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Insolvency, the zone of insolvency, bankruptcy, and the Assignment for the Benefit of the Creditors (ABC) are four key concepts that may come into play when a startup shuts down.
This article provides brief overviews of each term.
At a high level, insolvency is the inability to meet financial obligations. However, note that “insolvency” assumes slightly different nuances within different contexts. For example, the word may have differing definitions under federal bankruptcy law, state corporate law, and the terms of a loan agreement.
There are two types of insolvency: cash flow insolvency and accounting insolvency.
Cash flow insolvency occurs when the company doesn’t have sufficient cash to pay its liabilities as they come due. In cash flow insolvency, the value of a company’s assets may be greater than the value of its liabilities, but the form of the assets (e.g., in accounts receivable) prevent it from meeting payments it must make. Cash flow insolvency may be a temporary financial state for a company and doesn’t necessarily indicate it should shut down. However, the inability to effectively manage cash flows can lead to a cascade of events that ultimately results in a complete shutdown and the need to liquidate assets.
Accounting insolvency (also referred to as balance sheet insolvency) occurs when the value of the company’s liabilities exceeds the value of its assets. In this case, the company may still have the ability to make its currently due payments — but the total value of what it owes exceeds the total of what it owns. This financial state may have more severe consequences for the viability of the company.
“Zone of insolvency” refers to the period of time as a company approaches insolvency. While there are no precise barometers to indicate if a company is in the zone of insolvency, a potential sign is if the company is on the brink of either cash flow insolvency or accounting insolvency.
The zone of insolvency is important because decisions that company directors and officers make during this time may be subject to a different set of rules. Namely, when a company is solvent (able to meet financial obligations), company directors owe fiduciary duties primarily to shareholders since shareholders bear the most direct risk if company directors damage the value of the company. Solvent companies have sufficient resources to pay debts, so creditors are better safeguarded against a company director’s breach of fiduciary duties. However, when a company is insolvent, company directors and officers in Delaware also owe limited fiduciary duties to creditors since those creditors then bear the greatest risk of damages.
Under Delaware law, directors and officers of a company navigating the zone of insolvency continue to owe their fiduciary duties to the company and its shareholders. As long as the directors implement reasonable strategies in good faith, they are permitted to pursue strategies that would, if successful, create value for both shareholders and creditors. If the strategies ultimately fail and incur additional debt, the failure alone does not establish a breach of fiduciary duties.
In the US, bankruptcy is a legal process under federal law for companies or individuals that are unable to meet financial obligations. Insolvency may lead to filing for bankruptcy, but not necessarily.
Unlike larger corporations, most early-stage startups don’t file for bankruptcy (chapters 7 and 11 are two principal bankruptcy chapters in the United States). Bankruptcy proceedings may be prohibitively expensive or time-consuming for small companies. Instead, early-stage startups incorporated in Delaware typically pursue a dissolution structure.
ABC (Assignment for the Benefits of the Creditors) is an alternative to filing for bankruptcy available for insolvent companies. ABC generally is quicker and involves fewer administrative expenses compared to filing for Chapter 7 or Chapter 11 bankruptcy.
As the name suggests, ABC involves an assignment agreement between the assignor (the company) and an assignee (a third party). Through the agreement, the assignor transfers all of its assets to the assignee in trust. The assignee has a responsibility to act in a reasonable manner to maximize value as it liquidates the assets and distributes the proceeds to the assignor’s creditors. Creditors may feel more at ease knowing that an impartial third party with asset disposition expertise is responsible for the liquidation process.