In times of economic uncertainty, it is important for emerging companies to recognize, prevent and address financial distress. Below is a summary of what it means for a company to be insolvent, what are the warning signs of insolvency and what steps a company can take when it starts to detect them.
When is a Company Insolvent?
There are two recognized tests for determining insolvency:
Cash Flow Test. Under the cash flow test, a company is insolvent if it cannot pay its debts as they come due in the ordinary course of business (also called the equitable insolvency test).
Balance Sheet Test: Under the balance sheet test, a company is insolvent if the fair market value of the company’s assets is less than the corporation’s liabilities (also called the legal insolvency test).
State law determines which test applies, and Delaware courts have applied either or both tests, depending on the case. It is important to note that the bankruptcy code’s definition of “insolvent” is broadly defined; a company must consider contingent liabilities and other facts that could reduce its value, even if they’re not reflected on its balance sheet.
Warning Signs of Insolvency
Courts determine insolvency in retrospect by applying the appropriate test and determining the value of the company’s assets and liabilities in the past. But company must be aware of impending financial distress well before it is determined to be insolvent and get ahead of it.
Several warning signs may signal that a company is near to or experiencing financial distress:
Unsuccessful Attempts/Prospects to Raise Money. Unsuccessful attempts to raise capital may be due to a lack of investor confidence in the company itself or broader skepticism in the industry or economy overall.
Less than 3-6 months of Cash. Less than 3-6 months of cash might mean the company cannot meet payroll or pay accounts payable within vendor terms. A breach of any such financial covenants signals financial distress.
Loss of Key Customers or Contracts. The loss of a key customer or contract may be a warning sign of financial distress if it adversely affects a company’s cash flow or stems from a lack of confidence in the company’s ability or the industry overall.
Regulatory Change or Development. A change in the regulatory landscape the company operates in may be a warning sign if the company cannot pivot quickly or if a change in operations requires significant capital expenditure the company cannot undertake.
Changing Terms for Lenders. Another warning sign is when a lender, who was previously willing to loan money on an unsecured basis, is now willing to do so only by taking a security interest in some valuable collateral (e.g. IP, real estate, etc.). This signals that the lender is now concerned about the company’s ability to pay debts as they come due.
What steps can a company take if they are starting to see warning signs?
Companies that are aware of the warning signs and are ready to take action can better position themselves to avoid financial distress and ultimate insolvency by taking the following actions:
- Prepare three-month cash flow projections and understand the company’s burn rate;
- Look for additional cash sooner rather than later;
- Trim expenses;
- Maintain open and early communication between the board and management about the issues the company is facing;
- Evaluate whether it makes sense to add a legal and/or financial advisor with experience in advising businesses facing distressed situations; and
- Be careful about payroll and committing to things like severance or other accrued obligations that could be construed as wages (some states make individual directors and officers liable for wages in the event of insolvency).
As always, a company’s board of directors should be aware of its fiduciary duties as it makes decisions. A link to a description of board duties in general is here.
If you have any questions about insolvency or financial distress, you can always reach out to your Perkins Coie team member.
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