There are reasons why new business owners form corporations, limited liability companies or other legal entity forms. Branding and credibility in the marketplace are of course important, but limiting personal liability is a primary driver. In other words, owners set up these business entities largely to shield themselves from personal liability in the event something goes wrong with the business.
When you set up a particular business entity, you are required to proactively govern that entity from the initial documentation all the way through growth and global domination (cue Dr. Evil laugh). That process of governing your business entity includes following certain formalities and is often referred to as “governance” thanks to lawyers who like to use such words to overly simplify complex things. That being said, failing to practice this governance could mean losing the very protections these entity structures offer, in addition to many other issues.
But where to begin? I like to start with the 7 items listed below:
1. Choose Your Entity
There will no doubt be tax consequences to this decision, so make sure to enlist a sophisticated business accountant early in the process. Are you going to be a solo operation, or will you take on employees? How many owners are you going to have? What will you be selling as far as products, services, etc.? Do you plan on operating in only one state or in multiple states (or even countries)? Are you planning to raise capital with a focus on scaling and growth? Do you plan on an initial public offering, or just staying private? Strategizing with your accountant to answer questions like these will help you select the appropriate type of entity for your business.
2. Set Up and Maintain a Separate Business Account
After you select your business entity type (and give it a great name), file your IRS Form SS-4 application to obtain your Employer Identification Number. This EIN will be required to set up a bank account for your business entity and then report your business taxes, just as your Social Security Number is needed to do these things for you personally. Under no circumstances should you commingle your business and personal accounts. This means do not use your business account to pay personal expenses and vice versa. It’s difficult to argue you are leveraging a business entity to protect against personal liability when your business account has essentially become a second piggy bank!
3. Adequately Capitalize Your Business
It’s okay to enjoy the fruits of your labor and pay yourself from the profits of your business (from a separate business account, of course). That being said, make sure there are ample funds to also cover your operational expenses, or you could wind up becoming personally liable for them. For example, let’s say you enter into a contract with a service provider. That provider does its job, and you receive the benefit of those services. However, you’ve been a little aggressive about paying yourself from the business profits, persistently resulting in low monthly business account balances. In turn, you’re unable to pay your service provider, who sues your business for payment. Guess what? This unpaid provider may be able to “pierce the veil” of your business entity (which you had formed to shield you from personal liability) and then go after you individually, since you had not been adequately capitalizing your business to cover operational expenses such as this.
4. Identify Your Officers and Their Roles
If you have selected a corporation as your preferred business entity form, you may be legally required to appoint at least one officer (typically a president or secretary). However, LLCs don’t have such officer requirements, although it’s common for the owner or principal of that company to be referred to as a CEO or president to ensure third parties know they are dealing with the top dog. It’s generally a good idea to have officers in place to manage key functions, and to also ensure everyone stays in their respective lanes with central decision-making (and less confusion). But don’t just name officers as a means to award ceremonial titles. Instead, make sure there are specific roles and duties attached to these positions. And in larger businesses, especially those with more complex risk profiles, it may also be a good idea to identify nuanced officers other than the basic president, secretary and treasurer structure. For example, if you are business that leans substantially on technological needs, consider adding a Chief Technology Officer (CTO). If you are a product company with significant supply chain and operational issues, a Chief Operating Officer (or COO) may be needed.
5. Paper Everything Up Front
So, you’ve gotten this far and selected your business entity, filed the initiating documentation, obtained your EIN, set up a separate business bank account, and have all your officers identified and the roles they will be filling. Now prepare the rules and guidelines that will memorialize how your business is going to run, as well as the obligations of each respective owner and officer. If you set up a corporation, this governing document is known as the “by-laws”. And if you set up an LLC, it is known as an “operating agreement” or “company agreement”. If you utilize some other entity form, such as a limited liability partnership, you’ll want to memorialize the rules for that arrangement in an agreement to be signed by all of the owners and/or partners. The units of ownership themselves may also need to be documented in the form of official stock certificates or LLC membership units. Given the importance of these governing documents, it’s generally a good idea to engage a business lawyer to help you with these things, especially where there are multiple owners.
6. Memorialize Important Decisions
During the year, your business is going to be making certain decisions. While most of these decisions will be rather mundane, such as purchasing routine equipment or services to help you operate, some will be significant and should be documented. For example, if you add or divest owners, pursue the acquisition of other businesses, buy or sell substantial real estate properties, or proceed with operations in different states, then these decisions should be memorialized in documents called “resolutions” to be signed by the owner(s). These documents reflect real-time decisions being agreed-upon, effectively telling the story of what has transpired and ultimately preventing other owners from questioning them later. If you become a publicly traded company, your business will be legally obligated under the Sarbanes-Oxley Act, among others, to timely report certain events that could materially affect your business.
7. Hold and Document Annual Meetings
Your governing rules (whether through by-laws, operating agreement, or otherwise) should contain language requiring the owners of the business to meet annually to discuss and approve the activities conducted during the year, where and when those meetings will take place, and the minimum required number of owners who will be required to be present to vote on decisions to make sure they cannot be invalidated (also known as a “quorum”). There will be an air of formality at these meetings, and it will be important to memorialize what takes place in a document called the “minutes” of the proceedings. You’ll want to list the attendees, acknowledge the quorum exists, and discuss whether any changes will be made to the officers, bank accounts or governing documents (or if everything will instead remain the same for the following year). You’ll also want to review the financial documents for accuracy and discuss and approve the figures (if accurate). Make sure to spend an appropriate amount of time discussing significant and material business actions taken during the past year and get approval from the owners (called “ratification”) confirming these actions should become official acts of the business. These minutes should be circulated for review, comment, and signature by the owners to avoid any potential conflict down the road.
All documentation listed above should be included in an official record book maintained at the business headquarters (or at its attorney’s office) for safe-keeping and quick access if needed. This record book ensures an appropriate and on-going written story of the business is being told, and can be referenced in the event of a dispute among the owners with regard to particular business dealings. It can also demonstrate to federal, state, and local authorities that the business is operating legally in the event of outside scrutiny.
Following appropriate business governance and formalities can minimize exposure to risks such as personal liability for something your business may have done wrong, claims by minority owners that majority decision-makers were not authorized to undertake certain actions, and claims by third parties that they should somehow gain ownership or control over the business by way of an owner’s death, divorce or attempted assignment of interests.
By minimizing these potential threats, your business stands a better chance for long-term survival and prosperity, which includes the opportunity to sell your wonderful products and/or services to customers like me!
KEEFER is your ounce of prevention.