The March 2023 banking crisis has been an unexpected "stress test" for dealing with liquidity issues.

When state regulators closed Silicon Valley Bank this past Friday, many startups understandably faced severe liquidity issues triggered by the sudden and unexpected loss of access to their deposits.

Fortunately, this crisis appears to have been averted. Federal regulators announced yesterday that a federal bank-deposit insurance fund would backstop all deposits, even those in excess of the standard $250,000 insurance amount, and that customers would regain access to their deposits starting today.

Most startups are unprepared for a liquidity crunch.

While the announcement came as a relief across the industry, the crisis served as an unexpected "stress test"—highlighting the fact that a typical emerging company is woefully unprepared for the prospect of a sudden liquidity crunch.

When SVB closed last week, many startups and emerging companies spent several tense days looking for simple answers to basic questions about meeting payroll for their employees, prioritizing payments to vendors and key business partners, locating and securing emergency financing, and fulfilling their fiduciary duties to investors, just to name a few.

While the crisis appears to be on its way to a resolution, the high-interest rate environment and rumors of an upcoming recession continue to persist. Startups should be prepared for the possibility that they may have to deal with similar issues in the future.

In this client alert, the Morrison & Foerster Business Restructuring team provides 10 tips for navigating a liquidity crisis as an emerging company.

Tip #1: You should start conserving liquidity earlier than you think.

Identifying and executing a solution to a liquidity crunch will take longer than expected. Cash should be conserved early to buy time. It may be tempting to hide distress and continue with business as usual, but with every dollar that goes out the door, you give up runway and leverage that may end up being critical.

Tip #2: Ensure you can pay all accrued employee wages.

Ensure you have sufficient available funding to satisfy accrued wages in full. Wages accrue each day an employee works, not on the payroll date. The law varies from state to state, but there are severe penalties and personal liability for failure to pay accrued employee wages. In a sudden liquidity crunch, reductions in pay and hours and unpaid furloughs may be necessary.

Tip #3: Ensure you deliver all sales taxes and employee tax withholdings to the appropriate taxing authority.

When you collect sales tax or deduct taxes from your employees' paychecks, those funds do not belong to you. You are deemed to hold them in trust for the benefit of the taxing authority. Do not use these funds to bridge your general liquidity needs. Individual officers and directors can be held personally liable for failure to deliver these "trust fund" taxes to the appropriate taxing authority.

Tip #4: Use the reality of "preference exposure" to negotiate deals with your vendors.

When you delay payments to your vendors, they may eventually refuse to do business with you unless they are "caught up" with a lump sum payment. You should remind them that payments outside the ordinary course of business can be "clawed back" in a bankruptcy. Instead, offer shorter terms or a payment plan in exchange for leaving the past due balance outstanding in the near term.

Tip #5: Do not wait until the last minute to raise additional capital or sell assets.

Address your liquidity issues early. The process of conducting diligence and negotiating the terms of bridge financing, an asset sale, or other liquidity transaction can take longer if you are in financial distress. You give up significant negotiating leverage and can end up with a worse deal if you have to rush the transaction because you are about to run out of cash.

Tip #6: Raise new liquidity by creating competition among existing investors.

Your existing investors are your first source of liquidity, because they want to protect their existing investments. You can create a bidding war among your investors by offering one set of investors, but not others, preferential treatment for their prior investments in exchange for new liquidity. This strategy is only available if the investment or loan documents permit it, so it is important to examine those contracts (as well as your corporate charter and bylaws) closely.

Tip #7: Your investors probably do not want to own and run your business.

If you are in default with your investors, they may threaten to foreclose or take other actions to gain control of your business. Although not always the case, as a practical matter, most investors have no desire—or ability—to actually own and operate your business. You should remember that your willingness to run the business on a day-to-day basis gives you significant leverage.

Tip #8: Structure "rescue" financing as debt, not preferred stock.

If you end up filing for bankruptcy, your creditors must be paid before holders of equity and preferred stock receive anything. If your equity holders or other investors are willing to provide rescue financing, you should structure that financing as debt to maximize the likelihood of repayment if a bankruptcy filing becomes necessary.

Tip #9: If the business is insolvent, you have a duty to maximize value for all stakeholders, not just equity.

If you are insolvent, your directors have a fiduciary duty to maximize the value of the company for the benefit of all stakeholders. You should consult with counsel before engaging in a "long shot" strategy that would benefit equity if successful, but would destroy the value of the business if it fails.

Tip #10: You can leverage a credible threat to file for bankruptcy.

It can take several weeks for you and your counsel to prepare for a corporate bankruptcy filing. You should begin those preparations early, even if the filing is not ultimately required. When you negotiate with your creditors, investors, and key business relationships, you will have more leverage if you are in a position to "pull the trigger" on a near-term bankruptcy filing.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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