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Published: 2008-03-26

Putting a Period to a Dot Com



What can you/should you do when it becomes obvious that your start up should wind down?

For the entrepreneur, winding down an insolvent company is a challenge: honor the legal rights of creditors while minimizing the damage to the founders and employees

First, some basic principles:

  • The board of directors of an insolvent company owes its duty of loyalty to the creditors, not the owners.
  • Creditors' claims get paid before the claims of equity holders
  • Management can legally pay some creditors and not others.

Bankruptcy or not

There is no clear or universal answer to whether a failed business should file a Chapter 7, which is a liquidation proceeding. It depends on the value and nature of the assets; the attitudes of creditors; and the availability of management to oversee the process.

Companies can go out of business without filing bankruptcy: they liquidate their assets and cease operations. Creditors have a right to recover their claims from the assets of the corporation. If there are no assets, the corporation cannot be further harmed by lawsuits that try to collect from the corporation.

The danger to management in this approach is the tendency of some creditors to assume that the business's failure to pay means that there is some sort of skullduggery afoot, and sue the officers as well as the corporation to collect the debt. While the claim against the individuals may be invalid, the individual has to appear and defend in the lawsuit, or a judgment will be entered against him.

Personally managing the wind up has advantages, if you are willing to devote the time and energy to the process. On the other hand, filing bankruptcy may protect assets from creditor action, preserving value for the payment of taxes and employees.

Doing it yourself has advantages

  • Management can usually get better price for assets since they know the market, know the asset and are motivated to get highest recovery.
  • Outside of bankruptcy, you control who gets paid with the available funds
  • You can act swiftly to limit exposure of management or investors by addressing debts guaranteed by insiders first, subletting space, returning leased equipment, etc.
  • Creditors are protected from having to give back preferential payments to the bankruptcy trustee
  • Assets can be sold to insiders so long as the price is fair

    But

    • May prevent management from accepting new employment
    • May require cooperation from creditors and lessors
    • May increase likelihood that disgruntled creditor will sue individuals too
Bankruptcy is simple

  • Bankruptcy trustee becomes responsible for liquidating assets, returning equipment, and dealing with creditors, freeing management to turn to other endeavors
  • Trustee has powers under Bankruptcy Code to sell leases despite anti assignment provisions and to avoid levies and writs of attachment, recovering value for creditors that isn't possible outside of bankruptcy
  • Filing bankruptcy seems to reduce the instance of creditors naming management as well as the business in collection actions
  • The automatic stay prevents aggressive creditors from diverting cash that could be used to pay taxes, employees, and guaranteed debts or recovering property needed for wind up

    But:

    • Trustee unlikely to get top dollar for saleable assets
    • Insiders may be prohibited from buying technology, intellectual property or projects in development
    • Trustee's fees and expenses are paid off the top
    • Trustee can recover preferences to trade creditors and to insiders and challenge pre petition transfers of assets if legally fraudulent
    • Bankruptcy process frequently slow and inexact
    • Claims are paid according to priorities in the Bankruptcy Code
This choice is not necessarily an either/or decision. Management can liquidate assets as feasible, and file bankruptcy thereafter to let the trustee mop up.

Winding up outside of bankruptcy

If you elect to close up shop outside of bankruptcy, consider the following issues. Involve the board of directors, if there is one: be forthcoming about the situation and the alternatives. Exploit the contacts and expertise of outside directors in the effort

Identify the assets

Figure out what the business owns and what it might be sold for.

  • Intellectual property, work in development, customer lists; licenses; partnership relationships. Which of these assets be sold to raise cash.
  • Security deposits with landlords, taxing authorities, Can they be recovered by terminating lease, sub letting, or filing returns
  • Real property leases: Is the price below market or in desirable location making the lease valuable to others

List debts for which officers are personally liable

Check real property and equipment leases, credit cards, and trade accounts where the contract may be in the name of an individual or an individual has guaranteed the debt

Officers, directors and those with check signing authority may be personally liable by law for the trust fund portion of unpaid employment taxes or sales taxes of the business

Segregate assets that are collateral for secured debts

Secured creditors have a property interest in the asset and the proceeds from its sale. Creditors become secured creditors when the business granted a security interest in specified assets, usually at the beginning of the financial relationship. Sale of the asset without the permission of the secured creditor may breach the security agreement and may be a fraud on the secured creditor.

Leased property belongs to the lessor; check the lease for any restrictions on assigning the lease to another entity

Get fair market value for all assets sold

The value of the business's assets belongs essentially to the creditors: management cannot give the assets away or sell them for less than their value.

Remember, the assets are only worth what someone will pay for them, here, now and in their present condition. With that in mind, find the best deal for what you have to sell. Sales may be for cash, for deferred payments, or for a piece of the future action, so long as you get a commercially reasonable, albeit liquidation, price.

Expose assets to the market, through brokers; contacts with competitors, suppliers, and partners; listing with electronic auctions, etc.

Make a paper trail

Document the condition of assets, especially intellectual property, at the time of sale and your efforts to find a buyer in the time available. If there is later a challenge to the disposition of assets, you have a record to support the sale at the price you received.

Develop plan for payment of debts to the extent possible

Pay trust fund taxes first: ear mark the payment for application to the trust fund portion of the tax

Pay vendors or employees essential to the wind up process

Pay debts for which individuals are jointly liable with the business

Arrange for final tax returns and issuance of w-2's to employees

Preserve records

Back up financial and other vital data now on computers so that the records remain available despite what happens to the computers it now lives on

Store paper records

Conclusion

Use these ideas to evaluate your options in winding down; call on experienced legal counsel to expand these concepts.

The principles discussed here are applicable to any type of business.