Insolvency and tech – burning bright and fast: the cash runway challenge and navigating insolvency

There has been an increase in company insolvencies in Australia. Startups and early-stage technology companies have not been shielded from this, with recent high-profile collapses including Tritium and Milkrun. In this article we discuss insolvent trading risks, the state of the startup market, unique risks to startups and the protections offered by the "safe harbour" under the Corporations Act.

While early-stage tech businesses do not necessarily fit the usual corporate stereotype (in terms of funding sources, cash burn, revenue runway and therefore risk), the businesses and their directors are subject to the same insolvency regime as companies in other sectors. Understanding insolvency triggers, directors' duties and the potential exposure of directors to personal liability for debts incurred by their company where there are reasonable grounds to suspect the company's insolvency is imperative in the context of early-stage tech companies to maximise chances of navigating the unique challenges they face.

Although there is limited data on the number and nature of companies that have sought to rely on the protection of the insolvent trading safe harbour, it is our experience that there has been an increase in technology companies utilising these protections to avoid immediate insolvency appointments.

Directors' duties – an insolvency perspective

Directors have a positive duty to prevent their company from incurring new debts if the company is insolvent. If a liquidator can establish that debts were incurred in breach of this duty at a time when there were reasonable grounds to suspect the company’s insolvency a director may be personally liable for them.

While determining when a company is insolvent is not always a straightforward exercise, it is assessed primarily by reference to available cashflows and liquidity, but also by having regard to the company's balance sheet and its ability to withstand immediate and sometimes interim short-term liquidity crunches.

Importantly, the Corporations Act provides a number of exceptions to the risk of this potential liability including, relevantly, the insolvent trading Safe Harbour.

Below we consider the somewhat unique risks faced by startups and how the protections afforded by the Safe Harbour can be navigated to maximise the prospects a company and, importantly, its directors can emerge from the storm delicately.

Venture Capital: State of the market

The Cut Through Venture and Folklore Ventures' 2023 State of Venture Capital report sheds new light on the state of the Australian VC market, and further explains the reasons for an increase in financial distress for many local startups.

Australian startups raised $3.5 billion in 2023, a 54% decline from the A$7.4 billion raised in 2022. The report also notes that in 2023:

• 90% of VC investors reported that a portfolio company had cut staff;
• 41% of investors reported a portfolio company shut down (and 21% of investors reported one portfolio company forced to shut down during Q1 2024); and
• the decline in VC investment in Australia is aligned with the slowdown experienced globally.

 

Further, as shown in the graphs, capital invested and the number of active investors in Australian startups have steadily declined since 2021. Rising interest rates and the trend-obsessed nature of the market have exacerbated financial distress. As the flavour of the month changes, so does the appetite of investors – most notably in the US, where more than 25% of funds invested in 2023 went into companies involved in the AI space.

Deals size and number of investors (data source: Cut Through Venture)

 

In the US, the startup funding landscape suffered a 30% decline in 2023 (US$170.6bn) compared to 2022 (US$242.2bn). Notably, WeWork (once valued at over US$11bn) filed for protection under Chapter 11 of the U.S. Bankruptcy Code and electric scooter company Bird's valuation plummeted from US$1bn to US$7m.

Market outlook 2024

While the number of general deals has declined, the slow resurgence of larger capital raises, such as with home insurance disruptor Honey Insurance's recent $108 million funding round, signals a promising trend. This shift suggests a growing investor preference for making fewer but more substantial investments. This trend could be advantageous for startups, as larger funding rounds provide a more robust financial cushion, enabling them to better navigate the turbulent economic landscape and extend their cash runways, thereby reducing the immediate risks of insolvency.

Unique risks to startups

Innovation at startups is linked to uncertainty and risk. Frequent fundraising is necessary. What makes startups unique is how susceptible they are to:

1. depleting cash runway (the duration a business can fund its expenses and fund its growth initiatives using its existing cash reserves before needing additional funding);
2. rapid shift in technological trends;
3. navigating stakeholders:
   1. building the right leadership team; and
   2. balancing shareholder expectations; and
4. global economic trends impacting both:
   1. profitability; and
   2. appetite for (re)-investment.

Running out of cash

For startups operating in the fast-paced, capital-intensive tech sector, the period between funding rounds is particularly precarious. Unlike established businesses with a proven product-market fit and predictable revenue stream, the nature of the rapid growth of startups usually sees product development prioritised over immediate revenue or long-term profitability.

The most recent Australian victim of rapid cash-burn is Brisbane-based electric vehicle (EV) fast-charger company Tritium. The company's $2bn valuation in 2022, was not enough to protect it from falling into administration and receivership in April 2024. Key factors leading to the collapse included:

• High costs: Tritium's high overhead management costs led to excessive spending, draining their resources.
• Strategic misstep: Hedging their bets on an Australian HQ and Brisbane factory limited their reach in the global EV market.
• Funding issues: Difficulty securing consistent funding ultimately hampered their ability to scale and compete.

Milkrun aimed to revolutionise the grocery delivery industry, and in doing so, raised one of the largest early stage-funding rounds in Australian venture capital history, banking $75m in a venture capital funding round. Despite its promising start, Milkrun's operating costs were too burdensome, and it entered administration in April 2023 (subsequently the company's operations were acquired by Woolworths for an 88% discount). Ultimately, the company's failure to generate profitability left the heavily VC-backed startup burning cash far too quickly.

Uncertainty in the global economy flowing into the tech industry

The fall of SaaS developers Plutora marks another corporate casualty to the global economic downturn. With over $35m in liabilities, and an ongoing dispute with the ATO, Plutora's appointment of administrators comes off the back of mass redundancies in software and tech companies, domestically and abroad. The tumultuous state of the global economy, coupled with the uncertainty of the tech industry, amplifies the cashflow risks experienced by startups.

Securing steady revenue streams

On top of navigating regulators, cashflow demands and economic downturns, startups must also continue to grow their market presence, to generate profitability through engaging new customers. Lygon's inability to meet this requirement, lead to the blockchain startup falling into liquidation.

The fintech startup, once lauded as the future of banking was backed by some of Australia's largest financial institutions. Lygon implemented blockchain technology to digitise bank guarantees to eliminate the time, costs and risks associated with guarantees being couriered as hard copies. Even after raising $12.75m in a crowdfunding campaign, and despite its ongoing efforts, Lygon failed to convince the market of the blockchain technology's implementation and attract a steady flow of new customers after its initial successful launch, which resulted in the company going into liquidation in January 2024.

What should directors do?

As cash runways shorten, companies often face cashflow challenges and struggle to meet their financial obligations, putting them at risk of insolvency. In assessing whether a company is facing insolvency, its directors need to consider projected cashflows against the company’s debts and determine whether these can be met when they fall due for payment. It is at this stage of a startup's often limited life cycle that its directors must be acutely alert to the possibility of insolvency and that specialist insolvency advice is imperative. Safe Harbour may act as a valuable tool and lifeline for founders and directors navigating this challenging period.

By engaging qualified advisers and developing a restructuring plan, directors may be able to benefit from protection from insolvent trading liabilities, giving them breathing room to explore options for securing additional funding, implementing cost-cutting measures, or more drastically, restructuring the business without the immediate threat of personal liability. Time is of the essence in implementing such initiatives and directors must act swiftly and proactively during this period as the Safe Harbour protections only protect directors for a reasonable period between consideration of a course of action and its implementation. Failure to take timely action or demonstrate a reasonable course of action could leave directors vulnerable to personal liability.

Safe Harbour: a lifeline for startups in financial difficulty

The Safe Harbour provisions provide directors with a legal safe harbour from civil penalties and compensation orders that may otherwise arise where a company continues trading while insolvent. In essence, the provisions are aimed at providing directors with the confidence to take reasonable risks, innovate and allow an entity to potentially chart a course out of financial difficulty or distress, rather than prematurely resorting to administration or liquidation. The provisions allow directors to resolve their distressed company's financial difficulties, by attempting to first avoid entering administration or liquidation, without the risk of attracting personal liability, under the insolvent trading prohibitions (section 588G).

Courses of action for a better outcome

For the Safe Harbour to be available, a director must be able to demonstrate that the relevant debts were incurred in the development of one or more courses of action that were "reasonably likely to result in a better outcome for the company" compared to immediate liquidation or administration of the company (section 588GA(1)(a)). Some specific examples that may be relevant to startups are:

 

It is key for directors to remember:

• Early action is key: Don't wait until the company is on the precipice of insolvency. The sooner directors take action and develop and implement a plan, the stronger their Safe Harbour claim will be.
• Seek professional advice: Consulting with a registered insolvency practitioner or turnaround specialist is crucial. Their guidance strengthens the course of action and provides valuable support.
• Maintain records: Maintain clear records of the company's financial situation, restructuring efforts, directors' decision-making process and communication with creditors and advisors. In the event a proceeding is brought against a director, the director bears an evidentiary burden to adduce or point to evidence that demonstrates that the courses of action undertaken were reasonably likely to lead to a better outcome.
• Safe Harbour is a powerful tool, but it's not a guarantee. Directors must act in good faith and with a genuine belief in the success of the chosen course of action.
• Keeping financiers informed: Transparent and ongoing communication with key financiers is essential. Directors should provide regular updates on the company's financial situation and restructuring efforts to avoid surprises.
• Comply with all Safe Harbour requirements. For example, the Safe Harbour protection will not apply if a debt is incurred by an insolvent company when it is not substantially complying with payment of employee entitlements (including superannuation) as and when they fall due or its taxation reporting obligations, unless the Court orders otherwise.
• Assess performance against planned courses of action: The plan should not be set and forget. Measure performance against the planned courses of action and modify the plan, and the actions taken, as necessary to deal with any new developments.

By following these steps and focusing on relevant courses of action, directors of startups can leverage the Safe Harbour provisions to increase their chances of navigating financial difficulties and achieving a better outcome for their company.