By Marcus Chow
“I have not failed. I’ve just found 10,000 ways that won’t work.” – Thomas Edison
Startups fail for all kinds of reasons. These include competition, product failure, promoter burn-outs or fall-outs, poor (or lack of) pivoting and cash burn-out.
The larger landscape has become more challenging. After years of sustained growth, Series A funding in Asia fell six per cent in Q2 2016 from the previous quarter, and while overall fundraising value remained stagnant, the total deal count tumbled by 12 per cent in the same period. VCs are now more careful about where they are putting their dollars. So when it comes down to it, and a shut-down is in sight, doing it right would help promoters minimise regulatory and legal risks.
Marcus Chow, Jonathan Choo and Seow Hui Goh of Bird & Bird ATMD walk us through the Q&As on issues that may come up in a shut-down:
If there is still remaining investors’ money in the company’s accounts, can this be returned to investors?
Any return of capital by a company is subject to capital maintenance rules under the relevant companies’ laws and regulations which restrict the return of a company’s capital to its shareholders. Due procedures, such as shareholders and board approvals, must be observed.
Contractual terms set forth in the share subscription agreement, shareholders agreement, investor rights agreement and constitution of the company should be reviewed to identify any general or specific consents required for the return of capital. Any return would have to be in accordance with the economic rights of the shareholders in accordance with such contractual terms.
Promoters should also be conscious that any preferential treatment of any specific shareholders contrary to contractual terms may render them liable in a minority oppression action by other shareholders. This is an acute risk in cases where there are promoter fall-outs or shareholders disputes.
If a startup has creditors and debt financiers, can the investors be paid?
Generally, the law frowns upon the dissipation of assets of a company which is detrimental to its creditors and debt financiers. Some of these transactions could be “undervalued transactions”, where a moribund company disposes of its assets to favoured parties at a value that is less than the underlying economic value of the assets, within a certain time frame prior to commencement of a winding up.
There may also be circumstances where a moribund company is partial to specific creditors or debt financiers and gives them an “undue preference” in repayment of debt owed, again within a certain time frame prior to commencement of a winding up. In such circumstances, the liquidation processes may result in a claw-back of such payments made or a voidance of such assets disposed. The courts will generally validate dispositions made in good faith and for the benefit of the company.
What is the process of a winding up?
A winding up or liquidation of a company may be prompted by a variety of reasons. These can range from a promoter fall-out to the company’s inability to carry on its business by reason of its liabilities. In all cases, the process begins when either a winding-up order is made by the court, or a special resolution to voluntarily wind up the company is passed by the members of the company.
Thereafter, a liquidator will be appointed to wind down the enterprise by taking custody or control of all physical property and rights enforceable by legal action to which the company is or appears to be entitled before realising their value. The company’s business will cease entirely except insofar as the liquidator thinks it is necessary for the beneficial winding up of the company. Finally, the funds from the sale of the company’s assets are used to pay off the creditors and any residual balance is typically distributed to the members on a pro rata basis.
How is a winding up different from a striking off?
Striking off is, in general, the faster and cheaper option suitable for private companies that are able to meet its conditions. Companies that meet the requirements may apply to the Registrar to be struck off the register. The grounds and conditions to be fulfilled include not being involved in any court proceedings, having no assets and liabilities at the time of making the application and not having any outstanding tax liabilities.
Winding up is a more formal liquidation procedure involving the winding-up of company affairs, the appointment of a liquidator, ceasing of operations, realisation of assets, payment of any debts and distribution of any surplus proceeds.
Are there alternatives to winding up?
Of course, there are alternatives. Instead of a shut-down, a startup could attempt to successfully pivot its strategy by changing its business model. We assume there is cash-flow supporting this. Pivots driven by specific customer feedback could eventually result in a startup finding the right customers, value proposition and positioning. Alternatively, where analysis reveals a sound business model but problematic execution, a change in management could address the issues holding the business back from success.
A debt-equity consensual work-out plan might be something to be considered. Startups could restructure and write down debt or engage in a debt-equity swap or a factoring or sale of receivables and other possible assets. In restructuring its debts, startups could offer lenders smaller or deferred payments, or a lower interest rate in the short term in exchange for the issue of shares or share options or warrants.
A renegotiation of the terms of different classes of shares may work in certain circumstances. Where cumulative dividends are to be paid, a waiver of such dividends may buy the startup some breathing space. If fresh investments can be secured by a renegotiation of the terms of the existing series of shares issued by the company, the company may be cast a new lifeline.
Buyouts by competitors or strategic investors are another option. startups could also seek strategic upstream or downstream business partners to collaborate with so as to harness efficiencies and focus on the value they can add to the business.
What happens to the employee options and performance shares granted?
Although the treatment of these benefits-in-kind largely depends on the terms of the relevant Employee Stock Option Plan (ESOP) or Performance Share Plan (PSP), practically speaking, it is very likely that the employee stock options and the performance shares (whether vested or not) will become worthless when a company is wound-up; unless there is a surplus of assets after the liquidator makes the necessary distributions to creditors, even if the employees are legally entitled to the company shares, they are unlikely to see significant returns on them.
There may be, however, tax consequences arising from the granted options and shares, and promoters need to be mindful of these.
(Note: The above does not constitute the provision of legal advice and may not be applicable to specific fact situations.)
This article, entitled “From startups to shut-downs: how to do it right“, originally appeared in e27.