Here’s What to do When Your Startup Investment Fails– Fast.
Investing in a startup requires a healthy appetite for risk, and with startups sometimes you have to kiss a lot of frogs to find a prince or princess. When the start up you’ve invested in fails, there are prudent steps to take before the company closes its doors (or garage doors).
Books and Records
The first order of business is information gathering, in order to get a complete picture of how the company came to its present financial position. Particularly important for the investor will be gaining access to the company’s books showing cash-flow, burn rate, and bank records. Investor rights to inspect a company’s books and records are contained in the statute of the state where the company is incorporated or organized. The rules are can be highly formal, both with regard to the manner in which a request must be made, and the categories of information that can be obtained. Generally speaking, it’s easier to get access to corporate governance documents, like the company’s certificate of incorporation, by-laws, and stock ledger. If the investor wants to get ahold of financial records, they should be prepared for a potential fight. I’ve also seen a trend of stockholder agreements that purport the shareholder has waived their rights to inspect the company’s books and records. (I don’t think such a waiver would be enforceable, as the ability to inspect books is set forth in statute and is integral to the rights of shareholders.) If the company refuses to open its books, the investor has the ability to sue and to seek turnover of the books. In fact, litigation can be an effective tool in information gathering, as one of the benefits of bringing suit is the broad scope of civil discovery. This includes demands to the company to produce documents, subpoenas to banks and accounting firms for their records, and depositions of persons at the company that are most knowledgeable about identified subject areas.
Any potential suit will be informed by the relevant shareholder agreements, subscription agreements, private placement memoranda, investment prospectuses, and other investor documents. I was recently involved in a suit representing a founder where the investment documents require private arbitration, which can involve deposits of tens of thousands of dollars from each party. The cost of arbitration was an impediment to the investor in bringing suit, and potentially weighed in favor of tracking the case for early settlement, before both sides were up to the necks in fees. The same documents also included an attorneys’ fees provision, whereby the prevailing party in the arbitration would be permitted to recover fees from the other party. This may have factored into the investor’s decision to pursue the lawsuit, the idea being that any sunken costs could be ultimately recovered.
One of the things an investor will look for is evidence that the company’s officers or directors breached fiduciary duties owed to investors. This is the duty to act in good faith, on an informed basis, and in the best interest of the company as a whole. There is a presumption of good faith, and the law gives wide latitude to the board and management in the running of a company, absent evidence of self-dealing, i.e. that insiders were on both sides of a transaction between the company and another party. Investors will want to look for instances of self-dealing, which will be carefully scrutinized by a court.
Another item that an investor and advisors will look for is evidence of fraud by the company or founders, either at the time of the original investment or in subsequent reporting. Fraud claims can be intentional or negligent. Fraud cases can be difficult to prove, and not every misstatement is a fraudulent statement. Forward looking statements of optimism, particularly if generalized, can be considered “opinions” or “predictions” about future events, and will not support a fraud suit. In fact, predictions of growth or success are often expected as run-of-the-mill “puffing.” Fraud also requires a misstatement if face that was false when it was made. Just because a company predicts success, but fails to achieve milestones, does not mean there was fraud. There could be intervening reasons that led to the failure, for example, changes in consumer demand, the rise of new competitors, or systemic challenges like an economic recession. The investor should collect all emails and other communications with the company, to determine whether the statements were rosy predictions, versus genuinely false and misleading.
Another consideration is whether there is evidence of fraudulent conveyances by the company. A fraudulent conveyance, despite its name, does not necessarily mean there was fraud in the traditional sense. Rather, this is a situation where a company transfers money or property for less than reasonably equivalent value in return. For example, the company might transfer its algorithm or other intellectual property, but for less than the amount that it is worth. The law allows these transfers to be undone and the property brought back into the company, so that it is available for all creditors. (Since 2016, fraudulent conveyances are now called “voidable transactions” in California, although it’s unclear how much the name has or hasn’t caught on.)
The bottom line? A founder of a failed company will want to demonstrate to investors that management made its best, most earnest effort, but success was not possible despite the best intentions. On the other side, investors will want assurances (and evidence) that this was in fact the case.