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Transitioning a startup involves an often-complex set of strategic, legal, financial, operational, and relationship responsibilities.
Onsen guides startups through this process with tailored services built on systematized expertise.
This guide is meant to help provide general familiarity with the core concepts involved in transitioning your startup.
Many of the concepts, rules, and processes outlined in this guide are unintuitive in important ways. Keep reading to learn more about key concepts to help your startup transition smoothly.
“Transition” refers to a change in the strategic goals of a startup.
In our work with venture-backed startups, this change in goals usually relates to moving from “obtaining a venture-scale business outcome” to one of the following:
The goals for a given business transition don’t always fit neatly into one of these two categories. They often overlap, but the categories provide a useful framework for setting out a transition strategy.
For some companies, near-term value may be maximized through selling the company itself or some of its assets.
This exit may take the form of a traditional acquisition - merger, stock purchase, acquihire, earnout - or may be a piecemeal sale of some of its assets (such as specific intellectual property assets).
The exit process typically takes several months to complete, but the actual process can be much longer or shorter depending on the facts.
The first few weeks are spent establishing interest in a sale with the remaining months dedicated to due diligence and negotiating terms of the exit transaction. Potential acquirers or buyers may include a startup’s competitors, customers, and employees or PE groups or industry giants.
For most early-stage startups, the value of the company and assets rests in the company’s intellectual property (IP). Common types of startup IP include codebases, patents, trademarks, copyrights, domains, and customer lists.
Where the value of the IP lies in a codebase, obtaining value is often dependent on the know-how of the founder or other key employees. As a result, successful exit processes often begin while the founder or key employees are still with the company and include their retention in some form during the transaction process.
Other assets that may be of value may include certain customer contracts, accounts receivable, and, of course, ongoing revenue streams.
At Onsen, we work with founders - and where they exist, their teams (legal, banking, finance) - to prepare for a smooth and integrated transaction process that maximizes company value.
A recapitalization is the process of changing a company’s capital structure. The company’s debt and equity composition and associated terms are adjusted to align with the company’s strategic goals and macroeconomic conditions.
Most early-stage startups are financed through infusions of debt agreements and equity investments over the course of months or years. These financing events often involve multiple parties and different economic terms.
Over time, the macroeconomic environment and the company’s strategic business direction may change. As a result, the target capital makeup for the startup may shift and the startup may need to formally “recapitalize” in order to align the actual and target capital structures.
For early-stage startups, recapitalization tends to focus on the equity structure of the company rather than the debt structure. The term “recap” is often colloquially used to reference changes to the startup’s capitalization table (the “cap table” is a spreadsheet recording the ownership structure of a company).
Recapitalization can help address a number of challenges for early-stage startups, commonly including:
For some venture-backed startups, the company has long-term viability but the leadership team no longer deems it sensible to pursue a strategy that is expected to generate venture-scale returns.
In these cases, startup leadership and investors may wish to pivot the company to a non-venture business model. This pivot often takes the form of renegotiated investment agreements or a buyout.
At Onsen, we support founders and investors in efficiently managing transitions to ensure all stakeholder interests are recognized and the company can continue to exist on a different strategic path.
“Winding down” refers to the legal and practical processes for ending a company’s existence.
The terms “winding down”, “shutting down”, and “dissolving” are often used interchangeably. We think it’s helpful to use “dissolving” more narrowly to refer to the formal legal process of ending a company’s existence. We use “winding down” and “shutting down” interchangeably to refer to the cross-functional set of legal, tax, and operational jobs that go into wrapping up a company’s life. These include completing tax and legal filings, addressing creditor and employee obligations, liquidating assets, and managing communications with stakeholders.
A company usually shifts its strategic focus to winding down when it no longer believes there is a path to continuing as a standalone business. The goal of the company in a wind-down becomes to wrap up its outstanding obligations in an orderly way.
A key part of winding down a startup includes realizing company value by liquidating remaining assets and managing liabilities. These activities are often done in parallel with managing other legal and practical responsibilities.
If a company has creditors, its wind-down may include one of several legal processes that are designed to protect creditor rights, such as ABC’s or bankruptcy.
Decisions made while transitioning a startup should be based on the company’s current context — the culmination of its historical activities.
As part of the transition process you will leverage information regarding the company’s formation, transactions, and previous operation.
Below is a list of company materials that frequently help in navigating an exit or wind-down.
In their roles as directors, officers, and/or majority stakeholders of a startup, founders are fiduciaries of the company.
Fiduciary duties are generally defined by the laws of the jurisdiction where a company is incorporated. For most US startups, this means fiduciary duties are a function of Delaware law.
Fiduciaries under Delaware law have a legal responsibility to act in the best interest of the company and its shareholders and, in limited cases, certain other stakeholders.
The main fiduciary duties are typically grouped as duties of care and loyalty - each of which is explained below.
At all stages of a startup’s lifecycle, founders who are a director, officer, or major shareholder have a fiduciary duty to their company. However, founders’ fiduciary duty often receives increased scrutiny during exit or dissolution events.
Founders, officers, and directors can protect themselves against personal liability by carefully considering any actions that could be perceived as advancing personal gain at the company’s expense.
A founder’s fiduciary duty of care requires that they conduct reasonable diligence and exercise reasonable judgment when making decisions that impact the company.
Examples of actions conducted with care include disclosing any personal conflicts of interest, abiding by usual duties as a founder, and not intentionally breaking the law.
A founder’s duty of loyalty requires that they make good-faith decisions and take actions in the best interest of the company and its beneficiaries rather than for personal gain. Any personal conflicts of interest should be disclosed.
Cash runway is the number of months remaining until a company runs out of cash.
This metric is particularly important for early-stage startups that are not yet generating steady cash income. Cash runway signals how much time the company has before it runs out of money and may indicate that a company should either seek additional financing, explore exit opportunities, or consider winding down.
Most companies should not wait until the cash runway reaches zero before beginning to consider next steps. At a minimum, companies should be prepared to meet employee and tax obligations, which may require preserving several thousands of dollars (or more). Company directors risk personal liability if the company is unable to meet employee and tax obligations.
To calculate cash runway, divide the total available cash by the company’s average monthly net burn (total monthly sales less total monthly expenses). If there is reason to believe that the monthly net burn will change substantively in the future, use a projected average monthly net burn rate.
An “exit” refers to the divestiture of key stakeholders’ financial interest from the company. For early-stage startups, these key stakeholders are generally the founders and investors. Founders and investors hold company shares and “exit” their positions upon an event that provides the opportunity to realize (sell) those shares.
Exit strategies differ depending on the goals and stages of a company. Common examples of exit events include IPOs/direct listings, mergers, and acquisitions.
Within the context of startup exits, due diligence refers to the appraisal process to confirm the key facts and details of the exit transaction.
This period of investigation often includes a review of the target company’s business operations, financial statements, and legal agreements by either the buyer or a third-party auditor.
The due diligence process can take significant temporal and financial resources that, once spent, are difficult to recover. Particularly for early-stage startups, a smooth due diligence process can be the difference between a successful transaction and one that falls through.
Founders interested in pursuing an exit in the near to medium-term can benefit from advanced preparation for the due diligence process (e.g., understanding the company’s tax exposure, organizing financial statements, and proactively addressing potential issues for an exit transaction).
A dissolution structure refers to the formal set of legal agreements, company approvals, and filings to formally end a company’s legal existence. The available structures will depend on the jurisdiction in which the company was incorporated.
Most early-stage startups incorporated in Delaware use one of three structures: Administrative Dissolution, Short Form Dissolution, or Long Form Dissolution.
Read more about Delaware dissolution structures here.
A certificate of dissolution is a formal document filed with the company’s state of incorporation that indicates that the company wishes to end its legal existence.
A startup must pay any taxes due at the state level, along with required yearly franchise taxes for each year of operation, prior to filing the certificate of dissolution.
Read more about the certificate of dissolution here.
If a startup expanded business operations outside of its state of incorporation, it will need to file for foreign (out-of-state) qualification withdrawal.
Note that the startup needs to “dissolve” in its state of incorporation, but “withdraw” from other states of operation.
Companies are required to file periodic reports and pay state franchise taxes and applicable compliance in states that they conduct business. When a company wishes to cease conducting business in a state, it should file for foreign qualification withdrawal in order to avoid continuing to incur taxes and fees.
The withdrawal process usually involves submitting a withdrawal application and paying a filing fee. The fee varies by state, but typically ranges from $10-$100. Each state has its own division that manages the business withdrawal process.
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.
At Onsen, we support startups through the ABC process by serving as the assignee.
Unpaid customer invoices — also known as accounts receivable — are one common asset in companies that are winding down.
The value of the unpaid customer invoices varies based on the specific facts. It generally depends on the strength of the legal claims and the ability and willingness of the customer to pay.
Factors that help strengthen legal claims include:
The presence of a signed service agreement.
Certain types of law firms and service companies specialize in helping assess the value of accounts receivable and collecting payment. For companies with substantial $ value in unpaid accounts receivable, it can be a valuable investment to work with these firms.
Managing liabilities is one of the most crucial activities for an early-stage startup as they exit or wind down.
Liabilities are legal obligations that impact what options a startup has in charting its transition course. Some of the most significant liabilities for startups include employee obligations, tax obligations, loans, and accounts payable to vendors.
Secured creditors’ claims are prioritized ahead of unsecured creditors’ claims.
Secured creditors issued credit that is backed by collateral; they have a charge over a particular asset and have the legal right to it in the event that the company defaults on the credit. For example, a bank with a lien on the company’s assets would be a secured creditor.
Unsecured creditors issued credit that is not backed by collateral. For example, credit card companies are typically unsecured creditors.
Companies have contractual and government mandated obligations to their employees. Contractual obligations are set forth in company policy documents and individual employment contracts while government mandated obligations are determined by federal and state law.
When a company is winding down, employees are generally treated as the top preferential unsecured creditor. This means that they usually have a right to payment ahead of other unsecured creditors, including tax authorities (such as the IRS), general unsecured debt holders, and investors.
Because of this, it makes sense to pay special attention during the dissolution process to meeting outstanding employee obligations.
It’s also important to note that as part of the protection granted to employees by various state and federal statutes, company officers may be personally liable for unpaid employee wages or benefits.
Contractual employee obligations
Companies’ contractual obligations to employees are outlined in individual employment contracts and company-wide employment policies.
Contractual obligations may include severance pay, an extension of benefits programs, written notice of a company shutdown, employment assistance, or other agreements. Company cash may need to be reserved to meet obligations such as severance pay and an extension of benefits.
Federal / state mandated employee obligations
In order to protect employees, federal and state governments mandate certain statutory rights for employees. Companies shutting down must account for these.
Each state government has a division and associated resources that outline companies’ statutory obligations to employees residing in that state.
Specifics vary by state, but in general, companies must:
A startup has tax obligations in its state of incorporation and potentially in states in which it conducted business.
Companies formed in Delaware must pay an annual franchise tax and file corporate income tax. In order to be considered fully caught up on taxes, the startup must file taxes through the year in which the certificate of dissolution is filed.
The company must pay all taxes due to Delaware and any applicable Delaware franchise taxes prior to filing the certificate of dissolution.
State franchise taxes
A state franchise tax is a tax levied on businesses for the right to legally exist and conduct business within a jurisdiction. A Delaware-incorporated company must pay its owed Delaware franchise taxes in order to file the certificate of dissolution.
There are two methods to calculate Delaware franchise tax:
1. Authorized Shares Method
To pursue this method, use the guide below to calculate state franchise tax:
As an example, if a company has 10,500 authorized shares, then the estimated state franchise tax is $335.
2. Assumed Par Value Capital Method
To pursue this method, use the following steps to calculate the state franchise tax:
A company can use either method to calculate the Delaware franchise tax and follow whichever method leads to the lower amount. Delaware provides a calculation for taxpayers using the Authorized Shares Method.
The minimum state franchise tax is $175 for companies using the Authorized Shares Method and $400 for companies using the Assumed Par Value Capital Method (both methods have a $50 associated filing fee). The maximum state franchise tax for a company is $200,000, unless it is identified as a Large Corporate Filer, in which case the maximum is $250,000.
It can be a valuable investment to consult tax and/or legal advisors for any assistance required to meet state franchise tax obligations.
Corporate income tax
A corporate income tax is a tax levied on the profits (income) of a business. A company is legally required to pay federal and state (if applicable) corporate income tax through the year of its dissolution.
Federal and state laws dictate who is responsible for paying the company’s taxes. Even for insolvent companies, in certain cases the IRS may look to hold company directors (which often include founders) personally liable to pay the taxes.
Form 1120 is the federal corporate tax return to the IRS. US corporations shutting down are required by law to file a final Form 1120 for the last year they exist and a Form 966 when they adopt a resolution or plan to dissolve.
It can be a valuable investment to consult tax and/or legal advisors for any assistance required to meet corporate income tax obligations.
Tax obligations vs. other liabilities
Tax authorities, like the IRS, are considered preferred unsecured creditors. As preferred unsecured creditors, they have a right to be paid ahead of everyone else aside from secured creditors and employees. (Note that environmental remediation costs and tort victims are considered preferred unsecured creditors as well, but these don’t apply to most startups.)
Managing debt obligations is a key part of a startup’s transition process. Companies that are insolvent are unable to meet all of their debt obligations. As a result, the order in which credits are paid becomes important.
In the United States, secured creditors are paid first, followed by unsecured creditors, then shareholders. Employees and tax authorities are considered preferred unsecured creditors and therefore given priority over general unsecured creditors. Outside of bankruptcy, the priority of claims is governed by state law and agreements between the company and creditors.
Particularly in early-stage startups, founders (and other company directors) may find that they are employees, creditors, and/or shareholders of the company. In order to uphold their fiduciary duties to the company, founders should ensure that they are paid pro rata alongside other employees, creditors, and shareholders; founders should not grant themselves preferential treatment over other company beneficiaries.
Active vendor contracts represent liabilities for a startup. As part of the wind-down process, these vendor contracts should be terminated as quickly as possible in order to reduce expenditures.
Company credit card statements from the past 12 months may reveal recurring expenses that need to be canceled.
While specific vendor contracts vary by company and industry, some common examples of recurring expenses for startups are listed below.
A liquidating distribution is the return of remaining company assets to company stakeholders once the company’s assets have been sold.
A distribution waterfall is a spreadsheet that outlines how much money (or in some cases, non-cash assets) will be returned to each stakeholder in the liquidating distribution.
This is typically used as a source of truth in making payments and ensuring payment amounts sum correctly.
The distribution waterfall is organized by payment priority — the “waterfall” refers to the order of payments flowing from highest priority (e.g., security creditors) to lowest (e.g., common stockholders).
Venture-backed companies typically prepare a distribution waterfall if they have any proceeds to return to creditors and equity holders after an exit or shutdown event.
Outside of bankruptcy, if proceeds are insufficient to fully repay all creditors, creditors should be prioritized according to the startup’s state of incorporation’s laws, by the terms of the debt agreement, then ratably.
Investors should be repaid according to their investor rights (outlined in their investment purchase agreements, such as a SAFE or Stock Purchase Agreement) and pro rata (proportionally to their investment).
It may be beneficial to seek the guidance of a legal or accounting professional to prepare the distribution waterfall.
Updating stakeholders of a transitioning company helps make for a smooth transaction and preserve valuable professional relationships. Company stakeholders include creditors, investors, employees, and customers. Depending on the stakeholder’s relationship with the company and legally-mandated notice requirements, it may be appropriate to send one or multiple updates.
Federal and state laws specify legal notice requirements to stakeholders for companies winding down. U.S. bankruptcy code and most dissolution or ABC statutes have notice requirements for creditors and shareholders. Delaware law specifies its own requirements for incorporated companies.Regarding employees, certain states mandate specific employee termination procedures.
Regardless of a startup’s stage, best practice is to share regular updates with stakeholders. Frequent communication can align expectations about the health and status of the company.
Each type of stakeholder may require a different level of detail and context about the business transition. For instance, investors may expect details about how much of their investment amount will be returned to them while employees may expect guidance about the separation process.