Orrick's Founder Series offers monthly top tips for UK startups on key considerations at each stage of their lifecycle, from incorporating a company through to possible exit strategies. The Series is written by members of our market-leading London Technology Companies Group (TCG), with contributions from other practice members. Our Band 1 ranked London TCG team closed over 320 growth financings and tech M&A deals totalling US$9.76bn in 2022 and has dominated the European venture capital tech market for 7 years in a row (PitchBook, FY 2022). In our previous instalments, we have guided founders through the process of incorporating a private limited company, building their team, how to use share options to attract and incentivise their employees, protect their ideas, identified key compliance considerations, what to consider when raising their round, and how to navigate the evolving cyber threat landscape and how to flip to a Delaware corporation.
Coming from a vibrant and founder-friendly year in 2021, global economic headwinds took a toll on high-growth tech-focused businesses in the second half of 2022, and have continued to do so in 2023. Markets have witnessed a correction in valuations, which has resulted in a slow-down in equity investments, a retraction of the volume and size of investments, and less favourable terms for founders looking to raise in 2023. For those less lucky, the reduction of available capital may have left companies facing financial distress.
In the ninth instalment of Orrick's Founder Series, our Restructuring team offer key guidance for UK founders steering a company through financial difficulties.
- Consider alternative sources of funding. While markets recover, founders may look to other sources of funding rather than facing a down-round (the terms of which may be too dilutive or particularly punitive in the current investor-friendly market). Founders could rely on their existing investors to provide bridge funding through convertible debt or consider secured debt from third party debt providers to acquire capital to bridge the gap to their next equity round or exit. Whilst such sources of funding may be considered expensive, as they often include high interest rates and an equity kicker, debt funding may provide the company with a welcome lifeline until the next equity round. Any lender seeking to provide debt funding will likely wish to protect against a downside scenario and ensure that the company has assets or that the company is capable of generating positive cashflow to service the debt in the event that the next equity round is delayed or not forthcoming. The tax implications of any such alternative funding should also be considered, including whether such funding could give rise to withholding tax leakage if an exemption is not applicable.
- Take steps to extend the runway of the business. When a company falls into financial difficulty the cost base of the company and the business plan should be reassessed to consider whether any non-essential costs can be cut out of the business. This may involve processes with respect to redundancies, or terminating or renegotiating legal agreements such as consultation contracts, leases and existing contract terms. Careful attention to proper processes should be made in these scenarios.
- Put a contingency plan in place and maintain optionality. Directors of a distressed company owe a duty to act in the best interests of the creditors of the company (as a whole). Therefore, whilst the primary focus of the directors of a company which is insolvent, or on the brink of insolvency, may be to secure additional funding in order to enable the business to continue to operate, they should also explore other alternatives. This may include pursuing an exit or a sale of the business or assets of the company. In the event that the preferred solution becomes unattainable, directors should ensure that there are alternatives in place which maximise the value of the business and ultimately minimise losses to creditors. When evaluating the merits of such alternative transactions, the tax treatment for both the company and (where relevant) its stakeholders should also be considered. Running alternative processes in parallel may also be prudent to ensure that a transaction may be implemented for the benefit of the creditors of the company.
- Seek advice with respect to the duties of directors. When a UK company is in financial distress such that the company is insolvent or an insolvency is probable, the general duty of directors to act in a manner that they reasonably believe will promote the success of the company for the benefit of the shareholders, is supplemented by a duty to act in the best interests of the creditors of the company (as a whole). When the duty to creditors arises, the directors should balance the interests of shareholders and creditors (to the extent they conflict). The greater the company's financial distress, the more directors should prioritise the interests of creditors. To the extent that an insolvent liquidation or administration becomes inevitable, the interests of the creditors become paramount, as the shareholders no longer have a valuable interest in the company. Directors should seek specialist legal and financial advice from an insolvency practitioner as soon as possible. They can advise the directors with respect to their duties and ensure that they do not take action that could result in personal liability, should the company enter into an insolvency process.
- Avoid wrongful trading. In the event of a liquidation or administration of a UK company, directors could potentially face personal liability for wrongful trading. Under the Insolvency Act 1986, an appointed administrator or liquidator may seek an order of the court that the directors of the company contribute to the assets of the company if (i) the director concluded or ought to have concluded that there was no reasonable prospect of the company avoiding an insolvency liquidation or administration and (ii) there is an increased deficit to the loss suffered by the creditors of the company. The court will not make such an order for contribution in circumstances where the directors took every step with a view to minimising losses to creditors. Therefore directors should assess whether the company has a reasonable prospect of avoiding an insolvent liquidation or administration on an ongoing basis and ensure they act with a view to minimising losses to creditors.
- Meet regularly and keep records. The financial position of the company can change rapidly. Boards should therefore meet as frequently as is reasonable in the circumstances (even daily if the financial distress is particularly acute) to consider whether the company is insolvent and to assess whether there remains a reasonable prospect of avoiding an insolvent liquidation or administration.
If a company does enter into an insolvency process, the appointed liquidator or administrator will scrutinise the conduct of the directors prior to the insolvency to consider whether there are any potential actions that could be brought to maximise the assets of the company and also for the purposes of preparing a report to the Secretary of State for Business and Skills with respect to their conduct. In the event that the conduct of directors is considered to be sufficiently poor, delinquent directors may be disqualified from acting as a director upon an application under the Company Directors Disqualification Act 1986. Keeping minutes of board meetings which record the decisions made by the directors will provide evidence to an insolvency practitioner that the directors have acted appropriately, sought specialist advice considering their duties and acted in a manner which they reasonably believed to be in the best interests of the creditors of the company.
- Consider the position of each group company separately. Where the group is financially distressed, directors of each company should consider whether any particular course of action is in the best interests of each group company (and its creditors) separately. There may be circumstances where the interests of all companies within a group (and their respective creditors) are aligned. However, there may be certain circumstances which give rise to potential conflicts, for example, where groups have operated centralised cash pooling arrangements and certain companies are reliant on the provision of cash from other group companies, and directors should consider whether such arrangements should be terminated. Any potential conflicts should also be managed by ensuring there is some independence on the boards of each different group companies.
- Avoid preferential transactions. A preferential transaction is a transaction where a company pays a creditor in preference of other creditors and may arise where:
If the creditor is an associate of the company, a presumption will arise that the company intended to put that creditor into a better position. This presumption is rebuttable.
- there is a debt due from the company to a creditor;
- the company does something (or suffers something to be done) which has the effect of putting that creditor in a better position than it would have been in had the action not occurred;
- there is a desire from the company to put that creditor in a better position (a high threshold for a liquidator to prove, and one which academic commentary suggests will not be found unless the company positively wished to improve the creditor's position in the event of its own insolvency);
- the action took place within the relevant time i.e. two years before the onset of insolvency if the creditor is connected to the company and six months before if the creditor is a non-connected recipient; and
- the company was unable to pay its debts at the time of the action or as a result of it.
A liquidator may apply to court for an order to restore the position to what it would have been had the company not given the preference. Under section 239(3) of the Insolvency Act 1986, the court shall make such an order as it sees fit. This power of the court is very wide and can include an order forcing the person who entered into the transaction, or who received the preference, to return the property or its value to the company.
Therefore, directors should be cautious about paying certain creditors over others, unless there is a genuine commercial reason for doing so.
A transaction at an undervalue, which is not on arm's length terms, may also be challenged from a tax perspective, under transfer pricing or anti-avoidance principles.
- Avoid transactions at an undervalue. Divesting of assets belonging to the company may be a way of obtaining additional cash to allow a company to continue to trade and bridge the gap to a future capital injection or exit. However, directors should take caution to avoid a transaction at an undervalue. In an asset sale in a distressed scenario, the company may not receive full value given the need to sell urgently.
A liquidator or administrator may apply to the court for an order to set aside gifts or transactions made by the company before it became insolvent where the company received no or inadequate consideration. In the case of a transaction with a person who is connected to the company (e.g., a director or associate of a director), any such transaction will be vulnerable if it was entered into up to two years before the company went into liquidation.
In order to be liable to be set aside, the company must have been unable to pay its debts at the time of the transaction or became unable to pay its debts as a result of the transaction. However, if the transaction is with a connected person, the court will automatically presume this to be the case unless proven otherwise. That is, it will be incumbent on the party opposing the order (e.g., the connected party or a director required to make a contribution) to prove that the company was not made insolvent in connection with the transaction.
A court will not make such an order if it is satisfied that the company entered into the transaction in good faith and for the purpose of carrying on its business, and that, at the time it did so, there were reasonable grounds for believing that the transaction would benefit the company.
- Instruct professional advisers. Seeking advice from legal and financial experts can assist in providing a defence to any potential claims by an insolvency practitioner if the company later enters an insolvency process. Advisers can also assist in identifying areas of risk where directors could potentially be in breach of their duties and provide guidance in dealing with circumstances that many directors may not have experienced.
Taking tax advice in advance of implementing any proposed financing or financial restructuring, with a view to identifying potential tax exposures, and, where possible, seeking to structure the transaction in a tax efficient manner, is also important. Potential tax exposures that could be relevant include withholding tax, the triggering of taxable loan relationship credits in the debtor entity where debt is released or amended, and stamp duty charges on certain transfers of debt or equity.
Orrick has built a sophisticated finance practice in London which has yielded high levels of activity across leveraged and acquisition finance, both syndicated and bilateral lending, refinancing, bespoke special situation financings, and other corporate lending matters. Our team advises insolvency practitioners, creditors (including banks and alternative credit providers) and corporates on all aspects of national and cross-border restructuring and insolvency transactions.
If you would like more details on any of the issues above, please contact Jamie Moore or Scott Morrison.
 BTI 2014 LLC v Sequana S.A. and others  UKSC 25