Business Women 2007 – Legal tools to protect you from your biz

It seems an obvious statement to say that there’s risk in starting a business. Business owners take measures such as financial planning and budgeting, building a team of experts, and developing processes and procedures to mitigate some of the operational and financial risk. However, the most critical, and often misunderstood, mitigation techniques lie in the use of legal tools: business structure, insurance and contracts.

Businesses take many forms, and the right one for your business depends on how you structure the ownership and management and distribute profits and losses, the tax position of the business and owners, and responsibility for the liabilities of the business. Given these criteria, three business structures are most practical for small businesses: sole proprietorships, corporations and limited liability companies (LLCs).

Of these three, only the sole proprietorship does not protect the personal assets of the owners from the business’ debts. If the business cannot pay its debts, whether they are debts to vendors, tax liabilities or a legal judgment, the creditors may seek payment from the business owner by reaching to the owner’s personal assets.

Alternatively, both the corporation and LLC limit an owner’s risk to the amount of money the owner invested in the business. An important caveat is that the liability protection only holds where the owners comply with the legal requirements for that business structure. For example, personal and business finances must be kept separate from one another, and certain business records must be maintained.

Corporations have additional requirements such as board of director and shareholder meetings, bylaws, and a corporate minute book. A frequent mistake is to think that your business is too small for these rules to apply. The law applies equally to Microsoft and to your small business, and if these formalities are not followed, the liability protection offered by the business structure will fail, putting your personal assets at risk

Business liability insurance augments the business structure in addressing risk. A sole proprietor may purchase insurance to limit the out-of-pocket payments and thus limit liability, but insurance policies are not foolproof. A good insurance agent will explain where the holes are in the coverage and where risk remains. For LLCs and corporations, insurance allows your business to continue operations in the case of a disaster or lawsuit. Without the insurance, all the assets of the business may be required to fulfill the liability, forcing the business into bankruptcy. Often, both the corporate structure and insurance are required to adequately protect the business and its owners from the business’ risk.

Contracts are another key risk-mitigation tool that is often ignored. Many business owners rely on handshake agreements with business partners, clients and other third parties, fearing that a contract will scare away the business. These personal contracts, whether oral or in writing, likely pose the greatest risk to your business because of their human nature.

Putting pen to paper and outlining the important elements of the relationship, including the specific requirements of the business relationship as well as the necessary legal terms to protect each party’s interests, enables the parties to clarify the agreement and eliminate ambiguities. The process, in and of itself, diminishes the number of disputes in a relationship. In the case of personal guarantees, contracts may circumvent the liability protection offered by a business structure. Third parties such as vendors and landlords may require the owner to sign a personal guarantee on the debt, in which case the owner is responsible for payment if the business cannot satisfy the debt.

When thinking about the structure for your business and the necessary contractual relationships, ask yourself, “What could possibly go wrong?” Assess your business’ risks and how to protect yourself against them. Some risks are mitigated by keeping a pulse on your business, but others may seem beyond your control. These tools allow you to exert some control over unforeseen liabilities, not by eliminating the risk but by limiting its impact.

Disclaimer: The information provided in this article is not legal advice. Contact an attorney familiar with your situation prior to taking or refraining from action.

Michelle Hayden Bomberger is an attorney and founder of Small Business Legal Services PLLC, which provides legal and business advisory services to small businesses. For more information, visit online at www.sblslaw.com. Bomberger can be reached directly at 425-646-2360 or by e-mail to michelle@sblslaw.com.