Many small business owners or other entrepreneurs start out with a great idea for a new product or service. They start a business and focus on doing whatever it takes to make the company successful. Many don’t take the steps necessary to properly protect the business from creditors or don’t really pay much attention to what they sign when they are making deals. The ones who do read the fine print may just have the attitude that they are so confident in the business’ success, who cares if they use their own personal credit to get some working capital. With the economic downturn over the last few years, many business owners have had to close their doors because they couldn’t get the funds they needed to even cover the simple things like payroll or rent.
Use of Personal Credit
Many entrepreneurs feel that they should put some ‘skin in the game’ by contributing some of their own money into the business. In fact, the Small Business Administration backed loans often require the founders to contribute at least a certain percent of their own assets or some other major contribution in order to qualify for a business loan. When the owner doesn’t have available cash, they look to other sources to get the money to contribute. That can lead to things like taking out a home equity line of credit or using personal credit cards to help fund the business. Obviously that is pretty risky, but often necessary to get early access to this seed money to start and grow. The banks that issued the credit did so based upon the owner’s personal credit rating. Just because the credit card may have the business’ name on it doesn’t mean the bank hasn’t covered their bases by making sure they can sue the owner personally if the business defaults in payment.
The other area where founders often don’t take the time to understand the agreements they are making is in the area of personal guarantees. In the majority of start-up or new business loans or other forms of credit, the bank or whoever is granting credit will require a personal guarantee. Within the stack of forms the founder signs, it will clearly state that the founder is responsible for payment if the company cannot pay. Forming a corporation or LLC does not protect you from a personal guarantee. The contract or agreement for the personal guarantee is between the bank and the founder, not the company. If the founder signed and the agreement is enforceable, they are stuck with paying it. Also, the one signing the personal guarantee or using their own personal credit cards will be the one with negative credit being reported on their credit report.
Limiting Liability Problems
Many founders come to me asking about filing bankruptcy for their small business or themselves. If the company filed bankruptcy (won’t get into discussion of Chapter 11 reorganization), any assets of the company are liquidated to pay off existing creditors. Any remaining debts are discharged. The business can probably get out of paying, but the company will no longer cease to exist. If you file bankruptcy, in most cases, you can’t take some of its assets (even if you contributed them) and go start another business. That would be defrauding the company’s creditors. Also, filing bankruptcy for the company will not get rid of any personal liability for credit cards or personal guarantees, even if they were used to benefit the company. Now the owner could file a personal bankruptcy to get rid of personally guaranteed debt, but they can’t just discharge the business debt, they have to include all their personal assets and liabilities in the case. In 2005, the bankruptcy code was amended to make it more difficult to use a chapter 7 liquidation which discharges debts. People with any significant recent income usually end up having to use Chapter 13 which is essentially a partial repayment plan over up to 5 years. I have personally had clients who started a business, signed personal guarantees for loans, and owed hundreds of thousands of dollars when the company failed. Even in a personal bankruptcy, if the creditor shows the owner was obtaining credit recklessly or using the money improperly to create some form of fraud on the creditor, the debt cannot be discharged even if done for a business.
The discussion to this point has assumed that the owner formed some form of business entity, such as a corporation or limited liability company (LLC). If the owner did not form a business entity properly, it would be considered a sole proprietorship or possibly a partnership and they (and their partners if a general partnership) are personally liable for any debts. However, even if a corporation or LLC is formed to limit liability, there are times when a creditor can still get after the founder’s personal assets.
In what is known as “piercing the corporate veil,” attorneys can try to personally go after the founder, owner, officer, or director for the company’s debts. Many of the online discount incorporation services fail to properly advise founders of just how important it is to be sure to do everything properly in the future to keep the limited liability alive. An LLC generally has less formalities and requirements to keep it in good standing. The corporation has more requirements. Some of the things a court would look at may be whether the company is not a separate entity, but really nothing more than the ‘alter ego’ of the founder. So if the founder commingles their actions so much as to make it appear that they are the corporation, they could be found personally liable. Some of the other things a court looks at are the failure to properly keep records of meetings, failure to hold annual shareholder meetings, failure to hold board of director meetings, and failure to adopt resolutions approving corporate actions. Also, if the founder commingles their own personal funds with corporate funds, such as using a company card for their own personal gas or paying for their rent or house payment with a corporate bank account, this can increase the chance of personal liability. Essentially, the court wants to see that the company is a separate legal entity, is independent in its actions, and acts properly under the direction of the shareholders and board of directors. If the founder simply starts a corporation and recklessly starts using credit when he or she knows the company can’t repay, this could lead to a claim of fraud by the bank and possible personal liability.
In California, an officer, director, or other high level employee can be held personally responsible for failing to do things like deposit payroll tax withholding or failing to get workers compensation insurance, even if the business was a corporation.
Many of these problems can be avoided with proper planning and following simple rules. The difficulty founders, start-ups, and small business owners face is being able to obtain credit in this difficult economic environment without resorting to things like personal guarantees or using their own credit cards. If you are in that situation, there are things you can do to try to protect yourself, but ultimately, understand the ramifications of your actions. Ask yourself, “what happens to the liabilities if this company goes out of business?” There is nothing wrong with planning for success and having confidence in your idea, in fact, most investors require this in order to invest in the company. At the same time, you still need to understand the risks of each action you take.
Also, if you are low on cash and want to use a discount online incorporation service or do it yourself, be sure that you understand the go-forward requirements and shop around, you may be able to find a start-up lawyer who believes in your idea and is willing to work in exchange for stock in your new venture or at least give you some guidance and overview of the pitfalls to watch out for. We will have to wait and see if the new JOBS Act makes a difference in bringing available capital to start-ups and small businesses.