Of course, these are hectic and chaotic times. Employee morale may be low; directors may be resigning because they fear potential liability related to a failing company; and vendors and suppliers may be pressuring the company for payments. All of these factors are difficult to deal with in a booming economy, but are extremely trying in an economic downturn.

Many high-tech companies are reducing their burn rate by curtailing expenditures and laying off employees. Companies are stretching out payables. Several companies in the Valley have endured two, three, or even four rounds of layoffs. One enterprise software company decided to lay off its entire sales force because none of its prospective customers were making any purchasing decisions.

What does a company do when it reaches this point? When a business runs out of cash, it generally has the following options:

- Raise a round of “desperation” financing.

- Sell the company to a third party. or

-Go out of business by closing its doors and/or filing for bankruptcy.

Desperation Financings

In many ways, a lot of technology companies are accepting “desperation” financing; the label is simply a matter of degree. It means that a company truly has no other choice but to accept Draconian terms in the financing.

For example, one recent scenario involved a technology client that had completed its last financing in the first quarter of 2000 with a post-money valuation of $41 million. Its pre-money valuation was approximately $2.4 million (This was originally going to be approximately $1.2 million, but the company was able to double it). After the new financing, the new stockholders owned approximately 85 percent of the company, and the ownership of the founders and the employees was reduced to less than 10 percent. Because the approval of the founders (as common stockholders) was required to secure the financing, the current chief executive officer (not a founder) understandably had a very tough time getting the founders to okay the deal. Ultimately, the founders painfully concluded that the Series B financing was the only way to save the company they had worked so hard to create.

Another client was recently forced to accept bridge loan financing with onerous terms after its preferred stock financing fell through. This company had been negotiating a new round of funding from a group of primarily European investors prior to Sept. 11. Although many venture investors have severely curtailed investments since Sept. 11, those from Europe seem to have ceased U.S. investments completely. As a result, the preferred stock financing in progress was terminated. The company has scrambled for other investment, but unfortunately has only been able to obtain bridge financing. The terms of the notes sold in the bridge financing include a 30 percent interest rate, and are secured by all of the company’s assets. Further, the notes are due in four months, providing they have not converted into the next round of equity financing (if such financing should occur). The company intends to use the bridge funds to try to sell the company in the next four months. Notwithstanding the bridge financing, the company intends to lay off all but five employees to try to stretch its cash until a buyer can be found.

Not surprisingly, companies are turning to bridge financings more often in order to keep the doors open. Investors often prefer this, as they receive a security interest in all of the company’s assets. If the company is unable to obtain permanent financing within a specified time frame, the investors can effectively take control of the company—either through exercising their security interest, or increasing their stake pursuant to conversion features of the debt instrument. In addition, in any bankruptcy situation, debt is paid before equity.

A new twist in recent bridge financing is the introduction of “pay to play” provisions. A typical pay to play clause in an equity financing provides that if current investors decide not to purchase their full pro rata amount in a later equity financing, their rights will be curtailed at a future time – including forced conversion into common stock in the most severe circumstances.

One of our technology clients is involved in a bridge financing arrangement in which the pay to play concept is being used. This transaction provides that if the current preferred stockholders participate in the bridge financing up to its full pro rata amount, they will have their existing series of preferred stock converted into a superior series of preferred stock. (e.g., participating Series A, Series B and Series C will be converted into a Series D, which will be superior to the first three.) Such a provision provides a powerful incentive for existing investors to continue to fund the company while it looks for outside investment, and it also virtually eliminates any “free rider” problems.

Selling the Company

For many companies, the preferred option is to sell the business to a third party. Unfortunately, though, many potential buyers have chosen to sit on the sidelines for a while as the economy stabilizes. Back in 1999 and 2000, a technology firm could pit potential buyers against each other in a sort of “auction” process, thereby driving up the company’s value. With only one bidder (who undoubtedly knows that the target company is facing financial difficulty), the sale prices are quite low—often far below the value of the liquidation preferences of the preferred stock.

This presents two main problems: First, most buyers want to place some of the acquisition consideration in the hands of the target employees who will be coming to work for them. However, the employees typically hold only common stock (or options to purchase it). Because the preferred stock liquidation preferences set forth in the target’s certificate of incorporation will leave no acquisition consideration for common stockholders, buyers often request (or demand) that the target company amend the liquidation preferences to provide some acquisition consideration for common stockholders. Naturally, the preferred stockholders often resist surrendering some of their bargained-for liquidation preferences. Accordingly, buyers need to strike a very delicate balance between motivating the employees and reducing the liquidation preferences (which are often already not being paid in full prior to any amendment). This usually comes about through intense negotiations.

Second, if the buyer does not demand that the liquidation preferences be amended to retain employees, the target company’s certificate of incorporation may have to be amended to provide some consideration for common stockholders so they will approve the acquisition. Frequently, under the applicable state law or the certificate of incorporation, the common stockholders are required to approve an acquisition. If they are receiving nothing in the proposed acquisition, there is little incentive for them to approve the deal.

Closing the Doors

Obviously, for any company this is the option of last resort. Shutting down the business, whether or not a bankruptcy filing is made, is not a particularly easy pill to swallow for any founder, executive or director. It is, however, occurring much more frequently—and not just because the company has run out of money. Sometimes companies with quite a bit of cash left in the bank have decided (or had the decision forced upon them) to close the doors and return the remaining cash to investors. For example, 12 Entrepreneuring Inc. recently announced its intention to do just that. At a certain point, the obligation of the board and officers changes from a duty to the stockholders to a duty to the creditors. Officers and directors of troubled companies must tread lightly to avoid liability.

Ultimately, the path a company elects during these difficult times must be followed carefully. The officers and directors must uphold their duties to the company’s stockholders, employees and creditors, while also trying to accomplish the best result for all.

Allison Leopold Tilley is a partner with Pillsbury Winthrop LLP in Palo Alto, California. She is also the West Coast head of Pillsbury Winthrop’s Emerging Companies Practice Team, and serves as the co-head of the Silicon Valley Corporate Securities and Technology Group.

Bradley D. Kohn is a senior attorney with Pillsbury Winthrop.
si