Blog of Intellectual Capital

By Stephen O’Neill, Esq. – Murray & Murray law firm

I was recently in Bankruptcy Court and I was having a discussion with a Bankruptcy Judge regarding “worst case scenarios”. On the way back to the office, I started to think about “worst case scenarios” and I realized that all of my clients, their management, directors and advisers need to start thinking about “worst case scenarios” because over the next twelve months “worst case scenarios” will become the norm not the exception. Here are the facts as I see them:

1. Banks and Venture Lenders have dramatically reduced their lending.
2. Banks and Venture Lenders are reviewing their loan portfolios to determine which of their clients are in the “danger zone” and they are taking aggressive actions to protect their positions.
3. Venture Capital Firms have communicated to their portfolio companies not to expect further investments to fund negative cash flow and continuing losses.
4. Economic conditions will significantly impact sale projections — bottom line, yesterday’s conservative projections are now very aggressive.
5. Management of venture backed companies are by nature optimistic and almost never think of the “worst” case scenarios. Many management teams probably do not have experience, bandwidth or skills to deal effectively with distress.

What should Board members be concerned about and what should they do:

1. The Board should scrutinize the Company’s cash position and projected cash flow/burn rate. The Board should drill down on the basic assumptions regarding the Company’s cash flow. The Board should consider hiring an outside party to conduct an independent evaluation of the Company’s cash flow and verify or refute Management’s analysis and assumptions.
2. The Board should assess liabilities, both known and contingent, and the fair value of both tangible assets and intangible assets (for example, technology or supplier/customer relationships, lease rejection claims, severance claims). Again, the Board should consider hiring an outside consultant to guide them through the potentially unfamiliar territory of distress.
3. If the Board determines that the Company has less than six months of cash, the Board should do the following:
   1. Obtain the advice of counsel, including insolvency counsel, to advise the Board and management of their fiduciary duties;
   2. The Board should expect in the current economic environment that further equity investment will not be forthcoming, and if sustainable cash break-even looks problematic, the Company should immediately formulate a set of options to avoid a forced crisis, including a sale process that will maximize enterprise value; and
   3. If the Company finds itself with less than six months of cash, a normal M&A process will not work. The Company should implement a “date certain” sale process, i.e., sale of the Company or its assets will have to close by a certain date due to the cash constraints of the Company. The Board should direct management or outside consultants to prepare a wind down budget which will allow the Company to sell its assets and wind down in an orderly fashion rather than a fire sale.
4. Understand which constituencies the Board is representing (stockholders, creditors), and how those duties may or may not change depending on the Company’s financial status:
   1. Analyze the tradeoffs implied by each strategic alternative between creditors’ interests and stockholders’ interests;
   2. Confirm that the record reflects a sufficiently deliberative process and the Board’s awareness of its duties to stockholders and/or creditors. Document specifically the scope of fund-raising efforts and alternatives to financings (such as a merger, asset sale or reduction of operations to conserve cash);
   3. Actions that are implemented to increase stockholders’ value but put creditors at risk should be thoroughly scrutinized;
   4. One creditor or one class of creditors should not be given preference over another;
   5. Transactions that would constitute a preferential payment should be closely scrutinized;
   6. f) Exercise care in approving transactions that leave the Company inadequately capitalized even if the Company is solvent at the time; and
   7. Scrutinize all insider transactions.
5. Assess likelihood of claims regarding breach of fiduciary duties.
6. Confirm that indemnification agreements are in place (but note that unless adequate D&O insurance is in place, an insolvent company is unlikely to be able to satisfy its indemnity obligations as it lacks cash).

Stephen O’Neill is a partner in the law firm of Murray & Murray, A Professional Corporation. Mr. O’Neill specializes in advising financially distressed companies that are financed by venture capital. Mr. O’Neill was named a “Super Lawyer” by San Francisco Magazine in 2006, 2007 and 2008. Mr. O’Neill is also a frequent lecturer to professional organizations on all aspects of insolvency law.

About Gerbsman Partners

Gerbsman Partners focuses on maximizing enterprise value for stakeholders and shareholders in under-performing, under-capitalized and under-valued companies and their Intellectual Property. In the past 60 months, Gerbsman Partners has been involved in maximizing value for 51 Technology, Life Science and Medical Device companies and their Intellectual Property and has restructured/terminated over $770 million of real estate executory contracts and equipment lease/sub-debt obligations. Since inception, Gerbsman Partners has been involved in over $2.2 billion of financings, restructurings and M&A transactions.

Gerbsman Partners has offices and strategic alliances in Boston, New York, Washington, DC, San Francisco, Europe and Israel.

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