Bankruptcy and Insolvency Laws for Startups: What Founders Should Know

Understanding the Complexities: A Guide for Founders on Bankruptcy and Insolvency Laws, Featuring Key Processes for Resolution.

Bankruptcy and Insolvency Laws for Startups: What Founders Should Know

For many startups, navigating financial uncertainty is part of the entrepreneurial journey. However, when financial challenges escalate to the point where liabilities outweigh assets, or debts become unmanageable, understanding bankruptcy and insolvency laws becomes crucial. These laws are not just about closing a business; they also offer opportunities for resolution, recovery, and reorganization.

In India, the Insolvency and Bankruptcy Code (IBC), 2016, serves as the primary legal framework for handling insolvency and bankruptcy. Here’s what every founder should know about how these laws apply to startups and what they can do to manage financial distress effectively.

Why Bankruptcy and Insolvency Matter for Startups

Startups operate in high-risk environments where external factors like market competition, regulatory changes, or unforeseen events can disrupt operations. Bankruptcy and insolvency laws:

1.     Provide a Safety Net: Allow businesses to restructure debts or liquidate assets to meet obligations.

2.     Protect Creditors and Investors: Ensure fair distribution of remaining assets.

3.     Enable Restart Opportunities: Empower founders to recover from financial challenges and start afresh.

These laws offer a structured way to handle financial crises, ensuring that all stakeholders are treated fairly while enabling startups to explore recovery options.

Key Features of the Insolvency and Bankruptcy Code (IBC), 2016

The IBC is India’s comprehensive legislation for resolving insolvency and bankruptcy. It applies to companies, partnerships, and individuals. Key highlights include:

Corporate Insolvency Resolution Process (CIRP)

CIRP is the cornerstone of the IBC, designed to resolve insolvency efficiently.

1.    Threshold for Initiation: Insolvency proceedings can be initiated if a corporate debtor defaults on payments exceeding ₹1 crore.

2.     Timeline: The resolution process must be completed within 330 days.

3.    Moratorium Period: A temporary halt on all legal proceedings and recovery actions against the debtor.

Voluntary Insolvency

Founders can voluntarily initiate insolvency proceedings if they foresee an inability to meet obligations. For instance, A fintech startup initiates voluntary insolvency to restructure its debts after a funding round falls through.

Fast-Track Insolvency

Startups recognized under the Startup India initiative can opt for fast-track insolvency, with a shorter resolution timeline of 90-180 days. For instance, A SaaS startup leverages fast-track insolvency to renegotiate vendor contracts and stabilize operations.

Role of the Insolvency Professional

An insolvency professional (IP) manages the resolution process, taking over the management of the debtor’s business and working to maximize asset value.

Steps in the Corporate Insolvency Resolution Process (CIRP)

1. Filing an Application

-        Creditors (financial or operational) or the corporate debtor itself can file for insolvency.

-        The application is filed with the National Company Law Tribunal (NCLT).

2. Appointment of an Insolvency Professional

-        The NCLT appoints an IP to manage the process and take control of the debtor’s assets.

3. Moratorium

-        A moratorium is declared, stopping all recovery actions and lawsuits against the debtor.

4. Formation of the Committee of Creditors (CoC)

- The CoC, comprising financial creditors, oversees the resolution process and approves the resolution plan.

5. Submission of a Resolution Plan

-        Potential bidders, including promoters, can propose plans to revive the company.

-        The CoC approves the plan by a 66% majority.

6. Approval by NCLT

-        The approved resolution plan is submitted to the NCLT for final clearance.

-        If no resolution plan is approved, the company proceeds to liquidation.

Liquidation Process

If the resolution process fails or no resolution plan is approved, the company enters liquidation. Key steps include:

- Sale of assets to settle debts.

- Distribution of proceeds based on a priority order:

1. Insolvency process costs.

2. Secured creditors.

3. Unsecured creditors.

4. Shareholders.

Challenges for Startups Under the IBC

1. Valuation Issues: Startups often lack tangible assets, making it challenging to determine fair valuations.

2. Limited Creditor Patience: Creditors may be less willing to negotiate with high-risk startups.

3. Investor Interests: Resolving conflicts between secured creditors and equity investors can be complex.

4. Time Constraints: Completing the resolution process within stipulated timelines can be difficult for startups with multiple stakeholders.

Alternatives to Bankruptcy

1. Out-of-Court Settlements

Negotiate with creditors to restructure debts or extend repayment timelines. For instance, A D2C startup negotiates deferred payments with suppliers to ease cash flow.

2. Debt Restructuring

Reschedule or reduce debt obligations with the consent of creditors.

For instance, A logistics startup restructures its loan with a bank, reducing monthly EMIs.

3. Equity Dilution

Raise additional funds by offering equity to investors, using the proceeds to settle debts.

For instance, A health-tech startup raises a bridge round to pay off outstanding liabilities.

 Case Studies

Jet Airways: Resolution Through IBC

Though not a startup, Jet Airways’ insolvency process showcases how the IBC enables resolution. After months of grounded operations, a consortium of investors proposed a successful resolution plan, allowing the airline to restart operations.

Lesson: Effective resolution can revive even distressed businesses with strategic planning.

Stayzilla: Voluntary Insolvency

The travel startup Stayzilla voluntarily wound up operations due to an unsustainable business model. By following the legal framework, it ensured transparency and fairness for creditors and employees.

Lesson: Voluntary insolvency is a responsible way to exit gracefully.

Proactive Steps for Startups to Avoid Insolvency

1. Monitor Cash Flow

Regularly track income and expenses to identify financial stress early.

2. Maintain Clear Records

Ensure accurate accounting and compliance with statutory requirements to simplify resolution processes if needed.

3. Negotiate Early

Engage with creditors and investors proactively to restructure obligations before defaults occur.

4. Engage Legal and Financial Advisors

Seek professional guidance to navigate complex financial challenges and explore alternatives.

While insolvency or bankruptcy may seem like the end of the road, the IBC offers startups a chance to resolve financial distress responsibly. By understanding the legal framework and exploring resolution options, founders can protect stakeholders, preserve reputations, and, in some cases, turn challenges into opportunities for a fresh start. Whether it’s restructuring, liquidation, or voluntary insolvency, the right approach can pave the way for new beginnings.

Disclaimer: This article is provided solely for informational purposes and should not be considered as legal advice. For accurate legal guidance, please consult a qualified professional.

Tanya Shree

This article was written by Tanya Shree A.O.R. of Supreme Court of India.