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Practical And Legal Considerations For Extending Cash Runway In A Changing Economy – Insolvency/Bankruptcy


The funding environment for emerging companies has fundamentally
shifted in 2022 for both venture capital and IPOs, particularly after a banner year in 2021. Whether these headwinds
suggest significant economic changes or a return to previous
valuation levels, companies need to be realistic about adapting
their business processes to ensure they have sufficient cash runway
to succeed through the next 2-3 years.

This article provides a comprehensive set of tactics that can be
used to extend cash runway, both on the revenue/funding and cost
side. It also addresses areas of liability for companies and their
directors that can emerge as companies change business behaviors
during periods of reduced liquidity.

Ways to Improve and Extend Cash Runway

Understanding Your Cash Runway

Cash runway refers to the number of months a company can
continue operations before it runs out of money. The runway can be
extended by increasing revenue or raising capital, but in a down
economy, people have less disposable income and corporations are
more conservative with their funds. Therefore companies should
instead focus on cutting operating costs to ensure their cash can
sustain over longer periods.

As a starting point, companies can evaluate their business
models to determine expected cash runway based on factors such as
how valuations are currently being determined, total cash
available, burn rate, and revenue projections. This will help guide
the actions to pursue by answering questions such as:

  1. Is the company currently profitable?

  2. Will the company be profitable with expected revenue growth
    even if no more outside funding is brought in?

  3. Is there enough cash runway to demonstrate results sufficient
    to raise the next round at an appropriate valuation?

Even if companies expect to have sufficient cash runway to make
it through a potential economic downturn, tactics such as reducing
or minimizing growth in headcount, advertising spend, etc. can be
implemented as part of a holistic strategy to stay lean while
focusing on the fundamentals of business model/product-market
fit.

Examining Alternative Sources of Financing

Even though traditional venture capital and IPO financing
options have become more difficult to achieve with desired
valuations, companies still have various other options to increase
funding and extend runway. Our colleagues provided an excellent analysis of
many of these options
, which are highlighted in the discussion
below.

Expanding Your Investor Base to Fund Cash Flow
Needs

The goal is to survive now, excel later; and companies should be
open to lower valuations in the short term. This can create
flexibility to circle back with investors who may have been open to
an earlier round but not at the specific terms at that time. Of
course, to have a more productive discussion, it will be helpful to
explain to these investors how the business model has been adapted
for the current environment in order to demonstrate that the new
valuation is tied to clear milestones and future success.

Strategic investors and other corporate investors can also be
helpful, acting as untapped resources or collaborators to help
drive forward milestone achievements. Companies should understand how their business model fits with the
investor’s customer base
, and use the relationship to
improve their overall position with investors and customers to
increase both funding and revenue to extend runway.1

If the next step for a company is to IPO, consider crossover or
other hybrid investors, understanding that much of the cash
deployment in 2022 is slowing down.

Exploring Venture Debt

If a company has previously received venture funding, venture
debt can be a useful tool to bridge forward to future funding or
milestones. Venture debt is essentially a loan designed for early
stage, high growth startups who have already secured venture
financing. It is effective for targeting growth over profitability, and should be used
in a deliberate manner to achieve specific goals. The typical 3-5 year timeline for venture debt can
fit well with the goal of extending cash runway beyond a currently
expected downturn.

Receivables/Revenue-Based Financing and Cash Up Front on
Multi-Year Contracts

Where companies have revenue streams from customers —
especially consistent, recurring revenue — this can be used
in various ways to increase short-term funds, such as through
receivables financing or cash up front on long-term contracts.
However, companies should take such actions with the understanding
that future investors may perceive the business model differently
when the recurring revenue is being used for these purposes rather
than typical investment in growth.

Receivable/revenue-based financing allows for borrowing against
the asset value represented by revenue streams and takes multiple
forms, including invoice discounting and factoring. When
evaluating these options, companies should make sure that the terms
of the deal make sense with runway extension goals and consider how
consistent current revenue streams are expected to be over the deal
term. In addition, companies should be aware of how customers may
perceive the idea of their invoices being used for financing and be
prepared for any negative consequences from such perceptions.

Revenue-based financing is a relatively new financing model, so companies
should be more proactive in structuring deals. These financings can
be particularly useful for Software-as-a-Service (SaaS) and other
recurring revenue companies because they can “securitize the
revenue being generated by a company and then lend capital against
that theoretical security.”2

Cash up front on multi-year contracts improves the company’s
cash position, and can help expand the base where customers have
sufficient capital to deliver up front with more favorable pricing.
As a practical matter, these arrangements may result in more
resources devoted to servicing customers and reduce the stability
represented by recurring revenue, and so should be implemented in a
manner that remains aligned with overall goal of improving
product-market fit over the course of the extended runway.

Shared Earning Agreements

A shared earning agreement is an agreement between investors and
founders that entitles investors to future earnings of the company,
and often allow investors to capture a share of founders’ earnings.
These may be well suited for relatively early stage companies that
plan to focus on profitability rather than growth, due to the
nature of prioritizing growth in the latter.

Government Loans, Grants, and Tax Credits

U.S. Small Business Administration (SBA) loans and grants can be
helpful, particularly in the short term. SBA loans generally have
favorable financing terms, and together with grants can help
companies direct resources to specific business goals including
capital expenditures that may be needed to reach the next
milestone. Similarly, tax credits, including R&D tax credits,
should be considered whenever applicable as an easy way to offset
the costs.

Customer Payments

Customers can be a lifeline for companies during an economic
downturn, with the prioritization of current customers one way
companies can maintain control over their cash flow. Regular checks
of Accounts Receivable will ensure that customers are making their
payments promptly according to their contracts. While this can be
time-consuming and repetitive, automating Accounts Receivable can
streamline tasks such as approving invoices and receiving payments
from customers to create a quicker process. Maintenance of Accounts
Receivable provides a consistent flow of cash, which in turn
extends runway.

To increase immediate cash flow companies should consider
requiring longer contracts to be paid in full upon delivery,
allowing the company to collect cash up front and add certainty to
revenue over time. This may be hard to come by as customers are
also affected by the economic downturn, but incentivizing payments
by offering discounts can offset reluctance. Customers are often
concerned with locking in a company’s services or product and
saving on cost, with discounts serving as an easy solution. While
they can create a steady cash flow, it may not be sustainable for
longer cash runways. Despite their attractive value, companies
should use care when offering discounts for early payments.
Discounts result in lower payments than initially agreed upon, so
companies should consider how long of a runway they require and
whether the discounted price can sustain a runway of such
length.

Vendor Payments

One area where companies can strategize and cut costs is vendor
payments. By delaying payments to vendors, companies can
temporarily preserve cash balance and extend cash runway. Companies
must review their vendor agreements to evaluate the potential
practical and legal ramifications of this strategy. If the vendor
agreements contain incentives for early payments or penalties for
late payments, then such strategy should not be employed. Rather,
companies can try to negotiate with vendors for an updated,
extended repayment schedule that permits the company to hold on to
their cash for longer. Alternatively, companies can negotiate with
vendors for delayed payments without penalty. Often vendors would
prefer to compromise rather than lose out on customers, especially
in a down economy.

Lastly, companies can seek out vendors who are willing to accept
products and services as the form of payment as opposed to cash.
Because the calculation for cash runway only takes into account
actual cash that companies have on hand, products and services they
provide do not factor into the calculation. As such, companies can
exchange products and services for the products and services that
their vendors provide, thereby reserving their cash and extending
their cash runway.

Bank Covenants

In exercising the various strategies above, it is important to
be mindful of your existing bank covenants if your company has a
lending facility in place. There are often covenants restricting
the amount of debt a borrower can carry, requiring the maintenance
of a certain level of cash flow, and cross default provisions
automatically defaulting a borrower if it defaults under separate
agreements with third parties. Understanding your bank covenants
and default provisions will help you to stay out of default with
your lender and avoid an early call on your loan and resulting
drain on you cash position.

Employee Considerations

As discussed extensively in our first article Employment Dos and Don’ts When
Implementing Workforce Reductions
,
the possibility of
an economic downturn not only will have an impact on your customer
base, but your workforce as well. Employees desire stability, and
the below options can help keep your employees engaged.

Providing Equity as a Substitute for Additional
Compensation.

Employees might come to expect cash bonuses and pay raises
throughout their tenure with an employer; in a more difficult
economic period this may further strain a business’s cash flow.
One alternative to such cash-based payments is the granting of
equity, such as options or restricted stock. This type of
compensation affords employees the prospect of long-term appreciation in value and promotes
talent retention, while preserving capital in the immediate term.
Further, to the employee holding equity is to have “skin in
the game” – the employee now has an ownership stake in
the company and their work takes on increasing importance to the
success of the company.

To be sure, the company’s management and principal owners
should consider how much control they are ceding to these new
minority equity holders. The company must also ensure such equity
issuances comply with securities laws – including by
structuring the offering to fit within an exemption from registration of
the offering. Additionally, if a downturn in the company’s
business results in a drop in the value of the equity being
offered, the company should consider conducting a new 409A
valuation. Doing so may set a lower exercise price for existing
options, thus reducing the eventual cost to employees to exercise
their options and furnishing additional, material compensation to
employees without further burdening cash flow.

Transitioning Select Employees to Part-Time.

Paying the salaries of employees can be a major burden on a business’s cash flow,
and yet one should be wary of resorting to laying off employees to conserve
cash flow in a downturn. On the other hand, if a business were to
miss a payroll its officers and directors could face personal
liability for unpaid wages. One means of reducing a business’s
wage commitments while retaining (and paying) existing employees is
to transition certain employees to part-time status. In addition to
producing immediate cash flow benefits, this strategy enables a
business to retain key talent and avoid the cost of replacing
the employees
in the future. However, this transition to
part-time employees comes with important considerations.

Part-time employees are often eligible for overtime pay and must receive the
higher of the federal or state minimum hourly wage. And if
transitioned employees are subject to restrictive covenants, such
as a non-competition agreement, they might argue their change in status should release them from such
restrictions. Particularly since the COVID-19 pandemic, courts have
shown reluctance to enforce non-competes in the context of similar
changes in work status when the provision is unreasonable or
enforcement is against the public interest
.

Director Liability in Insolvency

Insolvency and Duties to Creditors

There may be circumstances where insolvency is the only
plausible result. A corporation has fiduciary duties to
stockholders when solvent, but when a corporation becomes insolvent
it additionally owes such duties to creditors. When insolvent,
a corporation’s fiduciary duties do not shift from stockholders
to creditors, but expand to encompass all of the corporation’s
residual claimants, which include creditors. Courts define
“insolvency” as the point at which a corporation is
unable to pay its debts
as they become due in the ordinary
course of business, but the “zone of insolvency” occurs
some time before then. There is no clear line delineating when a
solvent company enters the zone of insolvency, but fiduciaries should assume they are in this
zone
if (1) the corporation’s liabilities exceed its
assets, (2) the corporation is unable to pay its debts as they
become due, or (3) the corporation faces an unreasonable risk of
insolvency.

Multiple courts have held that upon reaching the “zone of
insolvency,” a corporation has fiduciary duties to creditors.
However, in 2007 the Delaware Supreme Court held that there is no
change in fiduciary duties for a corporation upon transitioning
from “solvent” to the “zone of insolvency.”
Under this precedent, creditors do not have standing to pursue derivative breach of fiduciary
duty claims
against the corporation until it is actually
insolvent. Once the corporation is insolvent, however, creditors
can bring claims such as for
fraudulent transfers of assets and for failure to pursue valid
claims
, including those against a corporation’s own
directors and officers. To be sure, the Delaware Court of Chancery
clarified that a corporation’s directors cannot be held liable for
“continuing to operate [an] insolvent entity in the good faith
belief that they may achieve profitability, even if their decisions
ultimately lead to greater losses for creditors,” along with
other caveats to the general fiduciary duty rule. Still, in light
of the ambiguity in case law on the subject, a corporation ought to
proceed carefully and understand its potential duties when
approaching and reaching insolvency.

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during economic downturns, we invite you to subscribe to the Bearing the Bear Market Series by clicking here.

Footnotes

1. Diamond, Brandee and Lehot, Louis, Is it Time to Consider Alternative Financing
Strategies?
, Foley & Lardner LLP (July 18,
2022)

2. Rush, Thomas, Revenue-based financing: The next step for
private equity and early-stage investment
, TechCrunch
(January 6, 2021)

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.



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