Maybe you’ve completed a sale of your company via an asset purchase and need to wind down your company’s legal entity post sale. Or maybe you’re in the unfortunate position of having to shut down your company as you haven’t been able to raise additional funding for your startup. For various reasons, the wind down of a company is something that most founders don’t think about (or don’t want to think about).
In this two-part blog post, we are going to cover some key things you should consider if you find yourself having to wind down your company.
1. Secured Creditors
In a liquidation of a company, secured creditors are senior in terms of their rights to any assets of the company that were used to secure their debt. This means that secured creditors are generally entitled to be paid first, ahead of any other non-secured creditors, and ahead of any shareholders (both common and preferred shareholders). Secured creditors are often banks that have lent money to the Company, or non-bank lenders that have secured loans or other obligations. Any accounting of remaining assets of a company must first take into account amounts due to all secured creditors, and in the case of multiple secured credits, the order or seniority of such credits. In such situations a company should consult legal counsel, including bankruptcy counsel where the remaining assets may not be enough to satisfy all such claims.
2. Past Taxes and Withholding
In addition to secured creditors, companies should also expect to have to pay all taxes ahead of other creditors and shareholders. These taxes might include federal and state income taxes, withholding taxes due with respect to payroll, state and local sales and property taxes, and franchise taxes due to Delaware with respect to maintaining the good standing of the corporate legal entity in the State of Delaware. In some cases, complete dissolution of an entity will not be possible without payment of these taxes (for instance the Secretary of State of Delaware will not accept or process a certificate of dissolution for a Delaware entity without having all current and past franchise taxes paid first).
3. Employee Past Salaries
Any past wages due to employees should also be prioritized over the rights of stockholders. Failure to pay past wages may not only subject the dissolving corporate entity to ongoing liability, it may also subject the management team and certain shareholders to liability as well. Moreover, dissolution of the corporate entity does NOT cut off such liability. Under federal and state wage payment laws, management may be subject to PERSONAL liability to pay any and all past earned wages. Moreover, in certain states (such as California) depending on the level of involvement of shareholders (such as active investors such as venture capital firms or private equity firms), such shareholders may also be subject to suits by former unpaid employees seeking to recover for unpaid wages. Therefore, companies should never follow the strategy of “failing to pay” employees to try to preserve cash in a situation where they believe they may dissolve.
4. Unsecured Creditors
In addition to secured creditors, employees, and taxes, companies should also take into account amounts due to “unsecured” creditors. These unsecured creditors may be lenders (see the further discussion below regarding SAFE and Convertible Notes), as well as vendors, outside service providers, consultants, software subscriptions, and, and other general obligations. While companies will have an obligation to pay general vendors for past amounts due, that does not necessarily mean that you need to pay vendors for amounts due on an ongoing contract or service if you are able to terminate or re-negotiate the contract in connection with the winddown (see below re terminating existing contracts). As unsecured creditors, vendors typically don’t have a right of action against management personally or against individual shareholders post dissolution, however, to the extent amounts are distributed to shareholders without satisfying such prior claims, such vendors would still have the ability to sue the entity, even after dissolution.
5. SAFE and Unsecured Convertible Note Holders
Investors in early stage companies often invest via a SAFE or an unsecured convertible note. In the event these SAFEs or notes have not converted pursuant to an equity financing event, then the holders of such SAFEs and notes are still essentially unsecured creditors of the company in the event of a liquidation or winddown. Given the proliferation of SAFEs and convertible notes, this may be confusing to founders who think of such holders as if they were equityholders. In addition to payment of secured creditors, outstanding taxes, and employee wages, most SAFE/Note holders would also expect for other unsecured creditors such as vendors to also be paid before they are paid, to avoid any ongoing liability. In addition, most investors would also expect that some amount be budgeted for the final dissolution costs related to the wind down of an entity. Therefore, it is typical that such SAFE and Noteholders might not be paid until the end of the dissolution process and assurance that all final expenses and amounts due are paid back first. At that point, unless their SAFE or convertible note says otherwise, they would expect to be paid back before any amounts are paid to preferred or common stockholders.
6. Unwinding Existing Contracts (Vendors & Customers)
As noted above, vendors are generally treated as unsecured creditors. To the extent amounts are due to such vendors and the funds are available to pay such vendors after payment to secured creditors, payment of taxes, payment of wages due, and dissolution costs (see below), such vendors will be paid ahead of shareholders and SAFE/note holders. In addition to payment, companies should typically try to terminate or exit out of contracts if possible. In some cases, they may involve communication such as email or phone calls to the appropriate account manager or finance person at the vendor, explaining the situation. Often times, the vendor will allow for an early termination if the company provides proof of dissolution (such as a copy of the filed Certificate of Dissolution or some other proof the company has dissolved). In addition, where the company has ongoing clients or customers, the company should think about the appropriate messaging, whether its assistance with transferring the clients business to a competitor or alternative provider, or helping with potential transition or shutdown of the product or service that is being used.
7. Non-Cash Assets
In addition to cash, a company that is winding down may have non-cash assets, such as trademarks, domains, copyrights and patents (whether pending or issued), software, materials, inventory, know-how, data, customer lists, and equipment (like laptops, desks, chairs, and furniture). Rights to these non-cash assets do NOT automatically revert to the founders or management. All assets are property of the Company and ostensibly property of creditors and shareholders, and the company has a duty to use its best efforts to turn those assets into cash. Usually that means exhausting all avenues to market and sell those assets. That said, for certain assets such as laptops, furniture, etc., such assets typically depreciate quickly and may have little value in a dissolution. Thus, depending on the number and value of such items, the company may choose not to sell or auction certain items and instead count their remaining value as part of the distributions.
8. Non-Cash Assets – Intellectual Property Rights Specifically
For non-cash assets such as intellectual property rights in trademarks, patents, and domains these assets may have varying degrees of value, depending on the stage of the company and product, the sector it is in, the number of customers, the type of intellectual property, and the value of the domain. For instance, a top level, simple “actual word” .com domain often fetches $150K to $500K depending on the word. Pending or issued patents or patent applications may also have value to companies looking to bolster their IP rights in an area. There are certain small investment banks that specialize in auctioning IP rights, and so it may be worth exploring the sale or auction of such rights as part of a dissolution process. Finally, customer lists and information might also be of value and sold, but see below re: special considerations regarding the sale and transfer of data and personal information.
9. Data – Personal Data, Customer Lists and HIPAA
As noted above, customer lists may have value if sold. Whether such information can be sold in conjunction with a bankruptcy or other dissolution, will depend on the nature of the information collected, the company’s privacy policy and whether it provides for (and allows for) the sale of such information in a bankruptcy situation, and whether such information might also be subject to other regulations (e.g. patient data w/r/t a company that deals with patient/healthcare data and information). For instance, where a company holds medical records or patient information, HIPAA has certain requirements w/r/t transferring or disposing of such information, and bankruptcy or dissolution does NOT absolve the entity from complying with such requirements. In situations where a company intends to sell, transfer or dispose of personal data and information, we highly recommend conferring with privacy/data counsel to discuss the possible implications of such actions.
10. Establishing a Final Budget & Wind Down Costs Ahead of Time
As should be clear from the above discussion, dissolving a company is not always a straight-forward affair, and may require the involvement of specialist legal counsel, as well as an accounting of different creditors, investors, vendors, customers and other parties to understand each party’s rights with respect to the company’s remaining cash and assets. This is even more difficult because a company is often dealing with these issues in a situation where there is very little cash or budget to address these issues. For this reason, we recommend the company’s team try to think about these issues and try to budget for the potential costs well ahead of a potential wind-down or dissolution. Waiting until a company has only 1 or 2 months of runway is the wrong time to start planning for a potential dissolution. Even if the company is still not sure whether a financing or acquisition may occur, a company should try to start planning a potential dissolution at least 6 months prior to running out of cash. As part of the planning process, a company should think about the issues discussed above, as well as budget for the costs of the actual dissolution filing and process itself, as explained further below.
Inceptiv
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