What happens if the startup that funded by VC failed a couple of years later?


3

We've heard the good stories of startup that succeed after receiving funds but what happens if a startup that got funded by a VC but turns out being failure a couple of years later?

Do they get sued or go to jail? Or maybe get chased by a mafia? Does anybody know the consequence? I want to know the consequence before really dealing with VC.

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asked Nov 27 '09 at 17:37
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Jpartogi
1,342 points
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5 Answers


7

As Jason and others indicated in their answers, it is not illegal for the business to fail and unless there was some kind of fraud involved, you should not be worrying about your investors suing you or any implications of jail time, etc.

For the business itself, there are actually a few possible paths forward and exactly what happens depends on how the business is dissolved and what the creditor situation looks like and what kinds of assets remain in the business. For the sake of discussion here, because there are VC's involved, I'm assuming the business is incorporated and therefore all equity holders (owners) are insulated from the liabilities of the business (see footnote) unless somebody personally signed for something.

For the most part, the VC's, assuming they have controlling interest in the situation will want to do one or some combination of the following things with the business:

  • Licensing or direct sale of the developed technologies to another business prior to or part of bankruptcy.
  • Merging of the business with another business in the VC portfolio to pickup people and or technologies. The merged company generally assumes the liabilities of the failing company here, but this can be part of the bankruptcy process.
  • Chapter 7 Bankruptcy (US Code Term) - Court managed dissolution of the business where all assests are liqudated to pay liabilities of the company to maximum extent possible
  • Chapter 11 Bankruptcy (US Code Term) - Renegotiation of liabilities to allow the company to continue to operate and perhaps reemerge with new funding. Usually this case only makes sense when the company is generating revenue.

The exception to the above and the common cases that come to mind relative to personal signatures might have been involved include:

  • Office space leases. It is very common for landlords to ask for a personal guarantee on a lease for start-ups. Of course, I would not recommend this, but if the founder(s) did this, the landlord might trying suing for the balance of the lease when the business goes down the tubes.
  • Bank Line of Credit. Operational lines of credit with a bank are really hard to get without personal signature of some kind in a start-up. If the founder personally signed for such a line, this is likely to be a discussion point with the bank and highly recommend some way of paying this off with company funds prior to declaring bankruptcy.
Footnote: There are some exceptions to the corporation liability shield in some locales. For example, companies incorporated in New York State, employee payroll liabilities of the business extend personally onto shareholders that own more than a certain percentage of the company's stock. This is a really good reason to incorporate in a state like Delaware and not New York.
answered Nov 28 '09 at 02:51
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Tall Jeff
1,406 points
  • I wish I had known about the issue you mention above. I simply incorporated in NY since I wanted to avoiding having to file in two different states. – Tim J 9 years ago
  • great notes about dissolution and clean-up – Henry The Hengineer 9 years ago
  • @Tim - Yeah, me too - my first start-up was initially incorporated in New York as well. I didn't end up having any negative repercussions because of it (we later "moved" to Delaware too), but our lawyer did get an earful when pointing this fact out about two years into the venture during a "what would be our exposure here" kind of discussions. ie: Why did you not mention this fact BEFORE we incorporated in our home state! – Tall Jeff 9 years ago
  • @Henry - Thanks for the kind feedback! – Tall Jeff 9 years ago

2

When VCs invest they are accepting the risk that the startup may fail.
If your startup failed because of normal market circumstances (no illegal activities) and you didn't violate any binding contracts with the VC then you should generally be free from lawsuits or other legal problems.

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Disclaimer: The post above is an entrepreneurial tip and should not be considered legal advice. Please consult an attorney for legal advice.

answered Nov 27 '09 at 18:13
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Henry The Hengineer
4,316 points

1

There's all sorts of reasons why you shouldn't worry about this:

  • It's not illegal for a business to fail, thus there's no basis for a lawsuit.
  • VCs are accustomed to companies failing. In fact, most of their investments will fail as a general rule.
  • If a VC shop became known for suing founders upon failure, very quickly they would discover that no one would take their money.
  • One of the main purposes of incorporating is to protect everyone involved from bankruptcy.
answered Nov 28 '09 at 02:05
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Jason
16,231 points

0

Depends what they agreed but unless their was some criminal activity, they are unlikely to go to jail...

answered Nov 27 '09 at 19:18
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Mark Stephens
976 points
  • So does that means everybody just accepts the reality that the business fails? – Jpartogi 9 years ago

0

A business doesn't just up and fail one day. It usually happens over a protracted period of time, during which time both the entrepreneur and the investors are implementing as many measures they can to ensure the business' survival. Some times,however, the value proposition was not as robust or the busines not as scalable as everyone thought, or market conditions simply such that the business can no longer succeed.

An entrepreneurial undertaking has inherent risk from the start. Venture capital is risk capital. By its very definition, risk implies a significant potential for failure. The entrepreneur doesn't start out with that end in mind (in fact most don't even allow the thought to enter into their mind). The venture capital firm doesn't invest with the thought that they will lose their money, but know that it is a distinct possibility. Some times, stuff just happens! And, at the end of the day, all will,begrudgingly, accept that reality.

answered Nov 29 '09 at 00:49
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Lonnie Sciambi
369 points

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