Editor’s Note: this is a guest article from Martin von Haller Grønbæk, a partner at law firm Bird & Bird, partner at NordicMakers.vc and chairman of the #CPHFTW foundation.
Like all private businesses, large and small, EU tech startups are hit hard by the near total shutdown of the economy in the wake of the COVID-19 virus. The only good side is maybe that tech startups are probably already used to being in a near-permanent state of crisis. They are used to pivot, to adapt to new circumstances. The bad side is clearly that a crisis for any company is always basically about one thing: liquidity!
And EU tech startups are, almost by definition, very vulnerable here. They rarely have a lot of money in the bank. It’s all about cash. Do you have the liquidity to pay your bills in time when they are due for payment?
When assessing whether a business should be declared bankrupt, one does not look for whether the equity is negative, i.e. the value of one’s assets is less than the liabilities. No, one assesses whether the company is able to pay its creditors when their claims are due.
Liquidity means everything.
Government and management actions
Fortunately, the COVID-19 crisis has prompted politicians to act quickly and mostly in a consistent and constructive way. The Nordic governments have with broad political support adopted comprehensive – and unprecedented – support packages for businesses. Many of these initiatives are very relevant to tech startups.
Postponement of deadlines for payment of public taxes and duties will, of course, improve the liquidity on the side of liabilities on the balance sheet. The same applies to the compensation for salaries paid employees on a furlough. Compensation is paid as a percentage of lost revenue and as subsidies for payment of fixed costs.
Further action from European governments will continuously be taken. More information on different EU countries’ support and rescue efforts can be found here.
But if we briefly ignore how government is and should be helping, what can and should the leadership of a tech startup do to best ensure the liquidity that ultimately prevents bankruptcy? Initially, the effort should be directed to carefully study of arrangements that the company has with suppliers, customers, employees, creditors (as well as debtors) and its owners.
How are the individual contracts interpreted in light of COVID-19?
Are you failing to comply yourself or is the other party doing that? Should you try to renegotiate agreements on delivery and payments? Are there issues related to COVID-19 that are so extreme and beyond any influence of management that they fall into what lawyers call force majeure? > Read more here on what force majeure means in a COVID-19 context.
If ever this is the time that management must think ahead and be proactive. Tactically, it is almost always better tactic to confront the other party to a contract, if you want to negotiate changes. Rather than awaiting that the other party finds it necessary to make the first move.
It is always easier to negotiate for better terms when you have not yet broken the existing terms!
Banking on banks
Tech startups often only have a fairly one-sided relationship with their bank. Tech startups use banks to provide account where to receive money from customers and to pay its employees and suppliers. If you are lucky, then you have money in a deposit account, because you recently raised money from investors.
But European tech startups rarely have extended credit facilities in the form of longer bank loans. Loans normally consist of an ordinary bank credit line. Generally, it is not normal that a large part of tech startup financing is made up of loans, also called debt capital. Besides, often the only large loans on the books are those made by founders themselves.
A great risk to a startup’s liquidity is that banks may panic under the crisis and terminate existing loans and bank credit lines with very short notice. Without venturing into a longer more detailed legal assessment terms of bank loans, it is often possible that a bank credit line agreement allows the bank to, without further notice, to terminate the balances for full and immediate redemption.
Management of the startup should look through the ordinary terms of its loan agreements to assess whether they can be terminated under extreme circumstances like these.
Furthermore, you must remember that a bank will often be entitled to offset all deposits in all outstanding amounts. Thus, the bank can take the money from the account used to pay employees and suppliers, or the one where the proceeds from a recent investment round are deposited, and use them to offset the outstanding loan. Such offsetting can kill your liquidity!
Difficult times, difficult decisions
A startup owes money to many other entities than banks: Employees, government, suppliers and other lenders. Its management must carefully assess which creditors are most “important” to pay on time, and in what order?
The decision must be made based on assessment of existing agreements. Which claims are covered by collateral for the debt, e.g. personal liability, securities in rights to software and other IPR? Will failure to pay mean a stop to delivery?
Unfortunately, this type of evaluation is not a very pleasant one for a management team that otherwise takes pride in paying bills on time. But it is necessary to safeguard the survival of the company and protect the interests of its investors.
One must also keep in mind that we are all in the same boat, or maybe more aptly put, we are trying not to drown. Keep in mind that your own debtors are doing exactly the same calculation.
But again, it is better to be proactive. As soon as possible, you should contact creditors with whom you would like to change the terms of payment. Circumstances are dire and lack of appreciation from your creditors may lead to your company’s bankruptcy.
A rational creditor will understand that flexibility is needed. But it may require giving collateral to secure payment, higher interest rates, IPR, and others.
But remember that affording priority or better terms to certain creditors can be problematic in relation to other creditors. Others may have a right to claim their receivables paid immediately, if they are now disadvantaged. Also remember that in most shareholders’ agreements, collateral will often require approval from the board of directors and investors.
Claims against the tech startup as a limited company is often secured by a form of personal liability of a founder, or by the founder pledging personally owned assets such as a home or ownership in the business itself. This practise must be strongly discouraged.
Nevertheless, personal liability is often in smaller one-woman businesses, where the boundary between the person and the company is quite difficult to draw. Personal liability may work and apply to the extent it is more symbolic than welfare-threatening for the founder.
There are many good reasons why tech startups are always organized in companies with limited liability. It is unfair to demand that a founder, who often shares her ownership with many others, to assume personal liability.
Personal liability will always affect the founder’s will to act and decisions in an unfortunate way that may not be in the company’s best interest.
The most important creditors in EU tech startups, as in all companies, are probably the employees. They must have their wages paid in time every month. If this does not happen, the company collapses very quickly.
First, the employees will stop working, if they are not paid. Second, you will immediately get the tax authorities on your throat for not paying social contributions or other tax deducted from income at source.
Usually, it is very difficult to renegotiate terms with employees. But nothing is “normal” at these times.
Recently, it was announced that staff of the Danish esport firm, Astralis Group, had voluntarily reduced salaries by up to 30%. Employees in almost every firm currently under threat of closure will be open to discuss terms of employment, even if they are inferior terms to existing.
Employees of tech startups may generally be more flexible in this respect, partly because they have a more open mindset, partly because their personal financial circumstances are often more flexible than average. These employees are often younger people without large financial support obligations to dependents etc.
There are also significantly fewer competitors to go to today, if you as an employee are laid off because you will not “voluntarily” accept worse terms.
Relations with employees must be looked at in the broadest sense. Taking in the big picture is required from management. They have to take both the current situation and the longer-term into account. And there are many options for readjusting employment terms.
You can retain employees on unchanged terms, terminate their contracts in full, send them home with the state’s salary compensation or on furlough with pay or on mandatory leave or vacation.
These are changes that you as employer can force through depending on existing employment contracts and your country’s employment legislation. In addition to length of the termination notice which normally depends on seniority and cause for termination, competition clauses and participation in warrant programs must also be considered.
More on how to manage employees during the COVID-19 crisis in different countries can be found here.
More on employee relationships going forward
Instead, management can attempt to change the existing terms by negotiating new ones. This is the option based on voluntariness. All these forced and voluntary options should be carefully considered for each employee individually.
Tech startups rarely employ people on an agreement set by collective bargaining with trade unions. But employees are nevertheless often represented by a trade union lawyer in negotiations of terms of employment.
As mentioned, changing the terms of employment require voluntariness on the part of both parties. But willingness may be dictated by the circumstances. The new terms must nonetheless make sense to both parties. It is probably not a good idea to get too “creative” with respect to tax optimization!
It is likely that government during the crisis will less stringent and maybe postpone some deadlines for payments of social contributions or other tax deducted from income at source. But still, your starting point should be that, if the salary is accrued in a certain period, but payment is postponed to a later date to approve the employer’s liquidity, then social contributions or other tax deducted from income at source will almost everywhere fall due by the end of the following month.
So there is probably no way around having to persuade an employee to accept a pay cut with immediate effect, if this is to have a positive impact on the company’s liquidity.
To make it attractive to the employee, the offer should be based on calculation with different factors. These should on the downside include the loss suffered by the employee if made fully redundant, i.e. salary loss offset by support or unemployment benefits received from the government, any losses due to an interrupted warrant program and other benefits.
On the upside should be future benefits as part of the new terms. These could be a longer termination notice, a (extended) warrant program, higher pay at a future date. There must be something in it for both parties!
In most EU countries, there are few limits to what can be agreed upon, if the parties are in agreement. There are, of course, differences between the countries. But, and this is a very big “but” that will be applicable in all EU countries, all changes to salary terms are with the risk of having negative, unintended taxation consequences.
Therefore, all new terms must be reviewed for legal and tax implication before they are signed. The entire process should, in general, be carefully thought through before implemented.
Also, make sure that you bargain for good terms with your professional advisors. You would want to make sure that the legal, tax and other costs associated with implementation is proportional with savings expected from the new deals.
Professional advisor fees will hopefully reflect that we can expect – or rather demand – that under these circumstances tax authorities should adopt a constructive, pragmatic and flexible approach. Readjusted agreements with employees may be the most important part of ensuring the survival of tech startups.
Owners – i.e. shareholders and capital owners – are not creditors. They can only demand to have their investments repaid once all creditors have received their money and the company is dissolved (unless dividends or profit are paid out beforehand). Many investors have invested loans in the form of convertible notes.
These are ordinary loans but with a right to convert the loan into shares. Such loans are now very common as investment instruments in tech startups.
Until a conversion has occurred, the loans may be required to be repaid. Management of startups should refresh their memory of the terms of these convertibles. They must understand if investors are allowed to claim the loans extraordinarily repaid due to COVID-19.
If so, management should try to get agreements in place with investors to postpone repayment time. Or maybe even better, to get the loan converted right now.
Many investments in shares are made with the payment of the investment proceeds divided into tranches. Tranches are only paid when certain deadlines, with possible milestones, are reached and met. Here, investors and management may want to discuss accelerating these payments, prioritising the company’s liquidity.
All things considered, the extraordinary situation that tech startups are in now calls for management to get a clear picture of the startup’s liquidity and to try to come up with solutions. Employees, founders, and shareholders should form a group of stakeholders with aligned interests in the startup’s long-term survival.
If these stakeholders can reach common ground and renegotiate their relationship with the firm, it is far more likely that creditors, suppliers and the public will display flexibility and ‘play nice’.
After all, the alternative is bankruptcy or some other form of restructuring where everyone loses. So, if material readjustment of a startups agreement is going to happen it must involve almost stakeholders. But that being said, and it may sound contradictory under such a severe economic crisis, these times call for more equity investments into European tech startups now faced with existential liquidity shortage.
On being opportunistic
Many startups today are threatened on their survival as consequence of exogenous conditions caused by the shutdown of society. Others are healthy with big potential. So it may be right now that equity investments make sense.
Surely, the risk of buying into a tech startup today is big, but so is the potential. This prospect of a possible windfall should be the reason why all stakeholders who have claims against the company should offered a greater or lesser ownership interest in the company. This would a full or partial compensation for their flexibility in renegotiating terms, an important contribution to ensuring the startup’s survival.
This equity investment could be in the form of a warrant program for employees. It can also be made as an offer to creditors to rearrange part of their receivables as an investment into a warrant that can later be converted into an ownership interest. There are investment agreements today that grants the right to issue new shares but then also postpone negotiation on valuation, which is, of course, difficult to do in the middle of a crisis, to a later stage when the company raises more money.
Tech startups are in a crisis. The primary goal should be to secure liquidity. It is necessary to be proactive and to exercise due diligence. But this is also the time to be bold. Startups and their creditors have to be creative and come up with new ways of thinking.
Featured image credit: PIRO4D / Pixabay