At its heart, Episode 24 was about relationships – from the wayward dating lives of Richard and Dinesh to Big Head and Ehrlich’s marriage of “Bachmanity,” the Pied Piper entourage found themselves faced with the messy unraveling of unsuccessful relationships.  To recap some of those relationships, Richard loses a girlfriend over his obsession with code formatting, Dinesh sabotages his chances of dating a coworker by improving the video streaming and revealing “Pakistani Denzel” to be more of a “Dogface,” and Bachmanity faces the cold consequences of profligate and unnecessary spending and lack of accounting oversight.  Perhaps Jared’s “spreading his plumage” to display his dating prowess was the only silver lining.  Even though this episode left us feeling like the Pied Piper guys need the advice of a “Love MD” more than that of a J.D., some of their problems may still be solvable with a better understanding of the law.

Big Head and Ehrlich’s new business “Bachmanity” provides an insight into the risks associated with insolvency that unfortunately many start-ups face at some point.  Bachmanity is poised for its big launch party.  While Ehrlich makes arrangements to turn Alcatraz into a Hawaiian island for a night, Big Head meets with his business manager to learn that his financial decision making—whether to move his pool twice or give Ehrlich access to his accounts—has resulted in financial disaster.  As it turns out, between Ehrlich’s profligate spending and Big Head’s accounting challenges, Bachmanity is broke and dead on arrival by the time of the launch party.  “Aloha” is indeed appropriate as it means both “hello” and “goodbye” in Hawaiian.

Most start-ups fail, although hopefully not quite as quickly and spectacularly as Bachmanity.  When they fail, the question arises as to how the company pays off its debts and dissolves.  One option is formally filing for bankruptcy protection:  filing a bankruptcy petition with a bankruptcy court and having a trustee dispose of assets and deal with claims against the company under Chapter 7 of the bankruptcy code, or attempting to restructure under Chapter 11 of the bankruptcy code (a “Bankruptcy”).  But most start-ups prefer a different route.  Instead of filing for Bankruptcy, the start-ups enter into an out-of-court process known as an assignment for the benefit of creditors (“ABC”).  Unlike a Bankruptcy, an ABC is not a public proceeding and there are no public court filings.  An ABC approach is typically favored because it is much less public than a Bankruptcy proceeding, is often less expensive, and investors (especially venture funds) generally do not like to advertise the failure of their portfolio companies.  An ABC also lets the company pick the third-party that will liquidate its assets and pay creditor claims instead of having a bankruptcy trustee randomly assigned to the bankruptcy (in the case of a Chapter 7).

In an ABC, the company assigns all of its assets to a third-party assignee of its choosing.  This assignee acts as a fiduciary to the creditors, liquidating the company’s remaining assets and paying out those proceeds to the creditors.  The claims process starts with the assignee mailing out notices to all creditors with a deadline to submit a claim to the assignee.  These claims are then sorted by whether such claims are from secured or priority creditors, or unsecured creditors.  Creditors that don’t file a claim on time may be precluded from receiving payment (secured creditors will generally file claims too, however, their liens will protect them if the assignee is selling assets covered by those liens).

During this same time period, the assignee will sell the company’s assets.  The assignee will often use an auction process to complete the sale, though sometimes there may be a purchaser for the assets that has already pre-negotiated the purchase of the company’s assets.  If the assets of the Company are valuable but will be sold without generating sufficient proceeds to pay all creditors in full, an ABC is the minimum protection a buyer of Company assets will probably require to purchase the assets and cleanse such assets against remaining claims by Company creditors (for instance, that the assets were sold for too low of a price).  After the assets are liquidated, the assignee then sends payments first to the secured or priority creditors, followed by the unsecured creditors if any funds are still left.  Finally, equity holders in the Company are paid any remaining funds once all creditors have been paid back (but it is very unusual for them to recover anything).  Once the assets have been sold and payments distributed, the company is usually formally dissolved.

As start-ups near or enter into insolvency, they can face some interesting issues.  Directors may face the decision whether to forge ahead and run the risk of pushing the company further into the red, or to shut down (perhaps prematurely) to minimize the loss to creditors.  Properly valuing remaining company intellectual property can be tricky, especially for failed companies.  The company and founders may place unrealistic valuations on such IP, resulting in the company holding on too long or not covering the obligations to its creditors upon liquidation of its assets.  Conversely, when company insiders (board members, founders, investors) selectively buy company assets and leave creditors unpaid, this gives the appearance that the company IP may have been undervalued or sold off too cheaply.  This can further anger creditors by giving the appearance that company insiders are salvaging the company’s prime assets to make another go of it later on, while leaving creditors holding the bag.  And, if not handled through an ABC or a bankruptcy, such sales can expose the insider purchasers to claims by those unpaid creditors.

Bachmanity flamed out in grand fashion, but not before Ehrlich wrote a number of checks on Big Head’s personal checking account that bounced.  Ehrlich and Big Head should be brushing up on how an ABC works and they can only hope that the unpaid vendors from Bachmanity Insanity don’t realize Bachmanity was a general partnership.  If they do, chances are Big Head and Ehrlich will be on the receiving end of collection efforts regarding those unpaid bills because as general partners, they are both personally liable for Bachmanity’s debts.  Jared may not be the only one looking for housing by next episode if Big Head and Ehrlich both lose their shirts (and houses) following Bachmanity’s failure.

With thanks to Barrett Marum, Finance & Bankruptcy Partner, for his insights.