As an entrepreneur, you start a business with only one goal in mind: success. A bright future awaits as the reward for your investment of money and toil. Failure is not an option, and it sure isn’t something you want to spend your precious time thinking about. How can you protect personal assets if your startup fails?
That mindset is what it takes for founders and owners to put capital at risk and grow a startup into a profitable enterprise. Still, there is a difference between calculated risk and unnecessary risk. Investing capital need not mean putting all your personal assets on the line.
By structuring your startup as a corporate entity and by maintaining its legal and financial separateness from yourself, you can protect your personal assets against a business failure. Here’s how.
Limit Your Liability to Control Your Risk
Let’s get back to basics. Startup businesses need investment capital. Entrepreneurs and investors are more likely to commit capital to a startup if their maximum downside is the loss of their investment. Uncertain or unlimited risk is the enemy of business investment.
Startup founders who ignore this basic principle shoot themselves in the foot in two ways. First, they put their own personal assets at risk in the event the startup does not succeed. The business’s debts are also their own, personal debts. Second, they hinder their own ability to raise investment capital from outside investors. No one wants to invest in a business if doing so makes the business’s debts their own personal debts, too.
Enter the concept of limited liability. By forming a business entity – such as a corporation or limited liability company (LLC) – an entrepreneur effectively creates a separate legal “person”. That entity has its own assets and liabilities which stay separate from the founder’s personal assets and liabilities, so long as the founder maintains clear legal and financial boundaries between them. If the business fails, only the assets owned by the entity are available to pay the business’s liabilities to its creditors (unless the founder has personally guaranteed those debts or failed to maintain boundaries, which are both topics for another day).
Protecting Personal Assets in Practice
Here are two concrete examples to illustrate the distinction and why it matters:
- Founder 1 starts a widget manufacturing business, but does not form a business entity. Sales generate a profit of $10,000, which the founder deposits in his personal savings account, which also contains $50,000 that the founder inherited from a relative. One day, a widget leaves the factory in defective condition. The defective widget explodes, seriously injuring a customer. The customer sues and wins a $100,000 judgment. Because Founder 1 did not form a business entity, the injured customer can enforce the judgment against Founder 1 personally and potentially obtain the entire $60,000 from Founder 1’s savings account.
- Founder 2 also starts a widget manufacturing startup, but she does so by forming Widget LLC, a limited liability company. Founder 2 owns all the membership interests. Widget LLC turns a $10,000 profit, which Founder 2 deposits into Widget LLC’s business bank account. This account is separate from Founder 2’s personal savings account containing her $50,000 inheritance. Widget LLC also sells a defective widget that injures a customer, and also faces a $100,000 personal injury judgment. However, because Widget LLC is a legal “person” distinct from Founder 2 and used properly as such, only the $10,000 in Widget LLC’s business bank account is available to pay the judgment. Founder 2’s inheritance money is not at risk because Founder 2 limited her liability by forming Widget LLC.
Long story short: Founder 1 failed to limit his liability, so he put his personal assets at risk. Founder 2 controlled her risk by limiting her own (and any other investors’) personal liability.
Let a Business Lawyer Help You Limit Your Liability
Limitation of liability is a foundation of business investment. Through smart selection and structuring of a business entity, and routine maintenance of the legal and financial boundaries between yourself and your business, you can ensure that your personal assets stay protected against a business downturn. As a bonus, you also make it easier for investment capital to flow into your startup, which in turn will help it to succeed.
Business lawyers help entrepreneurs like you to build, grow, and protect their startups and the personal wealth they generate. Contact an experienced startup attorney today to structure your business for success and to limit your personal liability if it doesn’t.