A Learning Curve

26 October 2000

Brett Israel

The pace of the development of e-commerce - and its derivatives such as digital commerce and mobile commerce - has been irresistible. Or so it was thought.

The last six months or so have been financially much harder for dotcom start-ups. Hot on the heels of the initial blaze of publicity surrounding stock market flotations of the likes of Lastminute.com and other high-profile dotcom pioneers in this country have come market-wide concerns about the sector's financial health. There have been the liquidations of Boo.com and Netimperative and the placing of Leisureplanet.com into administration. And, more recently, high-flier Clickmango.com has announced its intended shutdown, while Urbanfetch.co.uk has laid off 15% of its staff only two months after its launch The liquidations have been particularly notorious for the huge disparity between the investments made and the asset values realised by the liquidators.

Commentators tend to focus on these financial problems from the perspective of the companies concerned or the investors This article will look briefly at certain impediments that hamper dotcoms generally and what this means for the management of the companies involved.

The dotcom arena

The market has readjusted since the initial frenzy of all things internet-related, and there is a realisation that things are not as simplistic as many thought. The market needs to be viewed in two distinct parts. To date, the failures have been concentrated in the tough business-to-consumer (B2C) market. Those active in the business-to-business (828) sector are showing much more resilience. B2C may have the profile, yet represents no more than perhaps 20% of all e-commerce activity.

The bulk comprises B2B transactions between businesses where the internet simply offers a much more efficient medium for buying and selling. There is less of a sea change in the attitudes to dealing than there is in the consumer market. After all, electronic data interchange has been around for many years as a mechanism where suppliers are automatically informed of what replacement supplies are needed by supermarkets when goods sold are swept through their tills' bar-code readers.

There are other problems for B2C firms. Key among these is the under-investment in most dotcoms. Or, more accurately, while fundraising activities may have brought in millions in the first financing rounds, subsequent capital has been much harder to attract In a large part, investors have been put off by what is known as the 'bum rate' - the rate at which cash is consumed, especially before there is much evidence of significant sales, let alone any profits Cash in many businesses is perceived to be being consumed too quickly, largely as a result of on-going, ambitious but costly marketing initiatives.

Dotcoms, other than perhaps those dealing in dematerialised products such as online share dealers, are generally constrained by their very essence while conventional companies will have at least some bricks and mortar and other tangible assets, most dotcoms have little more than intangible potential

This has one particular downside banks and other lenders refuse to lend them money. A full security such as a debenture (comprising charges over all of a company's assets) will be of illusory value when given by a typical start-up with little more than a rented office and a few chairs and PCs. Even if intellectual property rights are available, these are notoriously difficult to value accurately for security or other purposes. Moreover, such businesses an unlikely to be generating enough, or a regular flow of, cash to meet the interest instalment that would be due on such loans.

Dotcoms are left with one option: the issuing of shares to investors, whether institutional (such as venture capitalists) or individual (including business angels) However, following the initial seed capital financing rounds, investors will want to see tangible evidence of robust business progress before more money will be available.

Meanwhile, the company continues to incur both fixed costs (such as employee payroll, rent and software development costs) and variable costs (such as on-going marketing expenses) which will be difficult to meet.

So what if cash is fast disappearing and there seems little realistic justification for continuing the business?

Management Responsibilities

This impending crisis will require the director to be vigilant as their legal responsibilities will shift at this point. Until now, they will have been endeavouring to run the company in accordance with the wishes of their shareholders (typically for a start-up these are the same individuals, although venture capitalists and other investors may now be represented on the board), the emphasis now shifts. When there is a cash shortfall, the company may not be able to meet its obligations as they fall due for payment. Continuing to allow the company to trade could expose the directors to something known as 'wrongful trading' under the Insolvency Act 1986. The shift is towards acting in the best interests of the company's creditor, with the shareholders' interests now ranking behind.

Wrongful trading is notable in English company law because it represents one of few situations in which a statute lays down that a director can become personally liable to creditors for his actions as director. Usually a director could only be personally liable to their shareholders for acting improperly.

To protect themselves from possible personal risk, the directors must monitor closely and regularly the company's financial position. The point at which the directors need to consider taking action to stop the company from continuing to trade is when they can no longer reasonably expect it to be able to trade out of its financial problems. The action they should take varies - typically, the directors would call a shareholders' meeting to have the shareholders resolve to put the company into liquidation The company could also invite any secured creditor to appoint an administrative receiver or apply for the court to make an administration order. The effect of each of these steps is to relieve the directors from any potential liability from that date on for wrongful trading (but not necessarily for any action (or inaction) before then)

If the directors fail to take action as early as they should have, or if the company goes into liquidation, they could face a challenge by the liquidator who can ask the court to order each of them to contribute personally to the assets of the company, hence supplementing the assets available to meeting creditors' claims. A director (or someone who has acted as a director) found by a court to have traded wrongfully could also face possible disqualification, which would mean that they could not act in any managerial capacity in relation to a company for a period of between 2 and 15 years (There is also a criminal offence known as fraudulent trading, but this is rarely encountered.)

Ultimately, deciding when a dotcom has had its day and should stop trading can be trouble-some and opinions on the board may vary, but it is only a decision for the directors. Professional advice should always be taken from an insolvency practitioner or solicitor. If the directors conclude (preferably with the benefit of such advice) that there is no immediate need to stop trading, then their decision to carry on should be well-reasoned and fully documented, as should any difference of opinion among them.

First published in Legal Week 26 October 2000