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Always wondered what risks are at zone of insolvency

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I've sometimes wondered if I was ever in the position - what would be a reasonable course of action for a CFO when a startup reaches the zone of insolvency - from my limited digging, officers are liable for potentially adding debts when they know of insolvency. And in particular, federal payroll taxes can be pushed on the CFO and personnel or officer with authority. Same thing with state payroll and sales tax. Not sure, maybe also be liable for termination wages (not sure about Calif law). So, what if you were in that boat? What would you tell your CEO? What would be your course of action? Immediately confront the investor/shareholders and ask for more $ to avoid liability? Check on my D&O policy to see if i'm covered? Quit?

Answers

Topic Expert
John Kogan
Title: CEO/CFO
Company: Proformative, Inc.
(CEO/CFO, Proformative, Inc.) |

I've been in that boat, although the CEO and board knew what was happening b/c we tracked it all the way down. First off, if the ship is going down, there are many things you can and should be doing to take care of your employees, the board, your creditors and yourself.

Where to start? I would start with a blow-by-blow cash flow model, with current cash and every in and out transaction you can see. This lets you know right where you are on a daily basis including what's coming in and who do I have to pay for what. Needless to say, you are holding off on paying anything that's not positively required at this point. It has (happily) been a few years, but as I recall, a bankruptcy trustee can unwind any inappropriate transactions that they see from the 90 (I think) days prior to insolvency or receivership. So don't pay out those exec bonuses while neglecting tax payments :).

The CEO and the board should be there every step of the way and as CFO you are providing them with a cash dashboard. Clearly you need cash to survive. The CFO, CEO and the board should have seen this coming months (quarters) ago and will have been scrambling for more equity investment or debt. If it's that bad, prepare for cramdown - and that's if fresh equity is even possible. If there is not a clear path to new equity investment or other inbound cash (from customers, for example) you can probably forget about doing debt. Debtholders like understanding where their interest and principal is coming from. If you have any receivables or tangible assets you can see what kind of market there is for them. Values of all assets plummet as you near a liquidation event.

If there's nothing you can do to forestall going down, you can go chapter and live with a court-appointed trustee who liquidate all assets and wind up the company or you can go for an Assignment for the Benefit of Creditors (a.k.a. an "ABC"). In an ABC there is also a trustee involved, but they are hired by the company or its investors and can sometimes be friendlier to investor interests and you or your investors may have some bit of control over the final events of the company. If you need the name of one, let me know. Good to check it out as an option, regardless.

I don't know that I'd quit. Yes, it can be tempting to get off the sinking ship and it would certainly be natural to take a look around for possible employment alternatives. But closing a comany down is actually a great learning experience and despite the hardship and heartache, you take away great lessons that I find I apply in perfectly healthy companies in areas such as contracts, employment agreements, leases, and many other areas. Also, there are many ways to go under, but they can be generally grouped as either "clean" or "ugly". Ugly is simple. You slam into the wall, lots of creditors. Everyone is mad at everyone. And the rats leave the sinking ship which leaves the investors with an ugly mess to clean up. Then there is the "clean" option. Pay off all tax and statutory employee payments. Pay off senior debt if possible. Get a sale of assets so the investors can at least say (to their LP's, for instance) that they "sold" the company. And maybe in the process earn a bit of respect and gratitude from your investors, bankers, employees and everyone involved for sticking with a tough situation.

I'm sure there's a lot more that I am missing, but these are some of the highlights I took from the time I had to shut a company all the way down. Quite an experience...

Topic Expert
Joan Varrone
Title: CFO
Company: Cloud Cruiser
LinkedIn Profile
(CFO, Cloud Cruiser) |

I agree with most of John's points above and learned a tremendous amount from the process (I was involved with two sitations)

I would seek bankruptcy counsel if it looks like a shut down is inevitable. They can outline the issues and steps to be taken..whether it is an ABC or other arrangement. I can also get you in touch with a FENG member who is actually a bankruptcy trustee as he knows the ins and outs and would counsel you as a colleague and not charge you for his time.

One thing to note is that the wage laws in California are very strict and you should not let people work if you know you cannot pay them. There is also the duty for the Board at some point to start worrying about the interest of the creditors and your bankruptcy counsel can guide you on this issue.

Regarding the comment above about payments made prior to bankruptcy, any payments made 90 days prior to the bankruptcy are considered preference payments and can be unwound but I also heard that there are certain payments that might go back further.

Check out the FENG BayArea Yahoo site; we had a presenter this month talk about bankruptcy and there is a powerpoint of his presentaton posted

Andrew Landis
Title: Business Strategist/Consultant
Company: Andrew Landis
(Business Strategist/Consultant, Andrew Landis) |

Having built 3 startup business with commercial debt and private equity, the one thing I have learned was never try to fix it without telling your lendors. By telling them that covenant breaches are going to occur and for how long usually makes them feel comfortable that the CFO knows what fiduciary responsiblities he has. Depending upon the amount of the investment asking for additional money or terms could be prudent but I have never gotten a bridge loan or other capital infusions in today's economy.

In one company I consullted with, 95% of their business was one client in the homebuilding/remodeling industry. Based on projections and the rate at which this company was getting paid, it was clear that either the bank would take it over and boot management out or allow management to create a strategic plan showing how long before the covenants are back into compliance and when then would get their money.

We talk about if a CFO is coverd under a D&O policy and can be held accountable for the company's situation is a tough one. A very good example is a company I was hired to review their books, update their systems and create management reports that were useful and delievered daily. But once I dove into the forensic work and reviewed their internal reports and even audited reports , I knew something was not kosher here. In two weeks I found 4 sets of books and managment had no clue which one was right except to say the audited financials were the best picture. How they fooled the auditors is another story but by the time I finished, I recommended a $15M writeoff on a $60M company.

Knowing the issues, I did consult both a bamkruptcy attorney and a criminal one to see what liability I had if any. THe answer was "as long as I do not issue any reports with my signature I was safe, however to further portect myself I needed to alert the authorities".

Although the bank knew what I was doing and were grateful for the information and I told the President of the issues and what I needed to do, I was going to be held out as a culprit by the President to protect himself.

Enough said, finding fraud and other issues with your financials are the first steps in insolvency. Without good numbers who could tell. After talking with the bank, I was asked to stay on to wee them through this however the company was so upside down I saw no way to turn it around. In my case I quit the engagement and had my attorney draft a document that safeguarded me. In a nutshell, it stated that I was helping the authorites, prevented any new debt from being placed on the books and that all taxes were filed timely and accurately from the time of my arrival to the time I left.

My attorneys stated that you never really know how the government or federal agencies are going to re-act to a filing of Chapter 11 and told me to get out before I was dragged into the proceedings.

Rajeev Seshadri
Title: CFO
Company:
(CFO, ) |

Great comments.

In times of stress, the adage 'desperate times call for desperate measures' holds true. Only thing is that the desperate measures should be this side of legal and ethical.

Full disclosure to all stakeholders is paramount, along with a concise listing of options and solutions. This is a CFO+CEO job. My advice, having been in 'facing insolvency' situations before, is not to attempt an individual effort. It can be misconstrued. There is a turnaround practice that has evolved for situations such as this. If possible, I would highly recommend bringing an experienced turnaround practitioner on board (check www.turnaround.org for people in your area...a group I belong to which has the skills needed in this type of situation). While the situation can be a great learning experience, management stress can be compounded by sailing in uncharted waters.

Depending on the business position of the company, it could be also be a re-start, which means that all may not be lost.

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