How to Avoid the 10 Biggest Mistakes Businesses Make
While a business may fail for many reasons, this document identifies the 10 most common legal mistakes businesses make. Many of these mistakes expose the business, its owners, and in the case of corporations, its directors and shareholders, to needless liability. It is our goal that by identifying these common errors you will be armed with knowledge, which if properly utilized, is the key to avoiding these mistakes.
MISTAKE #1: Failure to consult with professionals prior to selecting or changing the form of business entity.
California recognizes numerous forms of business entities, each with important distinctions. The six major forms of business entities are sole proprietorships, general partnerships, limited partnerships, limited liability partnerships, limited liability companies, and corporations. Corporations are by far the most popular form of business entity and are unique because of the many types of corporations, such as, “C” Corporations, “Sub-Chapter S” Corporations, Professional Corporations, Non-Profit Corporations, etc.
A tradeoff occurs between adhering to special statutory formalities, thereby limiting personal liability, and maintaining management and control of the business. Additional considerations, such as, availability of capital, continuity of existence, and taxation, also play an important role in choosing the business entity. Generally, as the formalities increase, personal liability and management and control of the business decrease. Thus, a sole proprietorship enjoys very few administrative formalities, maintains full management and control of the business, but will be personally liable for the wrongs of the business. The chart below illustrates this concept:
By consulting with competent legal counsel prior to forming or changing the business entity, its owners will be apprised of the best form of business entity for their circumstances. Likewise, consulting with an accountant may save a business and its owners thousands of dollars in taxes.
If the corporate form is chosen as the preferred business entity, consideration must be given concerning where to incorporate. A common misconception among many small businesses is the idea that incorporating in Nevada or Delaware offers significant advantages. For the vast majority of corporations, this is not true. If the corporation plans to do business in California, plans to maintain a sufficient presence in California, or a significant number of shareholders will reside in California, there is usually no reason to incorporate in any state other than California, as generally California corporate law will be applicable to the business, regardless of the state of incorporation. Thus, a foreign corporation with sufficient contacts in California will be deemed a quasi foreign corporation and be required to pay California filing fees (as well as fees to its state of incorporation); taxes (as well as taxes of its state of incorporation); must comply with California securities law; and numerous other California corporate laws. Typically, corporations that may benefit from incorporating in another state are traded on the New York or American stock exchanges, or have been qualified for trading on NASDAQ and have at least 800 shareholders.
MISTAKE #2: Failure to properly document the business relationship between owners.
This mistake can be detrimental in two different ways. First, statutory entities such as corporations require strict adherence to document formalities. Oftentimes, businesses will attempt to incorporate themselves without legal counsel. In many cases, mistakes are made or steps omitted that result in an invalid formation. If the corporation is improperly formed, its shareholders may be personally liable for the debts and obligations of the business.
Second, in the case of a business where two or more individuals are running the company, disputes will inevitably arise alienating one or more of the principals. In extreme cases, a partner may wish to terminate his/her relationship with the business. It is critical the governing documents define the principals’ relationship by including clauses which set forth their duties and responsibilities; provide a means of resolving disputes; address allocation of income; and provide termination rights and distribution of assets upon termination.
Shareholders of closely-held corporations should also consider buy-sell agreements which serve such purposes as: preventing unwanted outsiders from acquiring control of a business or insiders who retire from continuing to hold shares; providing for the continuing ownership and control of remaining shareholders; preventing shareholders from selling their shares which might disrupt existing control or financial allocations; providing an assured market for the shares upon the death of a shareholder; and, establishing a value for the shares for federal estate and gift tax purposes.
MISTAKE #3: Failure to create and/or maintain a business plan which accurately describes the business.
At the formation stage and throughout the life of a business, the business plan provides a vision of the goals of the business and the capital required to meet those goals. It is a document which is relied upon by investors and creditors when making decisions to invest or lend money to the business. For this reason, representations made in the business plan must be carefully scrutinized by the business owner, as well as legal and financial professionals. If a business fails and litigation ensues, representations in the business plan often play a large role in determining the liability, if any, of the promoters of the business and/or its owners.
Equally important, the business plan serves as the company’s road map to success. The most often cited reason businesses fail is lack of capital. A good business plan accurately determines the capitalization needs of a business. Experienced investors and creditors will always carefully examine a company’s business plan prior to investing or loaning money to a business. As well, a good working relationship with your banker, established at the onset, is an invaluable resource to assist in meeting the financial needs of a growing business.
MISTAKE #4: Failure to memorialize agreements with key executives.
Both small and large businesses rely upon the skills and knowledge of their key executives. Indeed, for many smaller businesses, the identity of the company depends in large part upon its key executives. By memorializing its agreements with key executives, businesses avoid misunderstandings and ensure key personnel have a long-term commitment to the company. Fundamental provisions which should be found in every employment contract include: Term of Employment; Position, Duties and Responsibilities; Compensation, Benefits, and Expenses; Termination; Protection of Company Trade Secrets and Proprietary Information; Ownership of Intellectual Property; Notices; Merger or Integration Clause; Amendments and Waivers; Severability and Enforcement; Governing Law; Opportunity to Consult Counsel/Understanding of Agreement; and, Remedies. Depending upon the circumstances, additional provisions and/or agreements may be required which cover Inventions and Ideas; Non-Competition; Stock Purchase Options; Other Compensation or Incentives; etc.
MISTAKE #5: Failure to properly characterize and document the employment relationship with all employees.
Just as it is important to memorialize the employment agreement with key executives, it is equally important to properly characterize and document the employment relationship with all employees of the company. Disputes with employees can have a detrimental effect on a business and seriously undermine employee morale. Thus, it is vital the employment relationship be understood by all parties. It is also of paramount importance that if it becomes necessary to terminate an employee, a wrongful termination lawsuit is avoided. In California, Labor Code § 2922 provides a presumption that employment having no specified term is “at-will” and may be terminated by either party without cause. However, the courts have held statements by an employer, either written or oral, which create an expectation of job security, can rebut the presumption of “at-will” employment. It is important employees acknowledge their understanding of the at-will relationship in a signed writing. In addition, a business must ensure the “at will” language is expressed in any employment contract/offer, and not countermanded by an employee handbook, or other conduct of the supervisors and managers of the company. Courts have regularly found that despite a statement the employment was at-will, subsequent actions by the employer, or statements in an employee handbook, created an employment relationship which required terminations to be only “for cause.”
MISTAKE #6: Corporations – Failure to conduct regular Board of Directors’ meetings and annual Shareholder meetings.
Assuming the corporation is properly formed, the shield against personal liability afforded to the directors and shareholders of the corporation may be lost if the business fails to adhere to basic corporate formalities. California Corporations Code §1500 provides:
Each corporation … shall keep minutes of the proceedings of its shareholders, board and committees of the board …. Such minutes shall be kept in written form. Such other books and records shall be kept either in written form or in any other form capable of being converted into written form.
If regular meetings are not held and minutes adequately maintained, the corporate veil may be pierced and the directors and shareholders may be held personally liable for the corporation’s debts.
A. Board of Directors’ Meetings – The Board of Directors manages and exercises the corporation’s business, affairs and powers. As a result, corporations must hold regular meetings as defined in the corporation’s bylaws. Actions by the Board of Directors may also be taken at special meetings or by the written consent of the directors without a meeting. The bylaws typically require that regular meetings be conducted monthly, quarterly, annually or at other more frequent intervals. Under the California Corporations Code, the Board of Directors is required to approve key decisions which affect the legal rights of the corporation. Entering into major contracts, issuing shares of corporate securities, and distributing corporate profits, are just a few examples of the activities which require approval of the Board of Directors.
B. Shareholder Meetings – Shareholders must act on certain corporate matters. Action by the shareholders may be taken at annual or special meetings of shareholders, or by the written consent of shareholders without a meeting. For example, Shareholders must elect directors, approve changes to the articles of incorporation, approve mergers, acquisitions, or the sale of substantially all of the assets of the corporation, and authorize dissolution of the corporation. Shareholders should be provided with financial statements of the corporation which minimally include a balance sheet, income statement, and statement of changes in the financial position for the fiscal year.
MISTAKE #7: Failure to properly maintain books and records.
From the onset of establishing a business, a relationship should be established with a qualified Certified Public Accountant or accounting firm. Under their guidance, policies and procedures should be implemented whereby all of the company’s books and records are properly maintained. Regardless of the type of business entity, separate bank accounts should be maintained for the business and personal funds and transactions should not be commingled with company funds. This is particularly critical in the case of a corporation where the commingling of personal and corporate funds and/or the payment of personal debts with corporate funds may permit the protection afforded by the corporate veil to be pierced and expose the shareholders to personal liability for the corporation’s debts.
MISTAKE #8 : Corporations – Failure to properly issue shares for legal consideration, and failure to identify valid exemptions from security registration requirements.
The consideration for shares constitutes the basic equity funding or capital of the company. A common mistake made by promoters of corporations is the payment or partial payment of shares represented by a promise of future services, or by promissory notes of the purchaser which are not adequately secured by collateral other than the shares being acquired. However, legal consideration may take the form of money paid or past services provided, debts or securities canceled, or property actually received by the corporation.
Unless a valid exemption applies to the sale of a corporation’s shares, the securities may need to be registered with both Federal and State agencies, the cost of which can often exceed $75,000.00. Complex statutory schemes are enacted which provide exemption from registration under various scenarios. Generally, intrastate offerings are exempt from registration under the Federal Securities Act of 1933. However, a corporation must still comply with California’s regulations. In California, most small corporations will elect to avoid registration by seeking exemption under Corporations Code § 25102(f). This exemption allows the sale of shares without registration to 35 or less shareholders (certain qualified investors are excluded from this number).
MISTAKE #9: Failure to dissolve business entity when company is no longer in business.
When the useful life of a business ceases, it should be properly dissolved. Failure to dissolve may result in the continuation of liability for the partners, directors and/or shareholders. In the case of a corporation, the minimum franchise tax of $800 per year continues until the corporation is dissolved. In addition, a corporation which is suspended for failure to pay the minimum franchise tax may not defend itself in a lawsuit.
MISTAKE #10: Failure to establish a working relationship with a competent business attorney.
Businesses which fail to avoid costly and resource draining litigation are doomed to failure. The hard dollar cost of even a small business lawsuit ranges from $50,000 to $100,000 dollars. The cost of complex business litigation is much higher. It is paramount that you fully understand and appreciate the risks and liability of all parties when entering into any type of contract or relationship. More importantly, the contract or relationship must accurately describe the understandings of all parties.
The best way to avoid the risk of litigation is to work with an attorney to draft/review contracts and agreements, resolve employee issues, create/review/revise employee handbooks, review the business plan, and maintain corporate formalities. At Branfman Mayfield Bustarde Reichenthal, LLP we encourage our clients to work with us by addressing legal issues when they arise, rather than waiting for issues to become legal problems. In this manner, our clients are in the best position to avoid costly litigation.