Maintaining Corporate Formalities During Distressed Periods: Considerations for VC-Backed Companies
For VC-backed emerging companies, distressed periods often manifest as liquidity crunches, urgent fundraising efforts, or strategic pivots. These moments can put intense pressure on the corporation’s board of directors (“Board”). But rather than loosening governance, founders and directors should strengthen formal processes to help navigate complexity and reduce personal liability.
Growth technology companies are built on risk, but corporate governance should not be one of them. Especially during distressed periods, Boards should maintain corporate formalities with rigor—through regular meetings, clear disclosures, and well-documented decisions.
Maintain a good working relationship among the Board
When runway is short and options are limited, tensions can easily arise among Board members, especially between founder-directors and investor-appointed directors. Disagreements may center around strategy, personnel, or fundraising terms. While many Boards are able to navigate such differences amicably and maintain consensus, others may face irreconcilable disagreements over fundamental business objectives.
In such circumstances, it is essential to de-escalate tensions and maintain open, honest communication. Companies should prioritize consistent communication and transparency at the Board level. Counsel can help facilitate discussion and ensure that divergent views are aired constructively. If internal alignment proves difficult, a Board can consider engaging an outside advisor or interim executive to mediate or provide an independent perspective.
Keep track of potential conflicts of interest
Bridge loans, convertible notes, and other emergency financings often come from existing insiders. While such insider deals can be vital, they also raise conflict-of-interest concerns—especially when the terms are unusually advantageous.
Under Delaware law, deals involving Board members or their affiliates must be carefully vetted. If the transaction does not meet the “safe harbor” protections of Delaware General Corporation Law § 144—typically by securing disinterested approval—it can be challenged, and directors may face liability for breaches of fiduciary duty. Such transactions should therefore be carefully documented in corporate records and memorialized in written resolutions.
Understand creditor rights
Boards of distressed companies may be subject to additional obligations in the context of insolvency, depending on applicable corporate law. In Delaware, a Board of an insolvent corporation has fiduciary obligations to creditors in addition to shareholders as residual claimants. Quadrant Structured Prods. Co., LTD. v. Vertin, 115 A.3d 535, 546-47 (Del. Ch. 2015). After a Delaware corporation becomes insolvent, “creditors gain standing to assert claims derivatively for breach of fiduciary duty.” Id. at 546.
In early-stage technology companies, insolvency may seem academic—but once insolvent, directors must consider the interests of creditors alongside those of shareholders. Delaware courts generally use a “cash flow” or “balance sheet” test to determine insolvency, and other jurisdictions may have similar tests. Even in the absence of a formal determination of insolvency, corporate Boards should work with outside counsel to consider how to best manage the interests of creditors in a distressed situation. Because of the risks associated with managing a distressed entity, it becomes doubly important to foster a functional, aligned Board to ensure a proper corporate record, a workable plan, and reduced liability.
