[vc_row padding_top=”0px” padding_bottom=”0px”][vc_column fade_animation_offset=”45px” width=”1/1″][text_output]Another rant from the Grumpy Old Company Lawyer.
In case no one’s said it to you before, it’s a fact of life for entrepreneurs and early-stage investors: Not all startups succeed. By definition, early-stage investors have to be “big boys and girls.” So what happens when, despite heroic efforts at life support, you have to call it quits?
If I’m representing an investor, one way to make me really, I mean REALLY, grumpy is if startup founders disregard their commitments and corporate formalities. Most startups qualify as “close corporations” in their formative years. Close corporations—that is, corporations where the ownership is privately held by only a few investors—can sometimes appear to be run out of the founder’s back pocket. That can cause problems. Once you invite outside investors, you need to think about the company differently.
A minority investor in a close corporation needs to be aware of the kinds of actions that the officers, board, majority shareholders, and sometimes debtholders (I sometimes call these people the “control persons”) can take-with or without them.
Minority investors have rights too. In a close corporation, the majorities and minorities are, by nature, concentrated in just a few people. Taking a cavalier attitude to financial dealings with the company can be dangerous to your company and to the control persons’ own financial future. Even when you mean well, if the cost and effort of compliance with corporate formalities causes you to disregard those formalities, the devastating results can be the same.
One will often see additional commitments being made to minority investors to induce them to purchase securities in a close corporation. Some rights often added to the terms of common stock purchase agreements include:
- Disproportionate voting rights,
- Extra notice rights,
- Rights of co-sale,
- Bring-along rights,
- Higher threshold voting requirements,
Also, special classes of stock may be given preferential rights, and debt instruments with notice, conversion, or other rights are possible options.
It’s beyond the scope of this blog to get into an exhaustive (and exhausting) discussion of the details and differences among these protective measures. Suffice it to say—you may have made these kinds of promises in your company, and they need to be studied both when things go well (“Geez, now what do we do with all this cash?”) and when they do not (“Whelp, it looks like we have to move back into my parents’ basement!”).
Just a note: for the most part I use a corporation formed under state law for my examples. Many times a startup begins life as a sole proprietor, partnership, or limited liability company and converts to a “C” corporation (the “C” relating to the IRS regulation for taxable corporations) to prepare itself to raise capital. The paperwork would be different, but the basic principles discussed would generally apply to corporations organized under most states’ laws.
Have you explored other options to continue business before you pull the plug?
- Restructure your existing company
- You may be able to transform a sow’s ear into a silk purse with a few changes
- Re-cuts the capitalization layer cake
- It means a new deal for your investors. You need to find out whether they will “buy in” again. Give proper notice and a chance to vote before you shift their bits around.
- Create a new company
- Returning to an LLC? Partnership? Sole Proprietor? How will you raise capital if needed?
- Need to exchange new interests for old interests, you can’t just leave your investors by the side of the road in a broken down vehicle. Again, notice, meeting, and a vote of your voting stakeholders are expected, (and required by law in most cases) before you transfer assets to the new company or dissolve the old one.
Continuing in business is not possible.
Assuming you’ve worked through all the options—I hope with an experienced attorney—we need to talk about the “D” word, “DISSOLUTION.” Like couples with a pre-nup, the laws, company bylaws and investor agreements are your guides when the company needs to be split up. Dissolving the company doesn’t have to mean you and your investors can’t still be friends—provided, I think, that your actions are transparent, and you follow the basic terms of the bargain that you struck at the outset.
Remember, you are not the company. You brought forth a creature that had never been seen before, which was made entirely out of state laws and contracts (and other people’s money!). You need to follow those laws and agreements when the time comes to put that creature down. And, just for the record, although I tend to anthropomorphize them, I don’t believe corporations are people.
I have five basic principles; details will follow:
- Review all your company’s commitments to others;
- Tell them what’s happened;
- Tell them what you will be doing about it;
- Get all the consents, votes, and approvals you need;
- Follow through and finish the job properly.
I should add a sixth principle, but I hope it’s obvious by now: Consult an experienced attorney to help you work your plan to dissolve the company.
Details, details, and more details.
Get organized. Follow a plan for closing the company. Don’t let it drift away. Your plan will have guidelines set forth in state statutes, the Internal Revenue Code, and state and local tax regulations. The following checklist is adapted from laws in force in many states. Not all corporations will be required to follow every procedure, and some state laws may require additional procedures.
- Vote for dissolution.
- Contact your commercial insurance agent, notify them of the dissolution and figure out the best protection against third-party lawsuits that may arise after you dissolve.
- Surrender your Certificate of Authority to transact business.
- File appropriate forms with the IRS. Also, find out whether you will need to file IRS forms at a later date.
- Notify your secretary of state of the dissolution¾this may take the form of Articles of Dissolution and/or a Notice of Intent to Dissolve.
- Notify your secretary of state that you are discontinuing the use of any assumed or trade name.
- Obtain and file a good-standing or tax clearance certificate with your state tax authority. You may have to catch up with unpaid franchise or other taxes to get this.
- Publish notice of your business’s intent to dissolve.
- Notify your customers and deal with any remaining contractual obligations. Remember to return any deposits or payments for goods not delivered or services not rendered.
- Give employees as much notice as possible. Depending on the number of employees, you may need to provide notice under the federal or state version of the Worker Adjustment and Retraining Notification (WARN) Act.
- If you need, say, a finance employee to help wind up the business, consider offering the employee a small bonus to stay until the bitter end. Plan to pay employees their last paychecks on their last day, with the value of accrued, unused vacation days if your state requires it.
- Make your final federal and state payroll tax deposits. Also, submit final sales taxes due up to the closeout date.
- Collect your assets.
- Sell or donate property that you are not going to distribute to shareholders/partners. Comply with bulk sales laws, if required. (If you sold your inventory, you may need to notify your creditors a specific number of days before you close your business, and in some states, to publish a notice of your impending closure in a local newspaper.)
- Pay the debts you know about. Settle or pay company debts to the extent possible, prioritized to protect your personal liability — money owed to the landlord, bank, suppliers, utilities, and service providers. Ask for letters indicating that the bills are paid in full as you pay off each one.
- A NOTE ABOUT BANKRUPTCY: While many small business owners can wind up their business affairs (and protect their personal assets) without filing for bankruptcy, if you have a heavy debt load and creditors who won’t settle for less, bankruptcy may be your best, or only, option. If you do file for bankruptcy, it will be your first step in the closing process; the other steps discussed here will follow the bankruptcy process.
- Determine whether state statutes require that you notify creditors or the public of your dissolution. Notifying your creditors (suppliers, lenders, service providers, and utilities) the right way limits the amount of time a creditor can ask for a debt.
- Distribute the remaining property to your shareholders/partners.
- Cancel your business credit cards and subscriptions. Close your business bank account and any other accounts.
- To protect your finances and reputation, ensure that you cancel all licenses and permits that you will no longer need.
- If you have registered locally under an assumed, or trade name, other than your own name then you can cancel that business name registration with your local government.
- Your company probably had a digital presence too—so pay attention to websites, social media pages and shut those accounts, to avoid letting abandoned domains and pages turn into breeding grounds for scams.
- File the final notices with your secretary of state stating that all debts have been paid and all assets have been distributed. If you fail to legally dissolve your corporation control persons can continue to be liable for taxes and filings.
- Find out the statutory time limits for third parties to bring suit against you after the company is closed and plan accordingly. Retain documents for the required time period.
Common dissolution problems for early stage startups.
Did you assign some of your personal rights to the company, such as in an inventions assignment, non competition agreement or nondisclosure agreement? Check the terms with an attorney. Those commitments may survive the closure. Just because the company closes it doesn’t mean the inventions or intellectual property you transferred to the company will come back to you. If there’s any value there, they probably are assets the company is entitled, or required, to sell to generate cash for creditors, or to be distributed to all the shareholders.
Really think about what IP the company may have to sell. Are there any patentable inventions? Pending patents? Trademarks? Copyrights? Trade Secrets? Software?
Who can the company transfer assets to? Consider where any assets might have to reside for a period of time after the dissolution. Is there anyone left who can archive them for a statutory holding period?
Dissolution itself costs money: attorneys, filing fees, back taxes, etc. I hope, if the company has been on a negative cash flow trajectory, you’ve made the decision to dissolve before the money’s all gone.
The formal dissolution process publicizes what may look like the failure of the business—that can be hard on one’s personal reputation—but not as hard as lawsuits, personal financial losses, and lack of future credit availability resulting from failing to deal fairly with your stakeholders. If you follow the rules, no one objects, and time period passes, your personal liability is limited.
Formal dissolution provides a definite point in time where investments can be declared worthless by investors, and deducted on their taxes, if they have that ability. It’s one last form of value you can provide to those who believed in the company and put their money up front.
Why not let the company simply stop operations?
I’ve had several failed startup founders ask if they can just let the corporation go dormant. They either don’t have the inclination or the money to put any more into the corpse. As I’ve said, that’s not a good idea. When planning for closing the business, just like planning to build a business, plan for some expenses, and make the decision to close before the coffers are completely empty, if at all possible.
- Dormancy may seem cheaper and quieter—to just let the company go gentle into that dark night and let the founders get on with their lives.
- No last rites; but no absolution either. The control persons’ personal contingent liability to the state, IRS, creditors, and others can continue for years.
- Dormancy allows uncertainty to fester. You want your investors to agree, or at least accept, that the company is closing and there isn’t anything left for them to pick over. And, you want to show that acceptance was in writing if you can get it. You may not have many attendees at the funeral because some minority investors may choose not to respond. But, providing a good notice, holding a meeting, and reporting on the results of the voting provides you with a lot of cover.
- You may have a personal and emotional stake in the idea of your company. That doesn’t make it into something it isn’t: the company is really just a bunch of contracts and other people’s money. Terminating the company correctly is a legal matter that requires the use of an experienced lawyer.
I recommend founders do what is sometimes the hardest thing for the company. Dissolve it officially. You could end up spending more money dissolving it later, even if you never get into any legal battles with creditors or investors. Minority investors’ certainly want to know where everything went and get a well-documented accounting, but it’s really more in the control persons’ best interests to close the company correctly to avoid having legal risks follow them into the future.[/text_output][/vc_column][/vc_row]
