Who remembers Traf-O-Data? A business founded by Bill
Gates, Paul Allen and others to process the paper tapes generated
by traffic counting boxes turned out to be a dismal failure. But
the lessons Gates and Allen learned from that failed business led
them to build one of the 20th century's most successful
It is no surprise that Prime Minister Malcolm Turnbull has
suggested that we need to do more as a nation to foster a better
environment for Australia's venture capital (VC) industry.
Indeed, we are all looking forward to the imminent release of the
Prime Minister's science and innovation statement.
Venture capital has the potential to disproportionately support
innovation in the Australian economy by financing start-ups with
new business ideas and high growth potential. But one aspect that
needs urgent attention is the rules governing how we manage
businesses' failure, especially for small companies.
Inherent in any start-up business is the risk of failure. If we
are serious about supporting innovation especially through VC we
need better rules. There are always going to be more Traf-O-Datas
than Microsofts. To support innovation Australia needs rules that
do not stifle risk taking, rules that strike the right balance.
Countless studies including the Murray Inquiry into the
financial system have identified that Australia's current
insolvent trading laws stifle innovation and inhibit risk taking.
The FSI report tips the balance more towards directors, by giving a
push to proposals for a safe harbour for executives of financially
stressed companies. But we don't think that's the answer;
and especially not for VC backed companies.
Our regime places personal liability on directors for debts
incurred if the company trades while insolvent. These complex rules
are arbitrary, have significant shades of grey and are usually
imposed with the blinding clarity of hindsight.
As one judge commented: "It is easy enough to tell the
difference in hindsight, when the company has either weathered the
storm or foundered with all hands; sometimes it is not so easy when
the company is still contending with the waves."
Directors aren't fortune tellers so most of them find
themselves so fearful of the consequences of getting it wrong that
too often they choose not to take the risk of personal liability
and call the administrator unnecessarily or too soon.
Our insolvency rules discourage directors from taking sensible
risks to deal with a company's financial problems. Compare this
with the UK where directors are only liable if the director knew or
ought to have known that there was no reasonable prospect that the
company would avoid going into insolvent liquidation and the
director failed to take all reasonable steps to minimise the
potential loss to the company's creditors. This effectively
provides UK directors with more scope to navigate a company through
financial distress and corporate reconstructions and avoid
The main assets for most start-ups include the
entrepreneur's idea or technology, often not valuable to an
outsider, as the value often cannot be separated from the
entrepreneur. Obtaining bank financing is not only difficult
because of the lack of reliable cash-flows and security/collateral
but also expensive because of the riskiness of the venture.
Venture capitalists assume the risk of the venture failing and
invest equity capital. They earn returns only when the firm is
successful and either sold to another strategic/ financial buyer or
has an IPO.
The unsuccessful start-ups frequently become insolvent not only
because their liabilities exceed their assets but because the firms
cannot secure further rounds of equity financing. Often start-ups
do not enter into or are put into the bankruptcy system because the
process is costly relative to the realised value of the
We suggest that small proprietary companies like most involved
in venture capital should operate in a more debtor-friendly
corporate insolvency law regime. Under these rules directors should
be given power to continue running the company while the company
refines or restructures its business model if insolvent liquidation
is not a certainty. This would provide directors with the latitude
to allow the company to "test and lean" and
"pivot" its product or service or implement a workout or
restructure to potentially extract more favourable concessions from
creditors on behalf of shareholders, protect value or even save the
company from failure.
A change to a model closer to the UK Insolvency Act is not a
"race to the bottom", but rather a more flexible regime
based on a model that already works well in another
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
Most awarded firm and Australian deal of
Australasian Legal Business Awards
Employer of Choice for
Equal Opportunity for Women
in the Workplace (EOWA)
To print this article, all you need is to be registered on Mondaq.com.
Click to Login as an existing user or Register so you can print this article.
Do not depart from the contract terms, or encourage the other party to do so, unless you plan to alter the contract.
Some comments from our readers… “The articles are extremely timely and highly applicable” “I often find critical information not available elsewhere” “As in-house counsel, Mondaq’s service is of great value”
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).