Startups in troubled waters

While the public hype about “start-ups”, i.e. (more or less) innovative business start-ups that pursue aggressive growth strategies, is unbroken, a current PwC study shows that in recent years numerous so-called “fintechs” (i.e. start-ups that (at least allegedly) want to introduce disruptive business processes into the financial world through digitalisation) have already run out of steam (here). However, the awakening after bankruptcy can, though accompanied by less public fanfare than the start, sometimes be very bitter for the former founders. Namely, when it comes to liability. In this context it is worthwile noticing that the German Federal Supreme Court (“Bundesgerichshof”, “BGH”) in a decision of 2007, which still dealt with the consequences of the so-called “New Economy” imploding at the beginning of this century, explicitly raised the duties for managing directors of start-ups in the crisis. Against this background, the following brief might help to avoid a rude awakening.

The difference between setting up a normal business and setting up a start-up usually lies in the fact that the latter aims to capture large market shares as quickly as possible. To this end, the founders usually try to scale-up their respective business models – i.e. to win as many customers as possible in a short time frame. In order to achieve this goal, profitability is initially put on the backburner in favour of growth, with the result that start-ups incur losses over years. In order to compensate for the losses, it is essential that they are continuously compensated by money injected by third parties. The founders have to raise such funds at regular intervals in so-called “financing rounds” – mostly with specialised funds.

While in the so-called “New Economy” at the beginning of the 2000s such financing rounds usually still covered the necessary liquidity for two to three years, the liquidity acquired today often only suffices for twelve months. These – internationally customary – practices might conflict with German insolvency law: Because of the financing requirements and structure of start-ups, it is almost inherent in the system that they are chronically balance-sheet overindebted and any extended liquidity planning depends rather on the goodwill of third parties than on hard currrency. However, this short-term nature of the planning almost inevitably collides with the requirements of the so-called “continuity prognosis” (“Fortbestehensprognose“) according to § 19 InsO, i.e. the (obligatory) examination of the management as to whether there is a reason for insolvency.

In 2007, the BGH, after again clarifing the general requirements for managing directors of companies in a crises:

A managing director has to always ascertain the economic situation of the company. This includes, in particular, an examination of overindebtedness and insolvency. He therefore acts negligently if he does not obtain the necessary information and knowledge in good time to meet the obligation to file for insolvency.” (para. 16),

he then tightens these requirements for startups once again, as follows:

“In a start-up company like the debtor, which generally only produces debt in the start-up phase and – as here – is dependent on promotional loans, a constant, intensive examination of the economic situation of the company is particularly necessary. (para. 17; emphasis by author)

In other words, in order to avoid their own liability, it is important for the managers of start-ups to keep a constant eye on liquidity planning and to document the course of financing negotiations in such a way that it can also be proven afterwards that the success of the financing-round was “predominantly probable”. It is also advisable not to use handshakes to secure financing, which are also customary in the industry – as lead to a later law suit in one of my own cases. In this case, the management of the start-up had orally concluded a financing round with a fund between Christmas and New Year, but the documentation of the transaction was only made at the beginning of the following year. In spite of the fact that the money agreed upon in this financing round was actually paid-out and the start-up only failed later and independently of this financing round, the insolvency administrator tries to hold the managing directors liable for an undue delay in filing for insolvency on the grounds that the company’s liquidity was not properly secured in the time -frame between Christmas an beginning of next year.

In order to avoid such an even worse awakening after the failure of one’s own start-up, the above remarks of the BGH should be followed accordingly – even if this does not sound particularly cool.

BGH, Urt. v. 14.05.2007 – II ZR 48/06

Leave a Comment