You’re an entrepreneur about to launch your new idea and form your own company. You’ve done your homework and you’re ready to go into business and make money. What could possibly go wrong?
Let’s double-check that homework, because there are 3 very common legal mistakes that entrepreneurs make when they start out. Unless you avoid them, you may create ticking time bombs for the future that can blow up and cost you everything, right when your business is worth something.
Here are the 3 most common legal mistakes:
- Not creating the right business entity to protect you from liability.
- Not keeping personal and business lives separate.
- Not knowing when to seek professional advice instead of DIY.
The good news is that the pathway through this minefield is well mapped out, so you don’t have to fall into these traps. Let’s look at how to overcome all three of these challenges.
Mistake #1: Not Creating the Correct Business Entity
As you set up in business, one of the first things to consider is what kind of business structure you want. You form a company of some kind in order to protect your personal assets in the event that the company faces a legal claim, as well as to acquire and safeguard business assets as the company grows.
The type of company you create depends on how complex your situation is. An LLC is great for partners, a corporation is usually better if you’re going to seek outside investment at some point.
Typically a small company doesn’t find enough benefit in registering out of state. If you’re a sole proprietor you could become a single-member LLC for the ease of paperwork, but you’ll also want to know how your state law treats this new type of business entity, since the different states vary.
You’ll also set up the ownership of your company according to whether you have investment, even informally from friends or family. Investment can be dangerous ground with state securities laws, and on the other hand, having enough capital at start up is important to maintain liability protections.
Working and investing partners are an important aspect to consider as you form the business entity. Who earns what part of the income, at what stages of the company’s growth? A corporation can settle this definitively with stock, while an LLC has an operating agreement that is almost infinitely customizable, where you can spell out each person’s standing in detail.
Intellectual property is often overlooked. Do you own all rights to your logo and brand? Did you or your partners create some of the ideas you use while you were working for another company? Are all the co-creators in the company now? Could anyone sue later when the company has more money?
These issues aren’t necessarily all handled in the company formation, and may require additional agreements and assignments. But you should know the answers to the questions that apply to your situation. Exercise a little paranoia, and ask if any possible aspect could prove tricky. If in any doubt, it will pay you to consult a lawyer.
Mistake #2: Not Keeping Business and Personal Lives Separate
After you form your business entity, pay close attention to what’s required of you by law. Your limited liability entity can only protect your assets if you operate the business correctly.
Under a legal challenge, a court can “pierce the veil” of your company protection and reach through to your own personal assets, such as your home or a spousal income, to satisfy a claim against the company.
The most common way to open yourself up to this danger is merge your company and personal lives and fail to observe the formalities of the business entity. Make all the necessary filings with the state to remain in good standing. Conduct all the meetings required by your company structure, and keep minutes. Record all important company decisions.
One common bad practice that opens you up to liability is commingling personal and company funds, for example by cashing checks in the wrong account, or using company money to pay personal bills. Sharing company assets such as a vehicle is another common way to merge your two lives dangerously. The answer is to use a reimbursement system, and keep it all clearly in writing.
If you have partners, don’t overstep your company title simply because you’re the founder, let the designated decision makers share in the process. If you run it like your personal fiefdom, a court may call the company structure a sham.
The rules that protect you also bind you to specific modes of conduct, and to be safe you must be able to show compliance. Everything should always be in writing. It’s hard for entrepreneurs to grasp this shift from innovating to conforming, but this is part of the path to success. You should be one big paper trail.
Mistake #3: Not Seeking Professional Advice When Necessary
Entrepreneurs starting out in their new venture are often reluctant to pay for legal and accounting advice—and when money’s tight, it’s even harder to justify the costs.
But the best time to consult with an accountant is before you begin to make money. And make sure your accountant and your lawyer each know what the other is telling you, so that your tax position meshes with your liability protection.
Good startup advice is almost always an investment that pays for itself over time. Do yourself the favor of knowing that your company structure is built for success, that your money is safeguarded, and that you will own the fruits of your labors. You will kick yourself—hard—if you jeopardize your success in the future by not starting on the right foot now.
Author: Stan Huser is the founder of SunDoc Filings, a California-based company that helps entrepreneurs with their business filings in any U.S. state. A pioneer in document filing and retrieval, Stan started his first company in 1979.