While the majority of my practice consists of bankruptcy and divorce, I have had the pleasure of assisting with a few businesses startups. Also, over the course of handling thousands of bankruptcies; I have seen new startups make the same mistakes over and over. It would be impossible to make a comprehensive list of all the pitfalls that face a new business owner – but I will try to cover a few of the ones I see most often.
After you have worked on your business plan, but before you go to the bank to for a loan, you need to meet with two professionals, a lawyer and a CPA. I have lost count of the failed business owners that have sat in front of me and said, “I wish I had talked to you BEFORE I opened my business.”
One of the most common misconceptions that new business owners have is that they believe their corporation or LLC will protect their personal assets against the bank if they default on the business loan. Banks know the vast majority of new businesses fail, which is why, in almost every case, they require the business owner to personally guarantee the business debt. Once you sign for the business debt, if you default on the loan, then the bank can take action against you personally. This means that they may sue you, garnish your wages, freeze your bank account and place a lien against any real estate you may own – even your personal home. An attorney may be able to offer other options for shielding assets from potential creditors.
Despite the fact that it will not protect you from a bank with a personal guarantee, you should still create a business entity. The business entity (LLC, Corporation, etc.) will lend you a certain level of protection from customers and vendors. Typically, commercial landlords will require a personal guarantee, but many others vendors will not. You will want to consult with a lawyer and CPA to help you determine which business entity is best for you.
Once you have your business plan established, you will need to create your business entity with the State Corporation Commission; this can be done online for a nominal charge. Once you have your business entity created, you will need to determine whether it should be a sub-chapter S Corp.
Most small businesses are sub-chapter S. “S Corporation” is an IRS designation that allows your business income to pass through the corporation untaxed and be taxed at the personal level. Even though you will still file a corporate return, the income is only taxed on your personal return. You should consult with an attorney or CPA to help you determine if your business is eligible to be an S Corp. You will also need to apply with the IRS for your EIN (employer identification number). After setting up your corporation, and filing the appropriate forms with the IRS, you need to apply for a business license with the city where you intend to operate.
Another big mistake new business owners make is that they don’t keep their business and personal finances separate. If your business is sued, and the plaintiff can show that you were using business funds for personal use, they may be able to “pierce the corporate veil” and come after you personally. To avoid this scenario, you should not pull funds from your business account to pay personal bills and expenses. This doesn’t mean you can’t give yourself a regular paycheck or take a shareholder distribution; just that these activities must conform with accepted accounting principles.
Another problem I see is where a new business owner is taking assets and cash from a prior failed business to start their new business. If you close a failed business while owing employees and vendors money, then take the cash and assets from that business to jump start your new business; those employees and vendors will likely be able to sue the new business or pierce the corporate veil and come after you personally. If you are closing a business that has both assets and debt, you should seriously consider consulting with a bankruptcy attorney. You may need to file a corporate bankruptcy.
Once your business is formed and corporate bank accounts established, you can still run into problems if you don’t hold yourself out to the community as a corporation. Contracts with vendors and customers should be clearly marked so that everyone knows they are doing business with a corporation and not you as an individual. Receipts and other paperwork given to customers and vendors should make it clear which entity they are dealing with. If a plaintiff can prove that they believed you were doing business with them as an individual and not a corporation they may be able to pierce the corporation and come after you personally.
I have lost count of the times I have saved a client thousands of dollars in a consultation by helping them to avoid a mistake they would have otherwise made. It is far cheaper to pay a lawyer a consultation fee to answer a question, than to pay him to fix a mistake after it has occurred. If you are contemplating starting a new business, then before you start filling out paperwork and signing documents, hire a lawyer – even if just for a consultation.