How to Wind Down a Startup: Part 1 (Legal and Tax)
As a founder, you never want to think about, let alone plan for it. What is “it”? Failure. The reality though is many venture-backed startups will eventually fail.
While there is some disagreement about what percent of venture-backed startups percent fail, it happens a lot. On the low end, the National Venture Capital Association estimates a failure rate around 25%. On the higher end, Shikhar Ghosh from Harvard Business School estimates around 75% of venture-backed startups fail to return investors’ capital.
The first part of our 2 part series on “How to Wind Down a Startup” is not about “when” to make that decision, but rather once you have decided to wind down operations, this blog hopefully provides a checklist to some on “how” to do it the right way.
At this point, airCFO has worked with several hundred startups (and while our failure rate is WAY below either 75% or 25%), we have helped a few clients wind down. Over the years we have built our own checklist that should help most of you get started from a legal and tax accounting point of view. In Part 2 of our Wind Down Checklist we’ll review best practices for shutting down the back office.
First a few words of caution:
- We recommend giving yourself at least 3 months of time and cash burn if you plan to do this the right way.
- The reality is that many of you will need to be taking steps in parallel with trying to secure more funding for more runway. If you don’t, you’re going to make a lot of people really mad if you wait until the last minute.
- This process takes time and money, and if you don’t leave yourself time or money, some of this might follow you into your personal life.
- One area you never want to mess around with is cash reserves set aside for taxes or employee benefits.
- If you collected sales tax from customers, you need to pay those amounts out to the sales tax authorities. If you used that to fund the business, you can, and most likely will, be held personally liable for the debt (even if the startup is no longer in business).
- Beware of nuances in some states for accrued employee benefits such as earned, but unused vacation time or for employee 401K contributions withheld but not remitted during payroll.
Aside from known liabilities on your balance sheet, you need to allocate budget for future expenses to shut down a company. You should talk w/ your Accountants and Lawyers to estimate future fees and timelines for shutting down your startup. If you don’t leave at least a couple months’ runway of cash, it’s going to be really hard to get professionals involved to do this the right way. Instead you’ll likely need to handle this all on your own.
So what do you need to do for legal and tax?
Start with getting the owners on the same page (e.g. a board resolution), and then work to notify external stakeholders (government and tax authorities).
Most of our clients are organized as LLC’s or C-Corporations. Each is different, but in general you’ll need a majority of the LLC Members or Board of Directors to agree on the dissolution. Your lawyer should guide the formal process and help work through this. If not, dust off those formal organizational documents that came together when you formed the entity. There may have been updates and amendments, so make sure you have the latest version. Even if its just a formality at this point, you still want to document this with a board resolution or and have a dated, written statement because you’ll probably need to send this to outside stakeholders so they can have backup if they are claiming a write off on their own taxes.
With that first step completed, you can move on to notify state and local municipalities (e.g. city governments) of your intent to dissolve your startup.
Most companies in the U.S. are registered at the state level with the state’s Secretary of State, so you will notify each state separately that you are registered in with a notice to dissolve the entity. For example, if you are Delaware C Corp with an office in California, you are likely registered with both Delaware and California. You don’t need to notify every state, just those you are registered with.
This is one of those painful processes that is going to take some time. There is no central notification system to notify all the cities and states you registered in, so it’s going to be a manual process that probably involves written signatures, faxes and/or postal mail. If you have the budget, your lawyer probably has a streamlined process, but if not this is one of those things you don’t want to overlook.
For our clients, we generally view tax in three buckets: sales tax, payroll tax and income tax. Not surprisingly, you have different agencies within a state and city that manages each bucket. Each of those agencies will need notified. For example within a single state, you might need to notify the Department of Revenue and Withholding (for payroll taxes and income tax), the Department of Unemployment (for payroll tax) and the Department of Sales & Use Tax (for sales tax); also they don’t all use the same naming convention, so sometimes you need to do a little digging around (for example in California, you deal with the Franchise Tax Board for income tax..
If you aren’t sure which states apply, a good place to start is looking back through your financial statements or payroll reports over the past year or two to see what cities and states you have been filing with. Now that many startups are letting the team work remote, it’s pretty normal for us to see a 5 or 10 person startup registered in a handful of states.
Sales tax will generally be handled by one department (usually called something like: Sales & Use Tax Dept), whereas payroll tax can involve up to three different departments for unemployment tax, worker’s compensation (some states have their own agency, and some manage through an insurance company), and then a withholding agency for employee income tax withholdings. For each of these, you will want to notify them to cancel any license or permit that is currently assigned to your startup, as well as notify them that you will be filing you final returns and ask if there is any specific instructions.
While sales tax is at the state level, payroll tax and income tax have both state and federal levels. So be sure when you are filing income or payroll tax returns that you check the box on the return to notify the agency you are filing your “final return.” Make sure you work with your tax partner to check these boxes and make any other necessary notifications. The IRS has a checklist for handling things at the federal level which includes final steps including final reporting of W2s/1099s, cancelling your EIN (employer identification number), and record retention.
We know this situation can be daunting, but we also know that failure is a healthy part of the startup lifecycle, and we feel a responsibility to help destigmatize the wind-down process. Say it with us founders: failure is okay, and I can handle it the right way. You don’t have to go at it alone, if you allocate time and money to wind down, then you get access to the professionals that can ease this process for you. Winding down from a legal and tax perspective is only half the battle, in part two of this blog, we’ll walk you through best practices for closing out the back office of your startup.