What do insolvency, bankruptcy, and assignment for benefit of creditors mean when closing a startup?

If a startup is winding down, there are a bunch of legal terms you might hear for the first time. At the end of the day, a startup’s winding down can come down to four ideas: insolvency, the zone of insolvency, bankruptcy, and assignment for the benefit of creditors.

This note sums up each.

Balance Sheet and Cash Flow Insolvency

Generally speaking, an entity is insolvent when it cannot pay its obligations. But the definition of “insolvency” is a little loose. It appears in loan agreements, in state corporate laws, and in federal bankruptcy laws.

Two flavors of insolvency: balance sheet and cash flow insolvency.

The cash flow test for insolvency is simple. As the name implies, this is when you cannot pay your bills as they become due. Assets can be worth more than debts and still the company is cash flow insolvent. For example, a company can show as cash-flow insolvent because of late receivables. Insolvency can be temporary. Poor cash management may turn into a spiral into shutdown.

By contrast, accounting insolvency is a balance sheet test. The balance sheet test is whether the value of the company’s debts are greater than the value of its assets. Even then, the company may still be able to pay its debts that are due now. Still, if balance sheet insolvency is significant, the business itself may be unsustainable.

Coming Close to Insolvency

The zone of insolvency is the state of a business that is coming close to insolvency. There is not a specific test for a company’s passing into the zone of insolvency. It is not always possible to find an exact moment when a business becomes insolvent, but nearing either definition of insolvency is a warning sign.

This is a critical time. Directors and officers owe fiduciary duties to the corporation. While it is solvent, the primary beneficiaries of fiduciary duties are the shareholders, who directly bear the risk of corporate misdeeds. But by the time a company becomes insolvent, creditors’ debt is less likely to be paid. In Delaware, the general rule is that once the corporation is insolvent, directors owe a limited fiduciary duty to creditors as well, as that’s when they’re at the greatest risk.

In Delaware, directors are still managing for the company and its stockholders when the company is in the zone of insolvency. Directors may pursue reasonable strategies in good faith to make the company stronger and to benefit stockholders and creditors if the strategy succeeds. If the strategy is a washout and the company stays in trouble or accumulates more debt, that alone does not mean the directors breached their fiduciary duties.

Bankruptcy

Insolvency isn’t the same thing as bankruptcy. In the U.S., bankruptcy is a federal legal process for people and businesses who cannot pay their debts. Although companies and people can be “insolvent”, that doesn’t always mean they file for bankruptcy.

Of the bankruptcy chapters, Chapters 7 and 11 are the big two, but early-stage startups rarely file. Often it is too slow and expensive. Unlike large corporations, Delaware startups commonly wind down through dissolution.

Another way is ABC - an assignment for the benefit of creditors. It is generally run faster and cheaper than a Chapter 7 or Chapter 11 bankruptcy.

Under the ABC, the company (assignor) signs an agreement with a third party, the assignee. The assignor transfers all its assets to the assignee in trust. The assignee is bound to sell the assets with reasonable steps to get the best value, and then pays the money to creditors. Creditors may find comfort in having a neutral, experienced liquidator take charge.