Entrepreneurs should form a business entity as soon as they embark on a new startup venture. A key feature of business entities (e.g., corporations or limited liability companies) is limited liability, meaning that the assets of the owner of the business available to satisfy claims against the business would be limited to only the amount that the owner invested in the business. The business and the business owner are considered distinct legal persons, each responsible for only their own debts.
Despite the limited liability shield, however, founders occasionally find themselves personally liable for a startup’s obligations. The most common source of personal liability is a personal guarantee. A personal guarantee is a contract, pursuant to which the startup owner agrees with a particular creditor of the business to be personally liable for the business’s obligations to that creditor. For a new, poorly capitalized business, personal guarantees may be required for access to commercial bank loans or to secure an office lease for the business. Owners should understand that by providing a personal guarantee, they are waiving the limited liability shield that otherwise would protect their personal assets from creditors.
More rarely, courts may ignore the corporate form in the name of fairness. Courts typically justify their decisions to pierce the limited liability shield on either of two legal doctrines. The first is the alter ego theory, pursuant to which a court may find that the conduct of the owners and the business are so intertwined that the separate corporate identity has been lost. The second is the agency theory, pursuant to which a court may find that the business is acting as the agent of the owner. In either case, courts are reluctant to pierce unless necessary to correct fraud or a similar substantial injustice.
Piercing cases are fact intensive and difficult to predict. To reduce the likelihood of losing the limited liability shield, startup companies should:
Avoid intermingling funds.
The business should have its own bank account. All transactions of the business should be handled through that bank account, not out of the personal accounts of the owners. Loans and other transactions with owners should be fully documented and on market terms.
Raise business capital.
Adequate capital should be raised for the contemplated operations of the business.
Consider insurance coverage.
Business insurance can provide a source of recovery for unexpected obligations, thereby making it less likely that the assets of the owners would be needed to correct an injustice.
Observe corporate formalities.
Courts are less likely to apply the alter ego theory if the business acts like a business. The business should adopt bylaws, timely pay its franchise fees, properly elect and name directors and officers, issue share certificates, keep business books and records, and regularly conduct board and shareholder meetings (or at least approve written resolutions in lieu of such meetings).
In short, be careful not to waive or lose limited liability protection. It is why you incorporated in the first place.