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Startup Entrepreneurs Should Plan for Success But Prepare for Failure: Do You Have a Plan B?

Absent luck and preparation, failure equals disaster – it is folly to assume otherwise…

When a startup participant (i.e., company founder, investor, officer, director) prepares a business plan for success, they would be wise to consider their options under a Plan B in the event of failure. Bloomberg reports that 8 in 10 businesses will fail. While it may seem  counter-productive to  enter into a new venture  thinking about negatives,  you will avoid future regret by having minimized potential future risk. Typically, lenders leave no scrap for startup participants to keep in the event of default:  typically all assets are tied down. Participants are, by dint of custom and necessity, forced to be “all in.” Absent luck and preparation, failure equals disaster – it is folly to assume otherwise.

At stake are all existing and future property interests held by the company – and the willing participants. The company’s assets are tied down by the loan documents; the participant’s assets by guarantees. The execution of a guarantee, particularly one that is iron clad,  should be viewed (and is herein defined) as the “kiss of death.”

Given the potentially devastating consequences that can befall a participant of a company that enters into a financing arrangement with a lender, what can the participants who must sign guarantees do to protect their assets in the event of the company’s default? Here are some suggestions:

Don’t Let Your Spouse Sign the Guarantee

This is critical. This small protection can make all the difference between losing everything and settling for pennies on the dollar. This is because unless the spouse is contractually obligated, the creditor will not be able to look to the separate property interests of the debtor’s spouse to satisfy the debt.

Be a General Partner

Tax consequences permitting, make the debtor a general partnership or its equivalent and be a general partner. This will allow the participant to invoke the “sham guarantee rule” to invalidate the guarantee. That rule says that a person cannot guarantee their own debt and general partners of a partnership are already liable for the partnership debts. There are circumstances where this protection can have a huge impact.

Negotiate

Negotiate limits on the term and scope of the guarantee and eliminate, to the extent possible, triggers based on technical defaults.

Do Not Exaggerate Your Net Worth

Do not give the lender any reason to believe that they should pursue you before the company or any other guarantor: do not exaggerate your net worth.

Bankruptcy is No Panacea

If the company finds itself unable to service its debts or sustain operations, bankruptcy  court is often the last place it wants to be. With very rare exceptions, companies do not receive a discharge (i.e., exoneration of debts) in bankruptcy, yet all of the transactions between the participants and the company will be scrutinized to determine if any payments that were made to or for the benefit of participants while the company was insolvent are recoverable. Moreover, to the extent the participant may hope that the guarantee liability will be reduced by the net sale proceeds of the company’s assets, participants are likely to be disappointed, as assets sold in bankruptcy proceedings are typically sold for rock bottom values. Bankruptcy Court can be even less hospitable to the participant guarantor.

Bankruptcy Court can be even less hospitable to the participant guarantor…

Focus on Resolving Disputes with Creditors Informally

Unless the participant is a glutton for punishment, the better course is to forget bankruptcy as an option and focus on developing a  mechanism to resolve disputes with creditors informally. The best line of defense is a very good account payable clerk, who has established credibility with creditors.  Other mechanisms include: assignments for the benefit of creditors, liquidating agents, interim CFOs, consensual receiverships, and mediation.   Unfortunately, banks  are notoriously stingy in making concessions on their debts– the bank officers’ sense of self-preservation often seem to override the bank’s best interests. That is not to say that a bank is not within its rights to pursue every legal remedy against the participant to attempt to collect on its debt.   It is just that all too often the bank’s needless actions are brought at the participant’s expense (i.e., the bank’s attorneys’ fees will be added to the debt).

The best position is to hold some leverage against the lender – to  encourage it to be  more reasonable. Examples include a participant’s unique ability to maximize the value of the lender’s collateral or some technical failure in the lender’s documentation.

Show the Lender the Lack of Money

Where a company’s defenses or resolution mechanisms fail to hold up,  the participant may resort to an  “insolvency analysis” to establish that the creditor will receive more under the participant’s offer than under any alternative.   The insolvency analysis may include projected treatment of the participant’s assets and the creditor’s claim in a hypothetical bankruptcy case.  A convincing insolvency analysis will enable the company and participants to avoid having to file bankruptcy.

Mitigate

If the participants are nonetheless unable to resolve the company’s debts informally, and bankruptcy is either thrust upon the company by an involuntary petition or becomes necessary to stop litigation or collection efforts, then the participant guarantors should seek to buy the lender’s debt so that they may be paid back from the assets of the company.

Of course, in any of these default scenarios, it doesn’t hurt to have an excellent lawyer.