How do I know whether my company is insolvent?
Takeaway: Determining if your company is in the "zone of insolvency" requires a sober and continuous assessment of both your balance sheet and your cash flow; your board must ask a specific set of hard questions to fulfill its fiduciary duties.
Recognizing that your company is approaching or has entered the "zone of insolvency" is one of the most difficult and important judgments a board of directors will ever have to make. This is not a determination that can be ignored. Once a company is in this zone, the board's fiduciary duties expand to include the interests of the company's creditors, not just its stockholders. A failure to recognize this shift can expose the directors to personal liability.
There is no single flashing red light that tells you your company is insolvent. It requires a continuous, fact-based assessment of your company's financial health, viewed through the lens of the two primary legal tests: the balance sheet test and the equity test.
The Balance Sheet Test: A Valuation Question
To assess your solvency on a balance sheet basis, you must ask: "Is the fair value of our total assets greater than our total liabilities?"
The Challenge: For a startup, the "fair value" of your assets is difficult to determine. Your most valuable asset is your intellectual property, which is hard to price.
The Process: The board should engage in a formal analysis. This may involve obtaining an independent appraisal of your IP, reviewing any recent, bona fide acquisition offers, and creating a detailed liquidation analysis to determine the realistic, saleable value of all company assets.
The Equity Test: A Cash Flow Question
This is the more immediate and practical test for a cash-burning startup. The board must ask: "Can we pay our bills as they come due over the foreseeable future?"
The "13-Week Cash Flow" Model: A standard best practice is for the company's finance team to maintain a detailed, rolling 13-week cash flow forecast. This model shows, on a week-by-week basis, all expected cash inflows and all required cash outflows (payroll, rent, vendor payments, etc.).
The Moment of Truth: This forecast will give the board a clear picture of its "runway" and will identify the exact date on which the company is projected to run out of cash and will be unable to meet its obligations. This is the date you become "equity insolvent."
The Board's Responsibility
The board must be regularly briefed on both of these analyses. They should review the company's balance sheet and the 13-week cash flow forecast at every board meeting. If either of these tests indicates that the company is approaching insolvency, the board must immediately begin to consider its options, such as raising emergency financing, undertaking a sale of the company, or beginning the process of an orderly wind-down or bankruptcy. Proactive and documented monitoring is the board's best defense and its most fundamental duty when a company is in financial distress.
Disclaimer: This post is for general informational purposes only and does not constitute legal, tax, or financial advice. Reading or relying on this content does not create an attorney–client relationship. Every startup’s situation is unique, and you should consult qualified legal or tax professionals before making decisions that may affect your business.