Shutting down a startup: How to protect yourself and your investors from liability

"Like most entrepreneurs, you’re betting on a home run. The reality is that a strikeout is always a possibility. You should plan for it. An orderly shutdown of your startup, if it becomes necessary, will help protect you and your investors from potential liabilities. These founders and startup lawyers will help you navigate the ins and outs."

-- James

Two years after closing his video game business, Chris Oltyan got a call from a sheriff in Virginia, where his startup was based. “I’m calling about a notice for your arrest on fines in excess of $20,000,” he remembers him saying. The sheriff explained that Oltyan’s company had been accruing fines with the state employment commission. Although Oltyan had shut down the website and filed dissolution documents with the secretary of state, he had failed to inform the employment commission, and as the company’s primary officer, he was liable for unpaid bills.

A law student had helped Oltyan with incorporation and investor filings in the early days. By the time of the closure, the student had become a lawyer, and Oltyan couldn’t afford him. “He had said, ‘I can’t do this pro bono and you really should get legal counsel,’” Oltyan says. “So I said, ‘I got this, hold my beer.’”

Oltyan managed to clear things up with the state, file the relevant documents after the fact and escape jail time. But his story serves as a warning to founders who walk away rather than carefully shut down their startup without understanding the ramifications of a haphazard end to their business — if the business ends at all.

Of course, not every founder of a sloppily shuttered startup will find themselves in the sights of law enforcement, like Oltyan did, but they could face a series of serious issues ranging from liability for unpaid debts to claims from former employees and vendors.

“If a business doesn’t really dissolve and founders don’t close it down, it’s still open and there’s still liability out there,” says Andrew Comer, an attorney at Fortis Law Partners in Denver, Colorado.

Careless startup shutdowns have real consequences

No founder likes to contemplate failure. But the truth is that nearly 4 out of 5 of seed-stage startups don’t make it, be it because of lack of market demand for their product, failure to execute, insufficient funds, external factors like the COVID-19 crisis, or one of the many common challenges entrepreneurs face.

Whatever the trigger, unwinding a business is a painful process for any entrepreneur, not the least, because they’ll be among the last to get anything left in their startup. And it demands just as much detail and formality as starting a company, if not more. Before deciding to close the doors, you should understand yours and the company’s fiduciary and contractual obligations, consider assets and liabilities, know how liquidation works and follow the legal requirements for final dissolution. With the help of a lawyer.

“There is value, even in the case where there is no money, of going through the formal steps,” says Ivan Gaviria, a partner at Gunderson Dettmer, a Silicon Valley law firm that has advised startups for decades.

Even if a careless shutdown doesn’t land you in legal jeopardy, it is likely to have consequences for the entrepreneurially minded: it will be held against you if you ever try to raise funds from investors again.

Stay in the game until it’s over

Tempting as it may seem to many a burned-out founder, simply walking away is not an option. Company officers and directors have legally-binding fiduciary duties that require them to put the interests of the company above their own and maximize value in the entity on behalf of investors and other stakeholders. Some operating agreements may require a board vote on dissolution; in Delaware, the board must also approve a plan of liquidation. At the very least, investors should get the news before the team does.

Look for value everywhere you can

Your startup likely has all sorts of assets — everything from unsold inventory, to office furniture and intellectual property. It is your responsibility to get as much value as you can from them. Determining what they are worth is more straightforward when it comes to items like computers and desks, which can be sold in the secondhand market; it gets trickier with IP. “People often don’t assign a book value to their IP, so how it gets distributed gets into complex accounting schemes,” notes Comer. Valuation experts may be brought in to build models for determining the value — if there is any at all.

It’s worth thinking broadly about what IP means in your company. It may include software as well as things like customer lists and business plans. When a company dissolves, these assets become the property of no one and are not protected unless they are assigned to another company or individual, which can lead to disputes. “If you had a ton of litigation surrounding where your IP is going, that is definitely going to be a red flag for investors,” says Taylor Carrillo at Denver Trademark Law.

Start here: Talk to a lawyer and triage

No matter what’s left in the bank, or whether it comes from asset sales or unspent investor funds, you need to embark on a triage process. “The biggest thing is that you need to get advice from counsel and understand what you can walk away from,” says Gaviria, who has seen many startups go belly-up, including one in the late 1990s where laid-off employees grabbed printers and desk chairs on their way out the door.

In what Gaviria calls the “gold standard” of orderly wind-downs, bills to creditors, landlords, suppliers and others are paid, employees get severance and investors walk away with something. If that’s not possible, start prioritizing: “Maybe [the cloud provider] doesn’t get paid, or the landlord doesn’t,” he says, by way of example. “You need to understand where the lines are to meet obligations where there is the highest risk of liability and you don’t end up with creditors coming after you.”

Get in line: Employees first, you last

You will likely be the last one paid, if you walk away with anything at all. Your first obligation is to employees, for which there are legal and tax ramifications.

“Employees are sacred,” says Comer. “They are the number one recipient of everything. Pay off employees first, including back wages, vacation pay, before everything else. Then you can get into paying off creditors and debt holders by priority of secured and unsecured, then investors according to preferred shares. The last is owners.”

Pay the bills and close the contracts

If you can’t pay off all bills, you must create a priority list of outstanding obligations that could come back to haunt the founders and officers. Employee options should be accelerated or canceled, for example. Other items to consider: possible legal disputes, certain debts, customer agreements and open contracts. “There is still liability out there if you haven’t terminated contracts,” says Comer. “A lot of them auto-renew and when people walk away, that’s dangerous.” Permits and licenses should also not be left open for risk of being used by others in your name.

Paperwork matters

It’s not enough to file a dissolution document with the secretary of state. Businesses must file a final tax return with the IRS, including payroll tax obligations. The IRS can hold owners personally liable and seize personal assets if they go unpaid. Employee final transactions should also include clear separation agreements that absolve founders and the company of any liability.

Look for other business closure rules, too, and be aware that requirements may vary by state. In Virginia, as Oltyan found out, founders must file with the state employment commission. Some states require founders to inform creditors both privately and publicly. In Colorado, companies with creditors must post a notice in a publication announcing the business’s closure.

It’s best to start with the end in mind

Startups will be in the best position to wind down gracefully when there is a solid operating agreement in place that covers the details of a closure, such as who has decision-making authority, how assets are distributed and who gets paid and in what order. This is not usually top of mind when you’re starting out — either you don’t want to jinx your potential or you don’t want to think about worst-case scenarios.

But the best time to prepare for a potential shutdown of your business is truly the day you start your business, legal experts advise. “It can be a painful discussion,” says Comer. “But certainly less painful than when things go south.”