Venture-funded startups that are still in development or not yet at cash flow breakeven may end up at a point where they have no more cash. Some will be able to raise a new round in time. Some won’t. Here’s a guide to your options if you get there and your investors won’t put in more money.
Fiduciary Duties of Directors and Officers
First, a recap of the fiduciary duties of directors and officers in a troubled Delaware corporation. This is general background, not advice that takes the place of a lawyer who understands your facts.
Under Delaware law, the officers and directors of Delaware corporations have duties of care and loyalty. Duty of loyalty means you aren’t engaging in self-dealing, and you are not placing your personal interests ahead of the company’s.
As long as the company is solvent, the fiduciary duties to the corporation and its shareholders apply. That is still the case even when the company is in the “zone of insolvency.”
Once a company is insolvent (i.e. unable to pay its creditors in full), however, the fiduciary duties owed to the corporation by the directors and officers continue, and creditors can bring derivative claims but not direct claims for breach of the duty of care and loyalty.
A difficult determination that must be made is whether a company is in the “zone of insolvency” (solvent but nearing insolvency) or in fact insolvent.
Once insolvent, the fiduciary duties become focused on maximizing the enterprise value of the company. That means that how to handle it depends heavily on the facts. There is no one size fits all solution. It could mean burning cash to allow a valuable sale that’s likely to close, or it could mean an expedited wind down of the business if closing a sale wouldn’t generate more value than the cost of a sale.
How to Wind the Company Down
How to wind the company down
From an informal unwinding of operations to a public bankruptcy case, there is a spectrum of legal options for ending the operation of a business. One factor to consider is the ability of any banks or other secured lenders to foreclose on the company’s assets, as that may dictate everything else you do. This is just a short overview of each.
Informal wind down: Usually, an informal wind down involves a search for buyers for any assets, layoffs for staff, and shutting down anything remaining. The big difference is that nothing is being done to formally end the existence of the corporation. This lack of a final step can create a lot of loose ends, which is a good reason to evaluate the alternatives.
Dissolution: Under Delaware law, dissolving the company is a formal process, usually managed by an officer of the company. The company “winds up” its affairs, liquidates any assets, and terminates the company’s legal existence. It’s an option for companies that don’t need or want to do a bankruptcy, but that do want to go through a formal wind down process.
Assignment for the benefit of creditors (ABC): ABC is recognized in many states, including California and Delaware. In an ABC, the company hires a professional fiduciary (called an “Assignee”) and assigns all assets and liabilities to the Assignee. In California, this is done without any court filings, and the Assignee, working on behalf of creditors, would liquidate the company’s assets and call for creditors to submit claims. If a buyer is already in the mix and prepared to buy the company, then a sale could happen fairly shortly after the assignment.
Chapter 7 bankruptcy: Chapter 7 involves a public filing for bankruptcy in federal court. A trustee takes control of all of the company’s assets, including its attorney client privilege. The board loses authority over anything. It’s rare for a Chapter 7 trustee to try to operate the business. They usually terminate staff, and then liquidate assets. Chapter 7 proceedings create an automatic stay that prohibits other creditors from foreclosing on assets or filing lawsuits. The trustee may decide to sue to recover preferences and - in some cases - bring a claim against officers and directors for breach of their fiduciary duties. The company itself doesn’t have a choice over who becomes the trustee.
Chapter 11 bankruptcy: Chapter 11 bankruptcy is another form of bankruptcy that - again - is a public proceeding and has an automatic stay. In a Chapter 11, the Board and management maintain control at least initially. The company is the debtor in possession. This process is more costly, because the company and its lender will need to find a way to pay for it. This is often done through debtor-in-possession loans or by using cash collateral from the lender. Companies backed by venture capital often use a Chapter 11 bankruptcy as a way to do a court-approved Section 363 sale of assets free of liens and claims.
To Wrap Up
To wrap up, if your board decides that winding down the business is the best path to maximizing the company’s value, this overview will at least put you on the track to understand what options there are, but there are many factors to take into account, all of which are specific to each company. Before choosing a path, you should definitely seek guidance from experienced corporate and insolvency counsel.
About Delancey Street
Delancey Street is a premier, and award winning, business debt settlement company that helps business owners nationwide. Our goal is simple: help you escape debt in a safe and legal manner. Based out of New York, we can help in 49 of 50 states. We tell you how it is; because your business and future is on the line.
