In my last post I talked about the responsibilities that board members have to a company both before and after insolvency occurs. The list below provides some practical precautions for prudent directors in financially distressed companies to keep in mind.

Below are some practical precautions that a prudent director of a financially distressed company should keep in mind.

Financial Monitoring

1. Maintain vigilance over the company’s financial situation.
2. Convene board meetings as often as necessary to discuss important issues affecting the financial health of the company and consider alternatives to a particular course of action.
3. Avoid actions that benefit one creditor over another.
4. Place limitations on the company’s ability to incur further debt if the corporation is slipping into the zone of insolvency or it is unable to pay its debts when due.

Corporate Formalities

1. Maintain company formalities including holding scheduled meetings and keeping good corporate minutes of all actions taken by the board including the discussion of alternative courses of action that were considered and the advice of outside experts.
2. Ensure that all minutes reflect the attendance and active participation of directors.

Governance

1. If the board is considering entering into a significant transaction, such as a sale of assets, incurring substantial debt, a financial restructuring or any other transaction that could pose a substantial risk to company assets, seek legal and financial advice from outside experts which will also demonstrate that the board is considering independent, objective advice.
2. Before entering into a significant transaction of the type described above, consider seeking the advice and/or consent of major creditors.
3. Continue to act in the best interests of the company as a whole without favoring one corporate constituency over another, particularly any action that favors equity holders over creditors such as dividends or redemptions of stock.
4. Be aware that any action that benefits insiders including officers and directors will be subject to closer scrutiny and could be viewed as a breach of fiduciary duty or avoided as preferential or fraudulent payments.
5. Avoid increasing executive compensation out of the ordinary course of business unless it can be supported by the circumstances; consider obtaining outside advice to validate any decision.

Corporate directors of a financially healthy and solvent company have a fiduciary responsibility solely to the corporation and its stockholders and do not have a duty to creditors beyond the contractual duty owed by the company.

In today’s economy, many companies face unprecedented financial strains and, as the financial situation deteriorates and nears insolvency (aka zone of insolvency) directors must consider the impact of their decisions on the company’s creditors as well.  Once a company has passed the threshold of insolvency, the beneficiaries of a director’s fiduciary duties in many jurisdictions include the creditors of the company because, as courts have reasoned, the equity owned by its stockholders is worthless and the burdens of poor decision-making by management fall on the corporation’s creditors.

Generally, the fiduciary duties of a director are the duty of care and the duty of loyalty.  The duty of care requires a director to be fully informed of all material information reasonably available, acting with due care and consulting with officers, employees and outside experts as reasonably necessary to make informed decisions.  The duty of loyalty requires that a director act solely in the best interests of the company without personal or private motive, avoiding self-dealing and any conflict of interest that may compromise the director’s independent decision-making process.

Until fairly recently, the prevailing wisdom was to advise boards of directors that the shift in their fiduciary duties occurred once the company entered the zone of insolvency.  Recent case law in Delaware has rejected this premise, and, moreover, prohibited the rights of creditors to bring direct claims against directors for breaches of fiduciary duty even when the company is insolvent.  See North American Catholic Educational Programming, Inc. v. Gheewalla, et al., 930 A.D.2d 92 (Del. 2007).  However, “creditors may nonetheless protect their interest by bringing derivative claims on behalf of the insolvent corporation or any other direct nonfiduciary claim . . . that may be available for individual creditors.”  Id. at 94.  In Trenwick America Litigation Trust v. Billet, 906 A.D.2d 168, 175 (Del Ch. 2006), the court held that “so long as directors are respectful of the corporation’s obligation to honor the legal rights of its creditors, they should be free to pursue in good faith profit for the corporation’s equity holders.  Even when the firm is insolvent, directors are free to pursue value maximizing strategies, while recognizing that the firm’s creditors have become residual claimants and the advancement of their best interests has become the firm’s principal objective.”

While these legal clarifications permit directors to focus on maximizing corporate value, the impact on creditors must be carefully considered as it remains difficult to assess when a company actually crosses the threshold of insolvency.  Under Delaware law, a company is considered insolvent if it fails one of several tests, including whether its total liabilities exceed its total assets, the so-called “balance sheet insolvency test” or whether the company is unable to pay its debts when due, the so-called “equitable insolvency test.”  Other states employ other tests.

Because of the subjective nature of these insolvency tests, the board of a distressed company exercising its fiduciary duties must remain cognizant of the impact of its decisions on the corporation’s creditors.  In next week’s post, I’ll outline some of the concrete steps and precautions that a director of a financially distressed company can take.

Periodically we will have posts from local entrepreneurs that provide some sound advice from a slightly different perspective. Today’s post is from Jason McDowall, a local serial entrepreneur that I’ve had the opportunity to work with and get to know over the last couple of years.  Jason was previously the co-founder and CEO of Adhoc Mobile, a developer of a sophisticated mobile ad and content delivery platform, that raised $3M in Angel financing. Jason is now the VP of Product Development at Benchmark Metrics, an angel funded developer of web-based business analytics tools.  Just a brief editorial note…the angel investors he describes below were not from the Pasadena Angels. 

By Jason McDowall

You’ve  shaken the loose change from friends and family, and now you’re desperate for cash to get your startup to the next level.  Do you think any check that doesn’t bounce belongs in your checking account?  In my experience, I believe you should be picky about who supplies the cash.  If your investors aren’t helping your company, they’re hurting it.  Here’s what can go wrong:

Risk: the investor does nothing

Who cares?  At least you’ve got some extra time and resources to build your dream, right?  That hasn’t been my experience.  Sure that convertible debt or silent investor may have bought you extra time, but your milestones and plans are probably wrong to begin with.  You’ll need even more time and more resources to execute than your business plan indicates.  For seed-stage companies, there is so much work to be done, so many adjustments to make, so many relationships that need to be established that you need your investors working for you.  Why waste your time or equity on an investor who cannot contribute essential customers, contacts, or credibility?  Your competitor is already better funded and has that support.

Risk: the investor promises a lot and does nothing

This is even worse than the risk above because you have misplaced expectations and end up wasting a bunch of precious equity/cash/time on a non-delivering member of the team.  If you are lucky enough to have someone offer you money, you owe it to your company/team to do some reference checking on the source of funds.  Talk to other companies that have received investments from the same source, and find out if they have they delivered on similar promises in the past.  If the investor is taking a role in the company (e.g., temporary C-level exec, VP of anything) check the investor’s work references just as you would for any other hire.

Risk: the well runs dry…or loses interest

Chances are the specifics of what your company does and how it makes money will change between the start and the declaration of success.  And to make it more challenging, it will take longer and cost more than you think to get there.  An unsophisticated investor or one unfamiliar with your industry may not have the appetite for the inevitable trial and error process.  You definitely need to be smart about market validation and finding ways to try/learn/adjust quickly

But you also need an investor who appreciates the need for, and can supply or quickly facilitate, additional funding to get you to that next major milestone (assuming you deserve the chance).  Finding an angel who made a bunch of money in real estate to invest and take a board seat in your web widget software startup is probably not the best move.

Risk: adversity strikes and visions begin to differ

At the beginning, everyone is full of excitement and enthusiasm.  But as you struggle to make your milestones and find yourself tweaking the business model, things can quickly get contentious.  It can be hard enough to keep the founding team on the same page, motivated, and making progress.  Having to deal with investors who have different visions of how and where to make necessary adjustments can make life miserable.  I’m not suggesting investors should all be drinking the same amount of Kool-Aid and believe all of the hopeful assurances of the founder.  But you should make sure financial incentives are properly aligned and voting procedures clearly in place to help deal with the hard times.  Also ask other portfolio companies how the investor has dealt with hard times in the past.  If you’re looking for strategic money at the seed stage, understand how that will likely restrict your growth options in the future.  If you’re looking for angel money, he or she needs to understand the likely dilution of ownership and power that will come if you end up needing another round.  And when things begin to diverge from the plan, be clear, be honest, and be prepared to make some concessions.

Creating a successful company is hard.  It requires a market insight, hard work, tenacity, flexibility, and some luck.  And it requires a lot of help.  In addition to cash, seed investors (and board members) should bring or be at least one of the three essential C’s: contacts, customers, or credibility. Remember that due diligence goes both ways.

Now if you could just elicit enough interest to actually have a choice….