As the word “start-up” implies, it refers to small and young companies (“start”) aiming at a rapid growth (“up”). Start-up can be defined as a young and innovative company in the field of new technologies.
Start-ups have become an increasingly important business (ex: Dropbox, Uber, Snap…). As such, questions have been raised namely regarding how to best operate a start-up, invest in one or the protection of assets (ex: investments, Intellectual Property…). Mathias Avocats has written several articles regarding various aspects of start-up businesses: which type of company to choose, how to capitalise the company’s assets, fundraising… However, what happens when the start-up is wound-up?
It must be stressed that a company can be wound-up through two legal mechanisms: liquidation and ceasing business to sell the company. The business will come to an end and be dissolved. Liquidation occurs when the company is no longer able to pay its obligations when they come due. Ceasing business and selling the company occurs whenever the owner or board of directors so decides. In the event of a liquidation, the owner will not benefit from as much leeway as in a sale.
This question becomes all the more interesting considering the decline in the number of deals struck since 2013. TechCrunch published an article on the subject and explains what the term “peak start-up” implies. If the market is slower and less prosper, selling the business may be an option for a return on investment.
Before diving into the subject, it must be stressed that this article will focus on companies which have not been taken public with an Initial Public Offering (IPO). The latter implies different mechanisms.
Mathias Avocats stresses certain key points to consider when winding up your start-up.
What type of stock?
There are two types of stock: participating and non-participating stock. Each has its own advantages and drawbacks. They key element is knowing how much the holder will get back upon winding up the company. It all depends on the type of stock the holder has and the selling price.
Participating or preferred stock entitles the holder to receive his or her initial investment as well as an additional dividend of the remaining proceeds after the sale on a pro-rata basis. Furthermore, the holder will have certain rights and privileges such as voting rights, anti-dilution protection and so forth. In most cases, the investors have participating stock.
On the other hand, the holders of non-participating or common stock are only entitled to their investment or a pro-rata share of the proceeds after the sale. Founders and employees usually hold non-participating stock.
It may seem that participating stock is the best type of stock in all situations. This is not the case. Nothing guarantees that the holders of participating stock will get an additional dividend (ex: the sale price is too low; the capital of the company is mostly common stock…). Thus, when winding up the start-up, one must consider what type of shares he or she holds and how to best protect the interests of the shareholders while benefiting the founders.
What is seniority?
“Seniority” is an important term when it comes to liquidation. It does not apply if the start-up is sold. It refers to the privileged status of a holder and determines who will get their investment back first. Seniority benefits the holders of participating stock. It acts as a sort of security. Therefore, they will be paid before the holders of non-participating stock.
It must be underlined that there can be various degrees of seniority. Depending on the approach taken and the rules applied, some senior holders of participating stock may be paid before others. Creditors will be paid first.
Before selling a start-up, one must clearly determine whether there are any creditors and which holder will be paid 1st. In practice, the type of stock and when it was issued will determine seniority. Moreover, if the start-up is being liquidated, a professional will most likely analyse its capital to determine the payment hierarchy.
Are there other considerations?
When winding up a start-up, the investors or entrepreneurs should get a valuation of the business by an appraiser. The latter will draw up a detailed explanation of the business’s worth which will allow the seller/owner to have a gauge for the listing price. The seller/owner should also make sure that all corporate documents are in order.
Another factor to keep in mind the tax exposure. For example, there could be double taxation: taxing the company and the shareholders. The company may be treated as selling the stock to the shareholders which will lead to the corporate-level tax consequences. The shareholders will then be treated as exchanging their stock for their fair market value which results in gains or losses and will be taxed. Tax exposure namely depends on the start-up’s corporate type.
Thus, when winding up a start-up, whether through the sale of the business or liquidation, it is important to keep in mind the payment hierarchy and the creditors and shareholders’ interests.
Mathias Avocats can advise you in these matters.