Startups Rarely File for Bankruptcy. Could that Change?

April 21, 2017, 2:28 PM UTC
Boom With A View by Erin Griffith: Social Media
Illustration by Aleksandar Savic

This article first appeared in Term Sheet, Fortune’s newsletter on deals and dealmakers. Sign up here.

Plastc, a company that raised millions from crowdfunders with the promise of revolutionizing payments, has shut down.

On its own, this is not notable. Young startups with big dreams and piles of crowdfunding cash fail all the time. But this one isn’t just ceasing operations. According to a notice posted to the company’s website, it is “exploring options” to file for bankruptcy. Two things to note:

“Pretty taboo in the valley”

There is an increasing willingness of venture-backed companies to go through bankruptcy.

Normally when startups shut down, bankruptcy is pointless for a few reasons: With young software companies, there are usually no assets to reorganize. What’s more, venture backers and founders would rather not glorify their failure with an embarrassing public auction. And lastly, bankruptcy is expensive. If the company is truly out of money, who will pay for it? Not the venture backers – even if there are assets to liquidate, the equity holders would be last to get paid anyway. “Their muscle memory is to avoid Chapter 11 at all costs,” says Jeff Cohen, a partner at Lowenstein Sandler. “It’s pretty taboo in the Valley to use the term Chapter 11.” (To be clear: Plastc filed for Chapter 7 liquidation, not Chapter 11.)

But bankruptcy is becoming increasingly appealing for two reasons: One, the increase of asset-based lenders. Startups that took out debt with little collateral beyond their massive valuations need to at least try to cover those loan obligations. Especially in high-profile cases, Cohen says. “There is a larger group of activist attorneys that, if you don’t pursue the right path, will come after you,” he says. Further, depending on the state, sudden shutdowns resulting in mass layoffs without severance payments could result in personal liability for executives, which a bankruptcy process can help avoid.

And two, assets. Patent portfolios and customer lists are increasingly seen as valuable assets for a startup that might not have any physical assets. Firms like Boston’s Hilco Streambank specialize in monetizing these assets. “It used to be an afterthought asset, and now it’s a value driver in Chapter 11,” Cohen says.

“A signature away from closing”

The second thing that makes Plastc’s failure notable is that it represents another wrinkle in a tale that may as well be called “Danger: Crowdfunding!” Enthusiastic backers have had to learn, one outrage at a time, that most forms of crowdfunding entitle them to very little. This was most notable when Oculus VR sold to Facebook in 2014. It seems quaint now, but the fans who contributed to Oculus’ Kickstarter campaign were quite angry when Facebook spent billions to acquire a product they were emotionally and financially invested in, making its founders and venture capital investors very rich and leaving early backers with nothing.

Three years and lots of consumer education later, crowdfunders understand that if they’re not getting equity, the company they’re backing owes them nothing – they had merely made a donation toward a very specific goal (in Oculus’s case, to ship its first developer kits, which it did).

But Plastc did not merely ask for donations towards the development of its universal credit card. The company took pre-orders for the card in the range of $135 to $155 a pop. (Reports claim it had amassed $9 million worth of pre-orders from 80,000 people, based on this Magnify Money article.) Unlike the recently failed Lily Drone, Plastc has not its offered pre-order customers a refund. The company went so far as to delete its social media accounts.

After many delays, Plastc’s product was promised to ship this quarter. The company had raised $7.7 million in venture backing and convertible debt from Grayhawk Capital, IncWell, Mitsubishi, Peninsula Ventures, and ZenStone Venture Capital, according to Crunchbase. It blames its failure on two venture capital deals that fell apart at the last minute. “The round was a signature away from closing and we were extremely caught off guard when they notified us yesterday they were backing out,” the company wrote. Now, pre-order customers are calling their credit card providers and attempting to get refunds on the charges, most of which were made two years ago.

There are so many tales of crowdfunding hardware woe out there that I’m surprised anyone opens their wallets for a cool-sounding idea with nothing more than a slick demo video anymore. At one point, Kickstarter hired an investigative journalist to find out what happened with a highly funded failed project; the journalist determined that crowdfunding sites should have “better mechanisms to identify weak projects before they fund, as well as new processes to provide mentorship, support and expert advice to newly-funded projects.”

For companies taking on risky hardware endeavors, crowdfunding is a way to gauge customer interest, get some PR, and build a community around your product. But communities of supporters can quickly turn on a company when things go wrong (especially in today’s era of online outrage spirals). In other words, it’s a risky proposition for both sides of the transaction.

Note: This article has been updated to cite Magnify Money’s reporting on Plastc’s pre-orders.

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