Corporate & Business/Feb 16, 2015
Five Potential Pitfalls Of DIY Business Formation
Thinking of starting a business? If so, you may have paid attention to advertisements by companies claiming you can form your business in less than 10 minutes and for less than $100, and protect all of your personal assets against claims from creditors of your new business. Unfortunately, the companies behind these ad campaigns, designed to lure the unsuspecting entrepreneur, provide little more than the necessary forms for incorporation or formation of a limited liability company (LLC). Forming a corporation or LLC, however, is only one step to successful business ownership and operation. The mere formation of a business entity is not an impenetrable shield against creditors’ claims. In fact, without adherence to certain “corporate formalities,” simply forming a business entity may foster a false sense of security, but actually provide an individual very little protection.
Business ownership is not to be entered into lightly. According to a statistic published by the U.S. Small Business Administration (SBA), more than half of all small businesses fail within the first five years of existence. Lack of experience (i.e., lack of planning) is among the top reasons why businesses fail. To reduce the risk of failure, formation of a business must be coordinated with an overall plan. Successful entrepreneurs understand this and seek the services of experts who can direct them far beyond the mere formation of a business entity.
As a law firm that concentrates its practice on the representation of businesses, business owners and entrepreneurs, we make it our business to understand all aspects of business – legal and otherwise. We know all too well the potential pitfalls facing entrepreneurs because we have seen the devastating effects on those who sought help too late. The following is our list of the five most common pitfalls we have seen over the years:
- Uninformed Entity Selection. Choosing the structure of your business entity entails much more than determining which letters should appear behind the name of the business. There are several factors to be considered, as entity selection affects everything from taxation to operation. As stated above, the selection of business entity should be coordinated and consistent with an overall business plan. Without understanding all the implications of business entity selection, an entrepreneur easily can make an uninformed, and sometimes inappropriate, decision.
- Unrealistic Expectation of Protection. Most business owners understand that a key reason to create a business entity is to protect themselves from personal liability in the event that something goes wrong. Unfortunately, some of those same business owners have an unrealistic expectation of protection. The law affords no personal protection unless certain precautions are taken and certain formalities are followed. Business owners who are operating under this false assumption may be exposing themselves to potentially devastating and unnecessary risks. Adequate insurance should be part of any new business.
- Noncompliance with Regulations. Form it and forget it is not an option for business owners. The formation documents filed with the state are only the beginning of the state’s requirements for ongoing compliance. To avoid unintentional dissolution or to remain in good standing, business entities are required to file documents regularly with the state. Although noncompliant entities can continue to conduct business, they lose certain privileges, such as protection of their business names and the right to file suit against other parties.
- Ineffective Operating Agreements. Operating agreements should not be treated as a one-size-fits-all for all businesses. Such agreements should be specifically tailored to the entity. Furthermore, depending on the circumstances, other agreements (e.g., buy-sell agreements) may be necessary or recommended. An ineffective agreement serves no benefit – and may even cause harm – to the business.
- No Coordination with Other Areas of Planning. Business ownership does not exist in a vacuum. As such, business owners must be careful to coordinate all aspects of their lives that are affected by their ownership interests. This non-exhaustive list includes areas such as estate planning, asset-protection planning, marital agreements and division of marital assets in the event of divorce, and, of course, business succession planning. Without the appropriate coordination with these other areas, even very successful business owners may not be able to protect what they worked so hard to create.
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