In the course of any given week, I speak to a large number of people that want to start a business, or have recently started a business. Recently, there have been three distinct trends I find pretty disturbing and what I think are terrible mistakes.
1. My accountant/brother-in-law/father/garbage man told me I didn't need to, or shouldn't form an LLC for my business. This one gets me every time. So you asked everyone around you, except for an ACTUAL LAWYER, what kind of business entity you should set up? If I want advice about a medical condition, do I ask my local bartender? Do I ask my accountant if my car needs repairs? No. Why not? Because those people are not in that field. So why take legal advice from a laundry list of people who aren't lawyers?
Why does it matter? It matters because you could be exposing yourself to serious liability. I see a number of folks every week who have been in business for a year or more as a sole proprietorship. Many of them own homes (sometimes also vacation homes), cars, bank accounts and have a list of decent assets. They might also have business liability insurance, but if you are sued, you will be named personally in that suit. If there is a settlement or verdict above your policy limits, your personal assets are exposed. What if the lawsuit pertains to something that's not actually covered under your policy? You're out of luck, Chuck. It costs a few hundred dollars to set up an LLC. Why would you not spend a little bit of money to protect assets like your home, your cars, your investments and your business?
2. I'm already in business with several partners and we don't have an operating agreement and we don't want to spend the money right now to establish one. This is insane to me. I don't care if your business partners are your mother, your brother and your three best friends. Money does crazy things to people. People disagree. An operating agreement gives your business a road map as to how to do business together. It'll set out who is responsible for what, who owns what, what happens if you don't agree. When something comes up, as it inevitably will, all you do is turn to the operating agreement to figure out how to handle it. No guess work, no angry partners and no wasted time. Most banks will not open a business account without an operating agreement. Why? So they know who has authority to sign the checks or withdraw money.
A number of people tell me they already have the LLC set up but not the operating agreement and don't want to spend the money until they are bringing more money in. Well, if you don't have the money to spend on a basic operating agreement, it's highly likely your business is severely under-capitalized. Why is that a problem? There is a legal doctrine called "piercing the corporate veil." It's a way to get around the protection of an LLC and reach someone's personal assets. There are a number of factors that go into a piercing analysis, but under-capitalization is one. If you don't have the funds in your business to protect yourself properly, I think you need to re-consider being in business. How much is it going to cost you when you get into a dispute with one of your partners that can't be resolved because you don't have an operating agreement? A whole lot more than spending the money on that operating agreement, that's for sure.
3. I'm raising money for my business by giving out equity to investors, but I'm not going to consult a lawyer about how to do this. I'll just use some contract I found on the internet to present to investors.
WHOA WHOA WHOA. Hold the phone. You are going to do what? Quite honestly, this is probably one of the more disturbing scenarios I've heard. Why is this so bad? I mean, I see it happen on Shark Tank every week, right?
Soliciting investors for your business by agreeing to give away equity in your company involves securities laws. Securities laws are regulated by a federal agency, the SEC (Securities and Exchange Commission). You need to be extremely careful to not run afoul of the SEC, as the penalties are stiff. This is a complex area of law best left to an attorney. Many times a business looking to raise money through investors will fall under an exemption and not have terribly burdensome paperwork or filing requirements, but you really need a qualified attorney to make that determination. You will need to provide investors with certain statements and disclaimers. And please, for the love of all that is good in this world, do not rely on Google to tell you how to do this.
So people, please, I beg you, consult an attorney in any of these situations. I know it's expensive and money is tight when you first start a business, but you really need to protect yourself, your assets and your business properly. I can't tell you how many people call me every week that didn't do one of these things and are now in a huge messy situation that I can't get them out of.
I was a litigator for six years and what I really disliked was that when people came to me, they were angry and pissed off that they were getting sued. So many times, had they just gotten the proper advice ahead of time, they would not be in their current litigation situation. My mission when I started this law firm was to give small business people the proper tools and protections so that they wouldn't become one of those angry litigants, or at least had peace of mind that all of their worldly property was not at risk. What I did not anticipate is how hard it is sometimes to convince people that these legal services are really very necessary for their own protection. It's easy to understand why you need a lawyer when you're getting sued. What you need to realize is that to prevent being sued or in order to make it much less painful, is that a lawyer is most necessary at the very beginning. Prevention is the best medicine.
Sarah E. Holmes is a Philadelphia business attorney and strategist that helps start ups and established businesses looking to expand, protect their assets and increase their profits in an approachable, down-to-earth way. When you're looking for a business lawyer in Philadelphia, the Main Line or New Jersey, we can help.