There is little as exciting and dynamic as starting one’s own business. It is, “taking your own fate into your own hands,” one of our clients commented three months before he began what would be a successful construction business. Eight years later, as he pondered how to survive the greatest downturn in construction in sixty years, he ruefully lamented that, “fate is not always kind and never fair.”
Most start up businesses fail. In some industries, such as restaurants, the failure rate is above seventy percent on average. In others, standard retail outlets, the failure rate remains above fifty percent over three years. The safest businesses to start up are those with the least contact with end users, such as wholesale, material men for construction, as well as the service industries such as accounting, day care, etc.
But it is the chance to succeed that draws people to the attempt. There are certainly no guaranties of success…but the success has no limits, either, and if one wishes to go beyond the relative security but finite limits of a salaried position, commencement of a business one owns is the best route. Or, as one businessman told the author, “All business is risk, including the one you work for as an employee. If you are going to take the risk, you might as well grab the possible gain.”
But, to begin a business without taking intelligent steps to protect oneself from possible failure is to make your first big mistake in starting a business. Simple as that.
It is vital when commencing a new business to take those basic steps that can allow protection of personal assets if things go wrong. Optimism and hard work are the sinews of beginning a new business and without such conviction, no new business can succeed. But such optimism should not blind oneself to the simple fact that many new businesses fail and the wise pilot, when taking off, knows how to land with minimal damage.
The tools necessary to protect personal assets are readily available and considering their usefulness, not that expensive. Likewise the skills necessary to limit the economic loss to business assets are not hard to master if one takes the time and energy to learn them. Sadly, too many neophytes to the business world do not and face personal economic catastrophe if their businesses fail…economic catastrophe that could have been possibly avoided if the initial enthusiasm for the creation of the business did not result in them ignoring careful planning for all eventualities.
This article shall briefly outline some of the basic protections available to limit the downside of starting a business. Anyone considering such a venture should consult with accountants and attorneys to obtain detailed implementation of those tools that seem appropriate.
Most new business owners are putting the bulk of their energy and assets into the start up. Most have thought about beginning a new business for years and the excitement of the new business can be intoxicating and intimidating. One concentrates on the thousands of details critical for success, such as selection of location, design of logos and trademarks, design of web site, hiring of employees, plans for marketing, competitors, etc. etc. Often one does not prepare for failure or take time to carefully separate personal assets from company assets.
Which is a mistake. One can always decide to add personal assets into an entity, but getting them out again can be far more dangerous, (and tax expensive) as discussed below.
The overall goal of the entrepreneur should be to put in the assets and commitments necessary to make the business succeed but retain in personal control and protection as many assets as possible and only parcel them into the company if critically needed. Personal obligations should be carefully segregated from business obligations and that separation must be a continuing concern as outside vendors and creditors as well as banks ask for personal guaranties, more commitment of monies, and even pledging of personal assets.
1. LIMITED LIABILITY ENTITIES
While tax advantages may apply to certain limited liability entities, a primary advantage is that they provide what the name implies: limited liability for the owners. A corporation or a limited liability company incurs its own debts and obligations and is a “person” like any other member of the state. It can sue, be sued, pay debts, not pay debts and file bankruptcy. It allows one to participate in the creation of a business but retain outside of the risk of the business those personal assets not invested or transferred to the entity. If the business fails or goes bankrupt, those personal assets of the owners are protected from the creditors.
See our article on Limited Liability Entities for a more complete discussion of these useful structures. Unlike sole proprietorships or general partnerships, these structures are a critical protection to the owners of a business if created correctly and adhered to in terms of the mechanics of their operations. The creation and administration of these entities is simple and not remarkably expensive, requiring less than a day a year of the owner’s time and attorney fees for creation and accountant fees for maintenance. Given that an attorney and accountant are necessary advisors for any startup, the extra expense is minimal compared to the benefit.
Put simply, the entity is the “person” who engages in business, who is at risk when executing contracts, borrowing money, signing leases, etc. If the business fails, the entity may file bankruptcy and close its doors, but the individual owners, provided they have adhered to corporate or LLC formalities, are not individually liable.
The creditors often recognize the limited liability inherent in such structures and ask for the owners to personally guaranty the obligations of the entity. If that is done, personal liability can attach, but quite often creditors fail to do that or the guaranties can be limited in scope. Further many creditors, especially trade creditors, fail to ask for guaranties-a mistake on their part.
Some types of liability can almost always pierce through the limited nature of the entity and apply to owners. These liabilities are often tax obligations due, especially those connected with payroll taxes. Claims based on intentional wrong doing also “pierce the corporate veil” such as fraud or assault. However, most private liabilities, absent a guaranty, do not.
A wise entrepreneur will thus minimize his or her cash assets being invested into the entity to safeguard them, only putting in money from time to time if needed and usually in the form of a promissory note so that the money can be paid back with minimum tax. Note that the obligation to an insider shareholder or officer is normally considered subsidiary to obligations to third parties in the event of insolvency.
2. ADEQUATE LIABILITY INSURANCE
Third party liability insurance and, at times, directors and officers errors and omissions insurance is not prohibitively expensive and provides coverage for those claims predicated on torts or other types of non contractual wrongdoing. The insurance should be owned by the entity and is deductible as a business expense. Certain policies can cover other types of liability, such as selected types of contractual liability, and these options should be explored with a reputable insurance broker. Anyone selling a product should carefully inquire as to products liability insurance and malpractice insurance is often required in certain professions.
3. CONTRACT REVIEW PACKAGE.
Such basic tools of business as invoices, purchase orders, employment contracts, leases, etc. should not only be drafted or reviewed by experienced counsel, but should be made into a standard library of forms which the business utilizes in all of its transactions on a regular basis. Such clauses as arbitration of conflicts; providing that the winning party gets attorneys fees; choice of law; definition of performance and warranty, are all vital to any business and failure to adequately create excellent agreements is to await a dispute which will quickly escalate into unneeded expense and turmoil. See our articles on Contracts, and The Acid Test Clause. Various forms can be found on line and some of them are adequate. However, before you decide to create your own or use a website to create your forms, read our article Form Contracts Do Not Go To Trial.
How vital is this library? Consider the following: the average contract dispute will last two years and cost you close to one hundred thousand dollars in fees and costs. Arbitration clauses can limit that to a six month event with the winning side receiving back the fees incurred. And in our system of law, it only takes one side to force a law suit upon all others. It is not unusual for three year’s profits to be wiped out by a single law suit, whether the law suit is meritorious or not. The right agreements can limit that danger.
4. GOOD TAX ADVICE AND SETTING UP THE BOOKS
Not only is it vital to make sure you are aware of all taxes that may be due, from payroll to local business tax, but it is equally vital to have your books set up correctly and efficiently so that a CPA can efficiently determine the best method to prepare your tax returns. Tax authorities have no concern as to whether you go out of business or not, assuming they can impose personal liability, so to create the correct set of books and establish a good relationship with a good CPA and/or bookkeeper is vital. Failure to pay certain taxes, such as payroll taxes, can result in imprisonment. One of our nicest clients ended up for a weekend in jail before bail could be arranged since he had commingled funds between his operating account and his payroll tax account.
5. EMPLOYMENT LAW BRIEFING AND FORMS
While smaller companies are not held to many of the requirements imposed on larger companies, California law still imposes a wealth of requirements on the employer and the cost of ignoring them…or confusing independent contractors with employees…can be substantial. Even the cost of an audit by the EED can be in the many thousands of dollars. Getting some legal advice and creating the right contracts and procedures in this vital area before hiring the first employee makes good sense. Again, this is one of the areas that the limited liability entity may not give full protection, especially if payroll taxes are not paid or under withheld or if claims of discrimination are made.
6. LEARN THE LICENSE REQUIREMENTS AND ADHERE TO THEM
Many businesses require some type of license indicating expertise (realtor, professional corporations, appraisers, etc.) and most jurisdictions require one to obtain a business license (and pay local taxes) to engage in business. Some businesses cannot be run out of certain locations or would be in violation of zoning requirements. Violation of license or zoning requirements can be liability imposed personally and time should be spent in mastering those requirements.
7. CARE OF INTELLECTUAL PROPERTY
Quite often the most valuable asset a business has is its name, confidential information, logo and software. And many of these assets cannot be protected if registration is delayed. One of the most upsetting events for a business is to discover that years of hard work in establishing a name is eliminated by a hardnosed competitor who saw an opening in the protection of intellectual property. Take the steps to learn how to protect it and take those steps. See our article on Registration of Copyrights.
8. BACK GROUND CHECK ON KEY EMPLOYEES
As discussed in our article on Embezzlement in Your Business or Assets, embezzlement is widespread and seldom prosecuted. Recent studies indicate that over half the businesses suffer this type of action at least once in their lifetimes. A background check…and actually calling the references…can make a tremendous difference. The author knows of at least five businesses that were prospering until destroyed by an inventive employee-embezzler. A background check normally costs less than six hundred dollars and can save your business. The prospective employee should consent to the background check. If the prospective employee does not, do not hire him or her.
9. THE GROUP OF ADVISORS-MENTORS AND PROFESSIONALS
The ideal situation for you is to find someone who ran your type of business and either informally or formally find out the pitfalls and concepts that are to be considered in making the business work. Most business people are delighted to speak of their experience, often with wonderful “war stories” so long as you are not a competitor and one may be shocked at how much one can learn over a dinner table with a retired person in the field.
This dovetails into the second important group to gather, the attorneys, accountants, bookkeepers and tax advisors. These people are as necessary to a business as employees and will often have contacts in the field (including potential mentors) that are invaluable.
Consultants can also be retained, though that can be an expensive process, and if a consultant is hired, be sure to get a clearly written contract limiting the potential expense.
One thing is certain. One will eventually learn the pitfalls…but it is better to learn them from good advice than by experience.
10. THE DROP DEAD LINE
Before you begin, decide when you will know when you have failed.
That may sound strange, but the most usual way people lose personal assets when beginning a business is to keep pouring personal assets into a losing cause and guarantying the debts of a failing business. And after years of straining to make the business work, few can easily pull the plug and walk away-rather, they sign another guaranty or put in another ten thousand dollars, hoping things will turn around.
Enthusiasm and optimism are critical for business success. But those are two attributes that may get in the way of knowing when to give up and treat the failure of the business as a “learning event” that allows one to try again in a different forum.
How does one know when to stop? Each person must make their own decision, but one client we know, who made millions but failed in business two or three times to do it, had a formula which is intriguing. Before he started his second business, he created what he called “The Iron Nest Egg” which was a list of assets he would never touch to save the business. He advised us that it was the money he would need to begin yet another business. When his second business prospered, he put aside enough cash to increase his Iron Nest Egg by tens of thousands of dollars, knowing that he might need it if things changed.
They did. And when he was faced with the choice of invading his Iron Nest Egg to keep his second business afloat…or use it to start his third business, he told this author over the telephone that at least he had that choice and most of his competitors did not. (It was during the down turn in the early nineties.)
And when his third business prospered to the point where he sold it for enough to retire, he named his home in the country not after his third business-but called it The Iron Nest Egg. His neighbors often wondered what it was all about.
Despite all the warnings above, there remains nothing as thrilling as taking the chance, putting your economics on the line, and seeing if you can succeed in this freest of world markets. The risk is there-though can be minimized as described above-but so is the chance for great success.
Go for it.