to sell. They lose value fast. They might not even be worth the cost of the sale.

IP you have at your new business can be valuable, depending on the stage, sector, customers (if any) and type of asset involved. Often, a simple “real word” .com domain can be sold for $150K - $500K, and patents can be of interest to companies already building up IP in the same field. There are a few small investment banks who will auction IP, and the process may be worth exploring. If you have customers using your product, it can make sense to shop it around to see if any other company building the same product is interested in buying it. All of these assets, the real-world equipment, the other IP, can generate cash if you’re willing to make the calls, send the emails. But it’s up to you to figure out how much of your time is worth going after them. Customer lists, though, can be trickier because of privacy issues.

How valuable are customer lists or other data, and can you sell them? That depends on what’s on the list, what you agreed in the privacy policy, and which privacy laws apply. For patient data (if you have any), make sure to check HIPAA for rules on transferring or destroying patient records, which can live beyond bankruptcy and dissolution. Make sure you understand whether you’re even allowed to transfer or dispose of medical records and patient files, and what happens if you don’t follow HIPAA. See a privacy attorney first. Do not destroy anything until you speak with a lawyer.

Planning for the Dissolution

Another thing companies miss? Not planning for the dissolution. See, dissolution is complicated. It’s not a one-step, click here and go home process. It may involve specialist counsel, and there may be an accounting of who gets what. It may take time. Time you may not have. It involves employees, wages, vendors, possibly customers and their information, government filings, agencies, fees, and laws you may not know about. Here’s a little secret about shutting down: when founders start this process it’s sometimes too late to pay the investors (and vendors and everyone else) in the right order. Cash is usually tight when the end nears; so the sooner you can plan the costs, the sooner you know how much more cash you’ll need. Also plan enough cash to cover the actual dissolution filing. If you want to make sure you can pay for the accountant, lawyer, DE franchise tax, it helps to start early. Start planning a shutdown budget at least 6 months before the cash is expected to run out, and not 1-2 months before it happens. Six months may still be enough to pay secured creditors and then sell off assets and close up properly. One or two months? Nope.