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Key Concepts For Transitioning A Startup



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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.


Transitioning a startup

“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:

  1. Exiting (selling the company or its assets)

    1. The primary goal is a near-term monetization of value in the company — either through a sale of the company itself or the sale of substantially all assets.

  2. Recapitalization

    1. The primary goal is to change the company’s capital structure to align with short and long-term strategic and financial objectives.

  3. Pivot

    1. The primary goal is to continue operations with a fundamentally different strategy and ownership structure.

  4. Winding down

    1. The primary goal is to legally end the company’s existence as quickly, compliantly, and efficiently as possible.

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.


Exiting a startup

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.


Recapitalization

Pivoting to a non-venture business model

Winding down a startup


Company context for transition

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.


List of company materials

  1. Most recent financial statements (balance sheet, income statement, cash flow statement)

  2. Historical company tax filings

  3. Company Corporate Documents (certificate of incorporation, bylaws, any investor rights and voting agreements, any technology transfer agreements)

  4. Company cap table

  5. Investment agreements (SAFE’s, convertible notes, promissory notes, equity financing agreements, etc.)

  6. List of board members and advisors

  7. List of active vendors

  8. List of unpaid customer invoices (accounts receivable)

  9. Executed (signed) loan and borrowing agreements

  10. List of active employees and their states of residence

  11. Copies of employment contracts with active employees

  12. List of material real property (tangible) assets (computer hardware, furniture, etc.)

  13. List of intangible assets (patents, codebase, etc.)

  14. List of potential asset acquirers (such as competitors or customers)

  15. Contact information for investors, advisors, current employees, and active customers

  16. List of jurisdictions where the company has registered to do business


Founder fiduciary duties

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.


Duty of care

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.

Duty of loyalty


Cash runway


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.



Exit


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.


Due diligence


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).


Dissolution structures


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.


Certificate of dissolution


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.


Foreign qualification withdrawals


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.


Insolvency & zone of insolvency


Insolvency

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

Bankruptcy & Assignments for the Benefit of Creditors

Bankruptcy

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)

Unpaid customer invoices


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.

  • Documentation that shows the work was completed.

  • Acknowledgment from the customer that the work was completed.

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.


Liabilities management


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 vs. unsecured creditors

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.

Employee obligations

Tax obligations

Debt obligations

Accounts payable to vendors


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.

Common recurring vendor expenses

  • Office lease and utilities

  • Coworking space membership

  • Google Workspace

  • Domain registration

  • Website hosting

  • Zoom

  • Figma

  • Asana

  • Slack

  • Payroll provider (such as Gusto or Deel)

  • Tax providers (such as an accountant or TurboTax membership)

  • LinkedIn Premium

  • Atlassian (includes Trello, Jira)

  • Canva

  • Twilio

  • DocuSign

  • Zapier


Distributions

Liquidating distributions

A liquidating distribution is the return of remaining company assets to company stakeholders once the company’s assets have been sold.

Distribution waterfalls


Stakeholder communications


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.

Legal notice requirements

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.

Best practices


Additional resources


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