Top Ten Tips to Give Clients in the Zone of Insolvency in the United States

The likelihood of a funding crunch in the tech industry is growing and startup companies are having significant trouble securing ongoing financing.

Corporate attorneys, whether in-house to or outside such companies, have a critical role in advising strategies to manage potential disasters. Corporate counsel can use these tips as a methodical and succinct rundown to prepare their clients for the worst.

 

 

It is increasingly important for corporate boards, officers, and major stakeholders to not remain complacent and uphold the status quo when potential crisis looms in the future. 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. 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.

Corporate stakeholders must inquire for themselves the rate at which their company is spending its cash and 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 legal and financial liabilities.

 

 

In an effort to seek truer objectivity, having the company hire a consultant to ask the tough questions and get a candid assessment of its 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, whether an attorney with business experience or an expert in the field, is an effective interim option to set boundaries and address mismanagement or inefficiencies. This option also recognizes and can prevent creating strained relationships due to uncomfortable confrontations between management and significant stakeholders.

 

 

Although the general rule is that a company's board of directors and shareholders are not liable for a company's debts, there are exceptions. Payroll and payroll taxes, unfunded retirement accounts, and latent personal guarantees are all areas from which potential personal liabilities may arise.

While not personally liable, there are additional concerns regarding the company's ability to pay D&O insurance, employee severance, and accrued employee vacation. Though the Labor Board may not enforce these as personal liabilities, leaving such promised benefits and insurances unpaid would certainly damage the company's public image and the 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 should meet with their company's CEO and higher management to get an accurate portrayal of the company's true payables, and ensure that current and future expenses are accounted for in the event of a shut down.

 

 

Corporate officers should be extremely aware of personal guarantees for which they may be liable. It is common for credit card companies, such as American Express^TM, to not issue cards 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 capitalists 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. Take heed of hidden liabilities to avoid precarious situations by noting personal guarantees and planning accordingly.

 

 

It is human nature for people to want to pay off those expenses most near and dear to their hearts. 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 may become 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.

 

 

Stay informed of governmental rules and regulations. This may include violations of state or federal law, such as the Worker Adjustment and Retraining Notification (WARN) Act, or federal securities laws. For instance, if the company does not have enough cash to meet payroll, it may in effect be forced to violate the WARN Act's advance notice requirement.

Companies should also pay attention to bridge 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 with only a few months of burn left, it is not uncommon to oversell its prospects in order to raise cash on an interim basis. Once those last investors realize the company's fragile financial state down the line, problems may arise if they were led to believe others were amply investing.

Companies need to address the hazards associated with later-stage investing and disclose, both orally and in writing, all the related risks.

 

 

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. Companies should always have a plan for dealing with their creditors.

Having the support of secured creditors is crucial, regardless of the exit strategy the company chooses to implement. For instance, if the company uses an Assignment for the Benefit of Creditors (ABC), the assets will not be sold free and clear of the secured creditor's liens. However, with strong communication, creditors will be incentivized to cooperate with an orderly close out process because it will spare them the time and effort in foreclosing on the company themselves.

Engaging in open discussions and coordinating with secured creditors will ensure that your client's company will be in the best position to allow for an organized and systematic exiting process.

 

 

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 simply 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 initially 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.

Make sure that the company's management is not overstating their ability to pay in order to avoid frivolous lawsuits.

 

 

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. 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 does arise.

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.

 

 

It's easy to rely on internal projections. Companies often overestimate how much time is left. Where a company is down to its last six months of burn, managing its interests in an organized fashion and being positioned for an orderly sale or a potential restart, means facing realities sooner rather than later.

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.

 

 

In summary, the above highlights key recommendations that corporate attorneys can offer businesses affected by the impending funding crunch, particularly to technology and other start up companies. At the very least, the sooner your client assesses its realistic position, the better off it will be.

 

 

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 jim@btllp.com.

Caitlin D. Lalezari, Esq. is an associate at Baer and Troff, LLP.