How to close up shop on a failing startup (TechRepublic)

By Conner Forrest May 5, 2014

Most entrepreneurs are not afraid to fail, but sometimes they aren't prepared for it either. Here's how you can get your affairs in order if your startup bites the dust. 

Successful entrepreneurs aren't afraid to fail. Unfortunately, that leaves a lot of startups without a plan for how to shut down the company in such an event. The hard truth is that most startups do indeed fail; with some reports claiming a 75% fail rate and others suggesting it is closer to 90%.

Too often, founders carry a brazen pride of how unafraid they are that their idea won't work. Although subjective, this can be a helpful attitude as you try to get your startup off the ground. Sometimes, though, founders see a failure plan as an admission of defeat, like acknowledging the reality of failure and preparing for it somehow makes them more afraid. That is not the case.

Having your bases covered can save you time and money, and help you focus on the upside of failure -- the lessons you'll learn. According to Samuel Whitt, special counsel at Nexsen Pruet, startup failure doesn't carry the type of social connotations that it does elsewhere.

"Somebody that tries and fails is not a scarlet letter," Whitt said.

The proper handling of the wind-down process begins well before you start to notice the signs. It starts at the beginning of the startup process, with transparency and an open channel of communication.

Communicate

Maintaining an open line of communication with your people is critical to the lifecycle of your startup. Even though it may be difficult, taking the time to loop people in on what is going on is a way to show respect and be transparent. Here are the critical lines to keep open.

1. Shareholders
2. Vendors
3. Employees

It's up to you to decide when it is appropriate to begin alerting people of an impending closure. By reaching out to people early in the process, you are leveraging additional thought power that could end up helping you out of your rut or that could help you change direction. According to startup investor and entrepreneur Greg Langdon, you'll probably need to have a conversation about the numbers, too.

"Since most startups wind down due to a lack of profitability, a timely follow-on discussion with your finance and accounting staff is needed. This could be a CFO, or could be outsourced," Langdon said. "The management needs to understand the assets and liabilities of the business, whether any assets can be sold, in what order creditors are to be paid, and what the outcome for investors looks like. It's important to understand any residual taxes that may be owed to local, state or federal governments."

Conflict is difficult, and no one likes to bear bad news, but it is wholly necessary. At the end of the day, this is just business, and people will respect you more for letting them know what's going on at the onset. The is especially true with your investor who may have additional resources that you can leverage to make a final push.

"As a general rule, professionals understand when things don't work out," Whitt said.

If you want to make it as an entrepreneur you have to maintain healthy working relationships with people in the scene you inhabit. Being considerate of others by letting them know your intentions can go a long way. Great startups often thrive because of the network of talented individuals behind the founder who can help them get things done. Be honest and fair; be good to those people.

Much of this communication will involve closing out contracts and making sure people get paid. We'll discuss that in detail in a moment. Just as your reputation as an entrepreneur can flourish from the way you take care of people, it can also crash and burn for the same reason. So, once you've made a decision, you need to act on it.

"Once you have sufficient data and your gut is telling you to make a decision, the need, at that point, is to move quickly," Whitt said.

Making decisions

Now that you have decided to take your startup off of life support, there is a series of decisions that you will need to make over a set period of time. The first step will be to figure out what course of action you will choose to shutdown your company.

"If the decision is made to close up shop, there are still legal questions to address; including whether a wind-down or a bankruptcy makes the most sense, and how and when investors might see a partial return for their investment," Langdon said. "The management needs to be able to demonstrate that they've pursued every reasonable option to maximize a return for investors before deciding to throw in the towel."

The first decision you will need to make is whether or not to pursue bankruptcy. Bankruptcy has its own set of decisions to be made, so let's begin by looking at what you will need to consider if you decide against bankruptcy.

One of the first things to look at when you start to wind down, outside of a bankruptcy situation, is to look for any existing contracts that guarantee rights in a wind-down situation. If there are no guaranteed rights during wind-down, you can proceed by filing an article of dissolution. An article of dissolution is a basically a proclamation that you have decided to dissolve your company. Once you file an article of dissolution, the clock starts ticking.

"Most states have a wind-down period, which means that the legal entity is able to transact business for the purpose of winding down," Whitt said. "Said differently is that articles of dissolution are filed and that provides a clean cutoff for the existence of the entity. And, then, there is a period of time, based upon state statute, that allows for a winding down."

The winding down period could include actions such as collecting accounts receivable and using that to pay off debts and filing a final tax return. Check with your lawyer to get a checklist of everything that needs to be accomplished and develop a plan to get it all done. This will make the wind-down process much easier if you know exactly what needs to get done.

If you and your shareholders decide that bankruptcy is the right option, you first course of action is to find bankruptcy counsel. There are lawyers who specialize in helping companies file for bankruptcy and it is imperative that hire someone who knows what they're doing. Whitt, himself an attorney (not a bankruptcy one) but also an entrepreneur and investor, explains why.

"Because, there's things that you can do immediately prior to bankruptcy, and the process needs to be understood so that when you go into it there's clear communication so that you can extract as much value as possible for the shareholders and the vendors and the employees, of course," Whitt said.

Typically bankruptcy occurs in one of two ways. You can choose liquidation, a Chapter 7 filing, or reorganization, a Chapter 11 filing. With liquidation, all of a company's assets are sold off (liquidated) and the company will then be dissolved permanently. Think of reorganization kind of like a business plan. If you file a chapter 11, you will be allowed to continue operating as a business under the supervision of the court after you have presented a plan for how you will reorganize your company. Reorganization will technically keep you in business, but there are million different pitfalls you can encounter. Let me reiterate -- hire a bankruptcy lawyer.

Most of this advice has been relative to what is known as a "soft" wind down. Unfortunately some startups can meet a different fate. For example, Eren Niazi, CEO of Open Source Storage, had an investment rescinded and was forced to vacate the premises in 48 hrs. Heed his warning to know who you are taking an investment from.

"Make sure you get to know your investor," Niazi said. "Make sure that you guys are aligned on the same vision. Make sure that you guys see things the same way. It's really just like a marriage and it needs to be done properly. The company didn't go out of business because it wasn't successful, it went out of business because people had other political interests in other entities."

Protip: Don't pay your friends and contacts promised "bonuses" or as a thank you, especially if it is outside of standard procedure; because, during bankruptcy, they will have the ability to look back and collect non-standard payments. This can paint a bad picture of you as a business person and entrepreneur.

Failure is an opportunity to learn. What you learn from it is up to you; but the main thing to remember is that you'll get through it. The sun will rise tomorrow and you'll have another shot at building a game-changing company.

Conner Forrest is a Staff Writer for TechRepublic. He covers Google and startups and is passionate about the convergence of technology and culture.