What is insolvency and what are its legal tests?
Takeaway: Insolvency is a state of financial distress where a company can no longer meet its financial obligations; understanding the two legal tests for insolvency—the balance sheet test and the equity test—is critical for directors to know when their fiduciary duties may shift.
Insolvency is one of the most feared words in the business world. It is the line a company crosses when it is in such severe financial distress that it can no longer function as a going concern. It is not just a financial state; it is a legal state that has profound consequences for the company, its creditors, and its board of directors.
For a startup founder, it is critically important to understand what insolvency means, because as a director of the company, your legal duties can shift dramatically when the company enters the "zone of insolvency". There are two primary legal tests used to determine if a company is insolvent.
1. The Balance Sheet Test
This is a straightforward accounting test. A company is considered insolvent under the balance sheet test if the value of its liabilities is greater than the fair value of its assets.
How It's Measured: You look at the company's balance sheet. If the total amount of money the company owes to its creditors (its debts, accounts payable, etc.) is more than the total value of everything the company owns (its cash, equipment, IP, etc.), then it is "balance sheet insolvent."
The Challenge for Startups: This test can be tricky for an early-stage startup. Your company may have very few tangible assets but may have incurred significant debt through convertible notes or venture debt. However, a significant portion of your company's value is in its intangible intellectual property, which may not be fully reflected on a standard balance sheet.
2. The Equity Test (or "Cash Flow" Test)
This is often the more practical and immediate test for a startup. A company is considered insolvent under the equity test if it is unable to pay its debts as they become due in the ordinary course of business.
How It's Measured: This is a test of your company's cash flow. Do you have enough cash in the bank to make payroll next month? Can you pay your rent and your key vendors?
The Startup Reality: A startup can be "balance sheet solvent" (its assets are technically worth more than its liabilities) but still be "equity insolvent" because it has run out of cash and cannot meet its immediate, day-to-day obligations. For a cash-burning startup, this is the more common and pressing form of insolvency.
Understanding both of these tests is essential. If your company meets either of these definitions of insolvency, it has entered a new and dangerous legal phase, and the board must begin to act with extreme care and diligence.
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.