Owning a business is exciting at times, frustrating at others, but always demanding. There are so many decisions to make on a daily basis, and often, as a business owner, you not only have to make the decisions, but must also roll up your sleeves to make those decisions bear fruit. One decision you should make early as a business owner is determining who will be your trusted advisors to guide you through the legal and accounting issues your business will encounter. Selecting a professional to assist you with legal and accounting decisions is vital to launching and maintaining a viable enterprise, because decisions made early in the formation of a business can have far reaching consequences down the road.
In my practice, I often see clients who chose to handle matters without engaging attorneys and accountants early in the process, and later failed to recognize issues as they arose during the day-to-day operations of the business. Those decisions can cost business owners far more money down the road than hiring the appropriate professionals in the beginning, and can have a significant effect on the ultimate success or failure of the business. I have found those mistakes fall into seven basic categories. This is Pitfall number 1 of 7 common pitfalls I see businesses owners make. Over the next few weeks, I will be sharing all 7 of these pitfalls and proven ways to prevent them.
1. Failure to Organize and Observe Corporate Formalities
Selection of Proper Entity Type – The first pitfall made by many business owners when starting a business is not properly organizing a business entity. Too often owners start a business “on the side” and run that business as a sole proprietorship. This has a number of legal and accounting consequences, including personal exposure to liability for acts of the business, tax implications, and too often a comingling of personal assets and liabilities with business assets and liabilities. Let’s face it, the reason you form a business entity to conduct business is to separate the business operations and its liabilities from your personal assets. Owners need this protection right from the start, so selecting the proper entity type and correctly forming that entity under the law prior to commencing business is an absolute must.
It seems everyone wants to form a limited liability company these days, because something about it just sounds so safe. In reality a business may be better suited as a corporation or another type of limited liability entity. The business owner should also consider the tax options available under the chosen form. Is the business just going to own real estate? Is the business going to hire employees? Is the business going to be service related or manufacturing? All these details influence the type of business entity the business owner should form. Knowing the benefits and drawbacks of each business type is essential in making a smart start to the business. Thus, an early consultation with legal and accounting advisors will ensure the business starts off on the right track.
Importance of Shareholder Agreements and Operating Agreements – Another common mistake made by business owners is setting up an entity and then neglecting to define how the owners will govern the business. When there is more than one owner of a company, a Shareholder Agreement or Operating Agreement establishes the ground rules for operating the business and the legal relationship between the owners. These agreements cover management and governance of the company, voting rights and protocols, profit-sharing, adding new owners, transfer rights of existing owners, buyouts, and dispute resolution between owners. It is the playbook for the organization.
Failure to reach an agreement between the owners on these vital issues, and reducing that agreement to writing is the most common pitfall I see in my practice, and results in dissention and costly litigation more often than it should. Having a simple agreement drafted by an attorney covering these issues, and then referring to such agreement in times of conflict will generally resolve the issue, without the business suffering.
Establishing Entity Control – “We want to own the company fifty, fifty.” Spouses, family members, friends, all want to be completely fair and equitable in the ownership of a business. I get that, and it is admirable, but it is one of the most often encountered legal pitfalls for business owners. I always counsel against this and ask clients to make the hard decision of who will have entity control if there is a disagreement regarding an important decision. Every company has to have a final decision maker, and that person is going to be the person who owns the majority of the ownership interest in a company, be that shares of stock, membership interest or partnership interest. This makes good business, and personal relationships must be set aside for the moment so that entity control is established and the potential for “deadlock” is reduced or
Secretary of State Filings – The business is validly formed entity, and has a shareholder agreement establishing corporate governance, now it must keep up its annual filings and fees with the North Carolina Secretary of State. This is a simple process for limited liability companies, but often overlooked by many business owners, especially single-member limited liability companies. Failure to file annual reports and pay annual fees will result in an administrative dissolution of the company. Corporations must also file income tax returns every year to remain in good standing. Administrative dissolution may not seem like a big deal, but it is if the company wants to buy or sell real property, enter into a contract, or borrow money. Technically an administratively dissolved company is not in good standing with the North Carolina Secretary of State, and does not have authority to act as a valid entity to transfer title to property, enter into a contract or borrow money. A simple way to avoid this pitfall is to put an annual reminder on the calendar the beginning of every April prompting the company to file an annual report and pay the required fees. The annual report is a simple form and may be completed online and filed electronically. It requires no special assistance from a legal advisor, although most law firms will offer this service to its clients for a nominal annual fee.
Corporate Formalities – A failure to observe corporate formalities could be a very costly pitfall for business owners. Corporate formalities are the corporate governance actions taken by a business to establish the validity of the decisions made and actions taken by the company, which in turn maintain its separate identity from the business owners. This is important to shield the business owner from the liabilities of the company. Certain fundamental basic formalities should be observed from day one, and maintained throughout the operation of the company. Common corporate formalities business owners neglect are electing a board of directors, electing officers and managers of the company, keeping up corporate minutes of decisions and actions taken by the board of directors, or members or managers of a company, and maintaining separate financial books and records for the company from the personal finances of the business owner.
Often business owners operate “out of one checkbook” or “help themselves to the till.” Such practices are dangerous and may expose the business owner to liability of the business. If the assets and liability of the company are comingled with the person assets of the business owners an argument can be made for disregarding the entity form altogether and treating the individual owner and the business as one and the same. The same is true for a failure to file annual reports with the Secretary of State, maintain corporate books and records, and otherwise observe the corporate form as a separate and distinct entity.
About the Author
Ashley focuses her practice on Outside General Counsel Services and Business Bankruptcy and Creditor’s Rights Practice Areas. She is an effective, results-driven advocate for her clients. Her background of 30 years in business bankruptcies, distressed debt workouts, problem loan recovery, and real estate title and commercial litigation provides her with a solid foundation of general business, accounting and legal skills.