More startup founders are using Safe Harbour provisions when facing insolvency. Here’s how it works

The Australian startup ecosystem is facing its next wave of financial challenges. With a 54% decline in capital raised by Australian startups in 2023 and a 14.5% rise in insolvencies, Australian startups are financially strained. For those operating in the capital-intensive tech sector in particular, the time between funding rounds is harder than ever.

Tech startups must juggle the requirements of building a business from scratch, securing funding, navigating regulators, cashflow demands and economic downturns, all while establishing a market presence. Unlike established businesses with a proven product-market fit and a predictable revenue stream, early-stage tech startups often prioritise product development over immediate revenue generation. Despite clearly falling outside the usual corporate stereotype, tech startups and their directors are subject to the same insolvency regime as established companies in other sectors. In their early stages, tech startups and their founders must not only understand their duties as directors but also be aware of insolvency triggers and the potential of personal liability for debts, even if incurred by the company.

Insolvency triggers 

As cash runways shorten, tech startups are prone to cashflow challenges and may struggle to meet their financial obligations, putting them at risk of insolvency. Understanding insolvency triggers is key. To assess whether a startup is facing insolvency, directors should compare projected cashflows against debts to determine whether they can be met. Through this exercise, if a risk of insolvency exists, directors should seek specialist advice. 

A lifeline for startups in financial difficulty

Thankfully for startups, there are ‘Safe Harbour’ provisions in the Corporations Act that can provide a valuable tool for founders and directors navigating this challenging period. In some circumstances, the Safe Harbour provisions allow founders and directors to turn around their financially distressed businesses without personal liability for insolvent trading claims. 

We’ve recently seen an increase in tech companies relying on these protections. The regime encourages directors to innovate, take reasonable risks, and trade their business out of financial distress, instead of immediately entering administration or liquidation. This acts as a lifeline for startup founders navigating financial challenges, giving them breathing room to explore options for securing funding, cutting costs, or restructuring without the immediate threat of personal liability. 

For Safe Harbour to be available, a director must show that the debts were incurred in the development of one or more courses of action that were “reasonably likely to result in a better outcome for the company”, compared to immediate liquidation or administration of the company. Some examples of these courses of action include: 

• Securing investment: Larger venture capital cash injections traditionally used by startups are often few and far between. But a comprehensive fundraising strategy demonstrating active discussions with potential investors and reasonable prospects of implementation could qualify as a viable course of action. 
• Negotiating with creditors: Open communication and restructuring negotiations with creditors, including proposing extended payment plans or offering equity in exchange for debt forgiveness, can be a strong course of action.
• Selling assets or restructuring operations: Divesting non-core assets or streamlining operations to reduce costs can free up resources and improve solvency.
• Merger or acquisition: Exploring a strategic merger with a complementary company or seeking acquisition by a larger entity can be a path to a better outcome.
• Developing a new product or service: For startups with a strong product or service idea, focusing on rapid development and market launch, with a clear path to profitability, can be a viable course of action.

Acting proactively and swiftly

Failure to take timely action could leave directors vulnerable to personal liability, so even if Safe Harbour is available, it’s important to act swiftly and proactively. Safe Harbour only protects directors for a “reasonable period between consideration of a course of action and its implementation”. The sooner directors develop and implement a plan, the stronger their potential protection under the Safe Harbour will be.

Safe Harbour is a powerful tool, but it’s not a guarantee. Directors must act in good faith and with a genuine belief in the success of the chosen course of action. Directors must ensure they maintain accurate financial records, engage appropriately qualified advisors, assess performance against planned courses of action, maintain engagement with key financiers, and comply with all Safe Harbour requirements. Finally, always seek professional and independent advice from an insolvency practitioner. 

By understanding the triggers of insolvency, leveraging Safe Harbour provisions and taking swift and decisive action, directors of startups can increase their chances of navigating financial challenges and direct their companies towards a better outcome of growth and stability. 

Nicholas Poole is a restructuring and insolvency partner at Clayton Utz and Aran Haupt is a lawyer at Clayton Utz. 

Never miss a story: sign up to SmartCompany’s free daily newsletter and find our best stories on LinkedIn.