Building a new business from the ashes of the old-a primer on avoiding common mistakes

Here's a scene we see all too commonly. The old business is plagued with troubles that threaten to sink the ship. Unpaid bills are piling up and creditors are going to court. If only the old debts could go away, the business could survive and prosper. The business owners want to just start clean and start over. Yet all too often they charge ahead and make mistakes that result in their creditors and financial problems following them,  or worse. Early advice from experienced and qualified legal and financial professionals  is essential. This article will touch on the sources of trouble, the problems that arise, and the mistakes that are often made.

1. Mistake: Not putting together a comprehensive plan. A wag once said that "if you don't know where you're going any road will get you there". Success in moving on requires a careful business plan.Which suppliers will be critical to the new business? What debts have the owners personally guaranteed, either by agreement or by law? How the new business going to be restructured? What is the timeline? Where is the money for winding up the old business and getting the new one started going to come from?

Doing it wrong can mean the owners and the new business fail or the old debts follow them into the new endeavor. First, is the problem of fiduciary duty. When a business is at or near collapse (lawyers call this being in the "zone of insolvency") the owners and managers have a fiduciary duty to protect the interests of creditors and can become personally liable as "trustees" if they engage in self-dealing or act solely for their own benefit, at creditors' expense. This does not mean they owners must surrender the business to creditors. It means they have to exercise business judgment to make the best of a bad situation so that whatever is left can be applied to legitimate claims of creditors in some fashion that has the hallmarks of fairness and reasonableness.

Secondly, there is the problem of "successor liability". A new business which takes over an old business's employees, customers, business opportunities and/or operations can be held to be a mere continuation of the old business resulting in potential lawsuits and liability to the old creditors. This is always a risk, but with careful planning the risks can be avoided.

Advance planning and understanding is essential to minimizing these risks. The plan should include a careful evaluation of all the assets and liabilities of the old business, and a timeframe for wrapping things up.

2. Mistake: Not keeping a strict separation between the old and new ventures. A new business needs to be built with new money. The old business and its accounts need to be kept strictly separate from the new. This does not mean that a new business must start from scratch, but the more connections there are between the old and new ventures, the greater the risk of "successor liability". At a minimum, the new business should keep separate accounts and separate contracts. It should avoid using or having a name that is closely similar to the one used by the old business.

All business operations of the new business and the old business should be carefully and scrupulously documented to show that the old management acted responsibly in winding up the old business and everything was kept as much as possible at "arms length".

3. Mistake: Transferring business and business assets to the new business without paying for them. If the old business has equipment or assets that the new business needs, the new business needs to buy them on terms and for a price that are objectively fair and reasonable. More importantly, the payment needs to go into the coffers of the old business. Management should document how they came to the price and terms, if possible based on some objective third party criteria (eg EBay prices, auction sale values etc). The new business need not pay full retail, but should pay something that leaves the old business and its creditors no worse than what would be there in a liquidation scenario.  This obligation extends to contracts that the new business takes over and which the old business does not have the ability to complete. Payments from new to old could be structured in a variety of ways, depending on the circumstances. For example, the old company might receive an objectively reasonable percentage of the revenue when received  from completing an existing contract. There are a variety of ways to make these arrangements.

4.Mistake:  Winding up the old business without proper legal advice. Winding up an old business while starting a new business is risky at best. Owners need to have accountants and lawyers advising them in this process. Each situation is different, but having a carefully thought out plan that is documented is critically important. Both accountants and lawyers should be consulted early on, and should work together. Money should be set aside early for their fees.

5. Mistake: Lying or cheating the old creditors The owners and managers should never make misstatements of fact. Better to say nothing. The last thing you want are allegations of fraud or breach of trust following you. At the same time, every attempt should be made, within reason and within the bounds of financial reality, to settle up with creditors, especially those who are most vocal and aggressive. These offers should be documented. This process gets back to the need for a plan. Owners need to know how far they can go and what they can do.

6. Consider letting a court oversee the windup of the old business. Business owners who are simultaneously wrapping up the old business and trying to start up the new are always in a precarious position, fraught with conflicts of interest. Under the right circumstances, a bankruptcy under Chapter 11 or an Assignment for the Benefit of Creditors under New Jersey law may make a lot of sense. Having an independent fiduciary or court approval for critical steps of the transition goes a long, long way to avoiding later claims of successor liability or breach of fiduciary duty.

We have guided many business owners through these treacherous waters, and on the flip side have pursued on behalf of trustees or creditors those who got it wrong. If you are a business owner in New Jersey, we are available to help. Visit our website to learn more. Neuner and Ventura LLP