Protective framework reduces startup collapse risk

Software companies are in a particularly bad position because of reluctance by banks to recognise intangible intellectual property as collateral for a loan

Startup technology companies inevitably face financial risk. Even if the company seems to be going well, has won a number of clients and is producing a steady profit, disaster can strike.

Software companies are in a particularly bad position because of reluctance by banks to recognise intangible intellectual property as collateral for a loan. There is, therefore, a need for structures that will enable such a company to keep trading through a bad patch.

Kim Powell of EDX Ltd has put together a protective framework he claims will give companies facing financial strife the best chance of carrying on or, if closure is inevitable, recouping more from the sale of the assets than a liquidator would.

Powell has a background as a receiver and liquidator and as a business banker and has helped clients of the Massey University e-centre cluster struggle through those early stages to business viability. Perhaps more importantly, he owns a technology company and has experienced a major setback first-hand.

The protection of limited liability is not what it was, Powell says. Many creditors these days request personal guarantees for debts, which can be called up in full if the company hits trouble. Conversely, a secured creditor is “all-powerful”, he says.

Powell’s protection framework is designed chiefly for shareholder-directors who have given personal guarantees over loans and investments in their own company — sometimes the only way of financing a high-tech startup.

Using the provisions of the Personal Property Securities Act, 1999, the shareholder-director can take security over all the assets of the company to cover guarantees over loans and other liabilities.

If disaster strikes, for example through a large cancelled contract or a bad debt, the director can act as a secured creditor of the company, seize the company’s assets and use them to preserve the business while negotiating agreements with other creditors.

A business that is still running can generate cash to keep up rental payments and hire purchase agreements, the value of intellectual property may be preserved and the realisable value of stock, work in progress and debts on the company’s books increases. A liquidator would value these at comparatively little if anything.

If it is done right, “you preserve all that you have worked so hard to build; you continue to earn a living; you live to fight another day,” Powell says.

This is not a vehicle for evading responsibility, he says, but a way of keeping the core of a basically good company with good products or services secure, to the long-term benefit of all.

Powell’s own small company, EDX Ltd, once faced this danger. A contract went wrong and landed the company with a multi-million dollar contingent liability. Professional indemnity insurance amounted to only to $1 million. Fortunately, it was in the client’s best interests to get the contract completed, and EDX had a shareholder protection framework in place. Negotiations pulled the company back from the brink and it still has the client.

If a company must be wound down, this can be done in an orderly manner, while still supporting clients — and being paid by them — and at the end the director will almost certainly be able to get more for the assets than a liquidator would.

The framework must be set up just right, avoiding a number of legal traps. Powell says he has done this in collaboration with a respected legal practice, and is offering the shareholder protection framework to companies for a single fee of $500.

John Hopper of SofTech attended a presentation of Software New Zealand held in Auckland last week at which Powell outlined his framework.

If a contract has not been managed as well as it might be, Hopper says, “there might be a feeling that you deserve to be punished. But you don’t deserve to be punished to the extent of losing everything you’ve worked for.”

The idea of personal guarantees for debt has upset the balance between a company and its creditors, he suggests, and Powell’s strategy restores something of that balance.

Comparing a failed contract or bad debt to pulling out one card from a house of cards, he says “If the collapse of the whole house can be prevented that will be to the benefit of all parties.”

The scheme is “one more string to your bow” in preventing the worst consequences of having given personal guarantees, says lawyer Wayne Hudson, at Bell Gully.

Another way some of the assets can be preserved, he says, is to vest them in a company at arm’s length from the operational part of the company. Contracts should also be worded to minimise personal liability. All of these safeguards, plus indemnity insurance, should be considered, he says.

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Tags protectionintellectual propertystart-upsdisaster

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