Written by Ryan Coffield of The Van Winkle Law Firm (May 2017)
One common mistake I see in my practice is that entrepreneurs who are solely focused on sales and growth routinely neglect the proper legal steps in forming and operating their business. When setting out on a new venture, it is easy to prioritize product development, revenues, and client service over all else.
Nevertheless, time and time again, I see new businesses and their owners face significant challenges—and sometimes fatal ones—stemming from a failure to consider the legal issues surrounding their business from the start. Take the example of Karen and Charlie, described below.
Step 1: Ownership
Karen worked for a dog clothing store called Doggie Duds for several years, but recently lost her job when her employer closed up shop. Karen’s friend Charlie, knowing she still had a passion for canine couture, suggested that Karen use her clothing designs to open a new store. Charlie offered to provide Karen with some startup capital.
With Charlie’s financial help, Karen was able to buy supplies, obtain a lease in a dog-friendly business district, and engage the services of a couple salespeople, Melissa and Brandon. Caught up in the excitement of starting her new business, “Coats with Tails,” Karen never considered seeking the advice of counsel. Now, when money starts to flow into the business, Charlie takes Karen by surprise when he asks for his share of the profits. Karen is forced to answer the question she should have asked at the start: Who owns Coats with Tails?
The issue of ownership can be tricky, especially in a situation like Karen’s. How the issue is settled will help dictate what kind of legal entity she should choose and what each owner’s role will be in the organization. Many businesses I work with start out like Coats with Tails, with a “money owner” (Charlie) and a “service owner” (Karen).
Individuals with the idea or skills to start a new business often bring in someone with startup capital to contribute as an alternative to applying to a bank for a loan or running up credit card debt.
In Karen’s situation, Charlie was a friend who wanted to help her get back on her feet. What did the check he wrote represent? Was it a loan to Karen? Was it a contribution to capital? If he is entitled to some share of the profits, what is the amount?
To complicate things further, do Melissa and Brandon have some claim to an ownership stake, since they helped cash-strapped Karen open the storefront without drawing salaries?
As these questions demonstrate, it is critical to know exactly who has a right to the profits of your business. If you don’t have a clear ownership structure, you are likely to face problems like these as the business grows.
I recommend meeting with a business attorney as part of the process of creating your business plan. Being involved in the business plan process is important because it helps your attorney understand your goals and answer questions like who will own the business, if you plan to bring on investors, how much each owner expects to make out of the business, and what kind of entity and tax structure you want to pursue.
Step 2: Entity Choice
When Karen’s business began to flourish and the opportunity to expand to a nearby suburb presented itself, Karen contacted a local bank and obtained a loan commitment to purchase a building for a second Coats with Tails location.
After a difficult conversation, Karen and Charlie agreed that they own the company 50/50, and the two of them went to the bank to review the loan documents. When they arrive, a loan officer sits them down and asks them to provide their collateral for the loan and requires them to open a business account at that branch.
But whose property are they going to pledge as security for the loan? And under what name should the new bank account be opened? It is at this time that Karen and Charlie are forced to answer the second important question they should have answered a long time ago: What type of business do they own?
Once the ownership of your new business is decided, you will want to determine which legal entity is appropriate for your new company. In North Carolina, businesses can be organized into a sole proprietorship (if you have only one owner), a partnership (if there are multiple owners), a limited liability company, or a corporation.
The most common entity choice we see in small businesses today is an LLC. While there may be some instances in which it is appropriate to function as a sole proprietor or a partnership, one of the risks of doing so is that your personal assets—such as your home or your savings account—may be reached by a plaintiff if your business is sued.
It is even possible to form a partnership with someone else without knowing it—and in this scenario, Karen and Charlie have probably done so. If you take the right steps in forming and maintaining your legal entity, you may be able to protect your personal assets against many of the liabilities associated with your business.
I’ve seen quite a few businesses fail that were not protected by the correct legal steps in formation and operation, which exposed them to personal liability for the actions of their business.
Step 3: Maintaining the Company/Common Pitfalls
At the suggestion of a friend, Karen and Charlie finally consulted an attorney and followed her advice to incorporate their business into a new entity called “Coats with Tails, Inc.”. Afterward, Karen and Charlie quickly filed away the documents their attorney provided and turned their focus back to growing the business.
After a few years, business starts to slow and Karen and Charlie must take a step back, look at their outstanding commitments, and evaluate their exposure to liability. For the first time in years, they revisit the attorney that helped them incorporate and she asks them to answer one more important question: Have they maintained their corporate entity?
Even with all the planning that goes into forming a new business properly, the real value of doing so will be realized as the business continues to operate. Two specific mistakes I see operating businesses make are owners signing agreements in their individual names and using form contracts they find online.
If you sign a contract in your own individual name, you do not get the protection of your LLC or corporation when you incur liability. We often see people like Karen, who sign a lease in their own name because they need a space for their business.
Your entity can only protect you from liability if you use it. You can always try to assign a contract you signed individually to your LLC, but the other party could make it difficult to do so.
Sometimes I joke with clients that the odds of an online contract being correctly tailored to your business are about the same odds of you winning the lottery. But they aren’t too far off. Although online forms can be convenient on the front end, they can lead to some significant unintended results when there is a dispute.
Unfortunately, I’ve seen quite a few businesses fail that were not protected by the correct legal steps in formation and operation, which exposed them to personal liability for the actions of their business. With so much on the line, why wouldn’t you seek legal counsel at the very beginning? Karen and Charlie would certainly agree that it is worth the investment.
Ryan Coffield is an Attorney with The Van Winkle Law Firm of Asheville, North Carolina.
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