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Losing Limited Liability: Blending Business and Personal Finances in a Corporation or LLC

 

In the early stages of starting a new business, it can be difficult to tell what belongs to the company and what belongs to the founders as individuals. Even after a business is formally incorporated as a corporation or limited liability company (LLC), the distinction between the person and the entity may not be clear, either from a practical perspective or an emotional one. With this in mind, it can be tempting for startup founders to blend their own finances with those of the business. After all, it often seems (perhaps even accurately) that the money is going to go to or come from the same place when all is said and done. Why not streamline things by cutting out some of the intermediate steps?

The reason why it is so important to keep personal finances and company finances separate is that failure to do so has a number of practical consequences. These range from tax implications—blending personal and corporate accounts can be a nightmare when it comes to filing taxes or preparing for an IRS audit—to the complete loss of some of the key advantages of incorporating in the first place. This blog addresses only one of these consequences: specifically, the risk that commingling corporate and personal finances can lead to the loss of owners’ limited liability for business debts or wrongdoing.

 

Loss of Limited Liability

One of the major reasons that founders choose to form a corporation or LLC for their own business is to limit their own liability in the event that the business is sued. Unlike a partnership or sole proprietorship, a corporation limits the degree to which the founders can be on the hook for any debts undertaken or legal wrongdoing engaged in by the company. Normally, corporate ownership will not be liable for more than the amount of capital they have already invested in the business. Their personal assets remain off-limits.

The limited liability aspects of a corporation are only fully effective, however, if the founders clearly differentiate between and separate their personal finances and the company’s finances. This is because, in some circumstances, courts may “pierce the corporate veil” and impose liability on officers, shareholders, directors, or members. A court may pierce the corporate veil if all the following requirements are met:

  1. There is no real separation between the company and its owners
  2. The company’s activities were wrongful or fraudulent
  3. The company’s creditors suffered some unjust cost, such as unpaid bills or court judgments.

Some of the most common factors courts consider in determining whether these requirements are met include the following whether the corporation failed to follow corporate formalities, whether the corporation was improperly capitalized (i.e., if the company never had sufficient funds to operate on its own), and whether a small group of closely related people hold complete control over the company. Because of their size and business practices, startups and other small, closely held companies are particularly prone to losing their limited liability status under this framework. Smaller companies are less likely to follow corporate formalities and, more importantly, more likely to mix business and personal assets.

Courts often look for whether there has been commingling of corporate and personal assets in determining whether a corporation or LLC is little more than an alter ego for its owners. Commingling of assets may occur, for example, if a business owner pays personal debts using a corporate bank account or deposits checks made payable to the business into their own personal bank account. These kinds of activities should be avoided in order to keep the company’s limited liability status.

 

What Startups Should Do

To avoid these kinds of problems, there are a number of steps startup founders and owners should take, including the following:

  • Establish separate checking accounts for the business and for your personal assets, and also consider establishing a distinct business savings account.
  • Pay for business expenses only out of the business account.
  • Pay for personal expenses only out of a personal account.
  • Obtain a dedicated business credit card, and use this card to complete business-related transactions. If your business’s credit is not sufficiently established to qualify for a card, at the very least designate one of your personal cards that will be used only for business-related expenses.
  • Any money transferred to the business owner, including salary and dividends, should be transferred according to specific, formal protocols, not in an ad hoc fashion. Do not skip any intermediate steps.
  • Make a reasonable initial investment in the business so that the company is sufficiently capitalized and will not require regular payments of debts from your personal accounts.
  • Make sure that business assets and liabilities, including loans, are titled in the business’s name.

These suggestions are just a few of the steps that a business owner can take to maintain corporate limited liability status. Distinct finances alone will not protect this status if other factors, such as a complete lack of corporate formalities, are present. But keeping business and personal accounts separate is a good initial step towards ensuring that some of the key advantages of the corporate form, including limited liability, are actually available.

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Splitting the Pie

Photo Credit: DigiDi

Photo Credit: DigiDi

An early decision that can often trip up founders is how to divide the initial equity issued by the startup.  While there is no cookie cutter approach to this question, the following are some general principles founders should follow:
At formation, a startup is a long way from the finish line.

At formation, a startup is a long way from the finish line.
Photo Credit: Ben Shepherd

Future Effort– The vast majority of the equity awarded to founders should be based on the likely future effort needed to make the company a success.  Founders often over-value their contributions to the initial intellectual property upon which the founders are basing the company.  A general rule of thumb is that the founders’ equity granted in exchange for existing intellectual property being assigned into the company should be less than 10% (across all contributors), and often significantly less.

Aligning Interests & Properly Incentivizing – Don’t get too hung up on trying to precisely nail each founder’s value.  Instead, think about aligning each participant’s interests with those of the company.  To do this, you need to incentivize each participant to work their tails off to build a great company.  The right question is: how much equity is needed to properly incentivize exceptional effort from all involved?

Multi-stage Transaction – Founders should also recognize that taking a startup from concept to commercial success is a multi-stage transaction.  Investment rounds will often serve to correct any misalignments of interests between founders, the company, and investors.  For example, if a technical founder has 15% of the equity in a startup, but his or her role has become more important to the company than originally anticipated, investors will recognize the need for that founder to have a larger share of the company in order to be adequately incentivized.  The investors may require a reapportionment of the founders’ equity as a condition to investment.

Keep it Simple and Follow Established Models to Address Future Changes – Founders (especially student founders) are often concerned about the difficulty of allocating equity when the future time commitments of founders is up in the air.  Founders may be tempted to try to create an equity allocation that adjusts periodically based on the contributions of founders during that period of time.  This is unnecessary, can be unhealthy to team dynamics, and can cause tax complications.

Founders may be attempted to constantly adjust their equity to account for their changing contributions.

Founders may be attempted to constantly adjust their equity to account for their changing contributions.

Fortunately, there is an industry accepted model for aligning the interests of founders with the company and giving the company the flexibility to adjust its relationship with founders that are not living up to their end of the bargain.  This model includes:

  • establishing a “reverse vesting” schedule for each founder that grants the company a repurchase option in the founder’s unvested equity if the founder’s service to the company ends;
  • providing the company the ability to terminate a founder’s service at will (either through termination at will provisions in the employment offer letters or service contracts, or as a provision in the restricted equity agreement).

Accordingly, if a founder is not contributing the expected value to the startup, the startup can seek to adjust that founder’s equity split to something more appropriate.  If the founder acts unreasonably and is not willing to adjust his or her equity, the startup has the ability to terminate the founder’s service and stopping the founder’s stock from vesting.  This threat will either incentivize the founder to act reasonably and agree to an equity adjustment, or provides the company the ability to end its relationship with that founder without the founder leaving with equity that he or she did not truly earn.