Who remembers Traf-O-Data? A business founded by Bill Gates, Paul Allen and others to process the paper tapes generated by traffic counting boxes turned out to be a dismal failure. But the lessons Gates and Allen learned from that failed business led them to build one of the 20th century’s most successful companies.
It is no surprise that Prime Minister Malcolm Turnbull has suggested that we need to do more as a nation to foster a better environment for Australia’s venture capital (VC) industry. Indeed, we are all looking forward to the imminent release of the Prime Minister’s science and innovation statement.
Venture capital has the potential to disproportionately support innovation in the Australian economy by financing start-ups with new business ideas and high growth potential. But one aspect that needs urgent attention is the rules governing how we manage businesses' failure, especially for small companies.
Inherent in any start-up business is the risk of failure. If we are serious about supporting innovation especially through VC we need better rules. There are always going to be more Traf-O-Datas than Microsofts. To support innovation Australia needs rules that do not stifle risk taking, rules that strike the right balance.
Countless studies including the Murray Inquiry into the financial system have identified that Australia’s current insolvent trading laws stifle innovation and inhibit risk taking. The FSI report tips the balance more towards directors, by giving a push to proposals for a safe harbour for executives of financially stressed companies. But we don’t think that’s the answer; and especially not for VC backed companies.
Our regime places personal liability on directors for debts incurred if the company trades while insolvent. These complex rules are arbitrary, have significant shades of grey and are usually imposed with the blinding clarity of hindsight.
As one judge commented: “It is easy enough to tell the difference in hindsight, when the company has either weathered the storm or foundered with all hands; sometimes it is not so easy when the company is still contending with the waves.”
Directors aren’t fortune tellers so most of them find themselves so fearful of the consequences of getting it wrong that too often they choose not to take the risk of personal liability and call the administrator unnecessarily or too soon.
Our insolvency rules discourage directors from taking sensible risks to deal with a company’s financial problems. Compare this with the UK where directors are only liable if the director knew or ought to have known that there was no reasonable prospect that the company would avoid going into insolvent liquidation and the director failed to take all reasonable steps to minimise the potential loss to the company’s creditors. This effectively provides UK directors with more scope to navigate a company through financial distress and corporate reconstructions and avoid corporate failure.
The main assets for most start-ups include the entrepreneur’s idea or technology, often not valuable to an outsider, as the value often cannot be separated from the entrepreneur. Obtaining bank financing is not only difficult because of the lack of reliable cash-flows and security/collateral but also expensive because of the riskiness of the venture.
Venture capitalists assume the risk of the venture failing and invest equity capital. They earn returns only when the firm is successful and either sold to another strategic/ financial buyer or has an IPO.
The unsuccessful start-ups frequently become insolvent not only because their liabilities exceed their assets but because the firms cannot secure further rounds of equity financing. Often start-ups do not enter into or are put into the bankruptcy system because the process is costly relative to the realised value of the business.
We suggest that small proprietary companies like most involved in venture capital should operate in a more debtor-friendly corporate insolvency law regime. Under these rules directors should be given power to continue running the company while the company refines or restructures its business model if insolvent liquidation is not a certainty. This would provide directors with the latitude to allow the company to “test and lean” and “pivot” its product or service or implement a workout or restructure to potentially extract more favourable concessions from creditors on behalf of shareholders, protect value or even save the company from failure.
A change to a model closer to the UK Insolvency Act is not a “race to the bottom”, but rather a more flexible regime based on a model that already works well in another jurisdiction.