financing, debt, australiaI see that debt is a popular way of financing new businesses, but at least here in Australia, the threat of trading insolvent is quite large for a proprietary limited company. Particularly for anyone acting in a director capacity.
Given that startups initially have a negative cashflow and that they usually fail, how do they prevent the directors being personally liable to pay back the debt or incurring fines from the corporate regulator? Note that this is in reference to Australia, where directors can incur liability for insolvent trading.
Are there ways to write loan agreements to prevent being in a net debt position by having the lender’s claim limited to the market value of the company’s liquidatable assets minus any accounts payable?
Sample scenario
To make this more concrete, consider a startup that receives a $10,000 due in 1 year. They have only $1 of capital. They spend that $10,000 on development, but the product doesn’t sell at all that year. Debt becomes due, but no cash in bank. Hello insolvency! So at what point have the directors made a “mistake”? Was it initially with taking the loan? Or was it at some point during that year at which paying back that loan seemed unfeasible?
I think you’re misunderstanding the concept of insolvency. Details vary by jurisdiction, but the essence is being unable to pay bills as they fall due. So if a company has a debt note that requires it to pay 10x the original capital sum in five years, the threat of insolvency is essentially zero in the first three years.
If Directors give personal guarantees on debts, then they stand at personal risk. Boards should as a matter of good practice keep on to of key financial indicators, and as a legal duty if insolvency becomes a serious risk take appropriate action. For startups these events are typically rather black and white, involving the relationship between cash and burn rate.
Going to propose an answer that I’ve been considering
If you take on basic, fixed-term debt without enough assets to pay it back or a reliable income stream, you’ve already stuffed up. You shouldn’t plan for your net equity to go into the red, and if it starts to get close, you need to revise.
Alternative 1 - Equity
Equity is safer in terms of avoiding insolvency, as if there’s no profits, there’s no need to stream cash towards equity. That contrasts from debt, where even if profits are nil or negative, interest and the principal still is due.
Alternative 2 - Fancy debt
Convertible/hybrid options, or clauses to cancel the debt if the company is approaching insolvency. You can cut it how you want with the contract, but the underlying principle is to nullify the claim the debt has if a company approaches insolvency.
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