The dream for all startups is to have a great idea, raise financing from business angels or venture capital and private equity firms, bring their product to market, and make a multi-million exit. Even on that road to success, startups have to go through a cash-burn phase where they will typically need to survive from one financing round to the next. In that phase, the time left before the startup’s liquidities run out is called the “runway.”
We are convinced that startups will continue thriving despite the uncertain times we’re living. In case a startup fails or moves toward failure, startup directors need to know their obligations and be able to abide by them in the interests of their company, shareholders, and creditors.
Here’s some practical advice that we hope will help steer your startup back on the right track or, if worse comes to worst, help you mitigate the damage.
Please note that new legal provisions on this subject will enter into force on January 1st, 2023. These will not change this advice substantially but will increase the need for the board to be cautious from as early on as possible.
General advice
The board generally has the obligation to observe and monitor the financial situation of the company.
To document this monitoring, we advise founders to hold regular meetings or written discussions (even by email, ideally monthly).
The board should, in particular, look out for early warning signs that could indicate the company is headed into financial trouble or over-indebtedness. In the case of a startup in its cash-burn phase, this mainly means constantly evaluating the length of the company’s runway and, where necessary and possible, adjusting the cost structure accordingly.
To avoid personal liability (civil and sometimes criminal), the board should:
- not favor specific creditors against others; yet
- be especially careful that salaries, social contributions, and source tax be paid regularly and on time.
- Especially for startups who already have products on the market, focus on cash flow. It’s important to shorten the cash cycle and optimize debtors to avoid becoming insolvent.
Capital loss
Situation: In a nutshell, a company is in a situation of capital loss when its assets are insufficient to cover its debt and half of its equity. Subordinated debt is not taken into account in this calculation.
Specific obligations:
- In theory, the board should establish intermediary financials if it suspects capital loss. Should this be confirmed, the board should, per the law, summon a general meeting and suggest measures to remedy the situation.
- In practice, it is difficult to identify the effective moment of capital loss, and many of the measures that can be taken are within the board’s competence. Therefore, the obligation to summon a general meeting is rather unclear.
- Concretely, we advise boards to keep the situation in check and document their perspectives and the measures taken should the situation come close to capital loss.
Examples of concrete measures that can be taken:
- Streamline the bottom-line: the board can take measures to reduce the company’s cost structure which will tend to improve the overall situation (e.g., terminate employees).
- Increase the top line: Increasing sales will help the company’s situation. This is, however, easier said than done for startups, most of which are in a cash-burning phase.
Subordination declarations:
- In practice, the board can request subordination declarations from the company’s creditors to take the company out of its capital loss situation.
- Especially in the case of startups, this measure is widely used since these companies typically are indebted to their shareholders.
Raise funding:
- Conducting a financing round will de facto tend to correct the situation and is, therefore, the best measure possible to come out of the capital loss situation.
- Raising convertible financing is also useful, provided the lenders’ claims are subordinated. In practice, CLAs are subordinated precisely for this reason.
Over-indebtedness
Situation: A company is over-indebted when its assets are insufficient to cover its debt. Subordinated debt is not taken into account in this calculation. In two words, and most of the time, this is Game Over.
Specific obligations:
- If the board suspects over-indebtedness, it must draw up and audit two sets of intermediary financials, respectively, at going-concern valuations and liquidation valuations. The former valuation consists of the valuation of assets and liabilities with a view to the continuation of the company’s activity, whereas the latter presents the realizable value of assets and, typically, any hidden reserves the accounts may hold.
- Should the over-indebtedness be confirmed at both valuations, the board must:
Announce the over-indebtedness to the judge, who will:
- in principle, dissolve the company and open bankruptcy proceedings; or
- provided there are concrete improvement perspectives and, if requested, order a debt moratorium (delay in the payment of debts or obligations) which could lead to a restructuring of the debt (partial debt write-offs that can be imposed provided certain majorities of creditors are met).
Insolvency
Situation: The company cannot pay its creditors on time for a prolonged period. The situation is especially characterized when the recurring creditors cannot be paid (rent, social insurance, salary).
In the case of startups (in their cash-burn phase), this typically means hitting the end of the runway. It can therefore be forecasted quite accurately and should be planned for.
Specific obligations:
- The general meeting (in notarized form) has the option to dissolve the company and announce the insolvency to the judge for bankruptcy proceedings to be open.
- Should the board choose not to call a general meeting for this purpose, this could trigger their liability.
Consequences if the board does not fulfill its obligations
- Violations of the board’s obligations can trigger the personal civil liability of the directors, which can be assigned to creditors in the bankruptcy proceedings. The directors could be sued for the debts that were caused after the moment when the board should have known not to incur further debt.
- A delay in the announcement of overindebtedness or overly risky decisions is also a criminal offense (theoretically risking 5 years of prison time).
The rapidity at which a startup can grow means it is equally prone to rapidly burning through its cash. This can mean approaching the end of its runway. Fortunately, monitoring by the board and the proper actions taken as described above can make all the difference. Here is to hoping that when you approach the end of the runway, you take off and do not need to apply the aforementioned steps.
