The Early Years of a Business, Part 5: Mitigating Your Business’ Risks

This is the last post in a five-part series about the early years of a business formation.  To catch up, click here.

After you’ve selected your business entity, capitalized your business, purchased insurance for your business, and maybe even taken on some new employees, you will want to get into the mindset of identifying legal risks present in your business.  Often, your business risks can be minimized at little to no cost to you.

To begin the process of assessing your business risks, you will want to conduct an internal audit to help you identify those risks.  Many hear the word “audit” and believe it to be daunting and time-consuming; even so, an audit will be worth your time now in order to minimize risks and prioritize your business goals.

During an audit, here are the questions you are likely to come across in the process that will prompt the biggest red-flags:

  1. Is there a document for succession of ownership in the case of my death?
  2. Are my key employees prevented from using my business methodology against me in the future?
  3. Do I have an employee handbook that only contains provisions for the size of my business?
  4. Are the terms of my sales/services recorded in a written agreement with my customer that sufficiently limits my liability?
  5. Do I have written agreements for all installment purchases, financial leases, letters of credit, or other similar transactions?
  6. Do I have appropriate insurance coverage and limits for my business?
  7. Do I have legal counsel on all pending or threatened litigation, including claims brought by the business as well as against the business?

Business owners should put into place a system to help them identify their risks now and during future growth.  Knowledge of these risks can provide a great sense of comfort to the business owner. The business owner can either adopt a plan for mitigation of these risks, increase their business model to protect cash flows in the event of a risk, or simply accept the risk and carry on with their business.  Note: Any findings from your internal audits are protected by attorney-client privilege.

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The Early Years of a Business, Part 4: Documenting New Hires

This post is the fourth in our series about the early years of a business formation.  Read more in parts One, Two, and Three.

Another step most small business owners take in the first few years is hiring employees or staffing with independent contractors.  All of these professional relationships should be documented through the following agreements, forms, and letters:

  • Employment Contract or Employment Offer Letter. This document should include information such as the job title, scheduled work days/hours, term (or length) of employment, compensation details, responsibilities, and termination conditions.
  • Required Employment Forms/Filings. Some of these forms are likely ones that you are familiar with: the W-4 form for employees (W-9 for contractors), I-9 Employment Eligibility Verification form, State Tax withholding form, and direct deposit form.  You can also run the candidate through E-Verify, a system that checks employment eligibility in the U.S.
  • Necessary Agreements and Policies. When staffing your business, you can begin protecting your business from the get-go by having your staff sign the following agreements: non-competition agreement, non-disclosure agreement, employee invention form, employee handbook with an acknowledgement form, drug and alcohol testing consent forms, job analysis forms (this may encompass responsibilities, goals, and performance evaluation criteria), employee equipment inventory list, confidentiality and security agreements.  Depending on your business type, this list may vary or lengthen to suit your needs.
  • Employee Benefits Documentation. If you offer benefits to your employees, you may need documentation of the following: health/life insurance, mobile phone plan, company vehicle lease, stock options, retirement plan, disability insurance, paid time off or vacation policies (this would also include paid holidays), sick leave, employee wellness perks (such as gym memberships), and tuition reimbursement for continuing education.
  • Personal Data Collection. You also need to gather your staff’s personal data and keep it updated with the following: emergency contacts, brief medical history or relevant impairments, and any food allergies or preferences if there is a company-funded lunch or related event.

Employees are the small business owner’s greatest asset, but they do not come without risks.  Start your employer-employee relationship out the right way through proper documentation.  It will mitigate your risk, and it will also help you get to know your staff and keep you on the same page.

The Early Years of a Business, Part 3: Insuring Your Business

This post is the third in a series we are bringing to you about the early years of a business formation.  If you are getting caught up, here is Part 1 and Part 2.

Since every small business has different needs, there is no longer a one-size-fits-all coverage out there; as such, you are sure to find a plan that truly suits your business’ unique needs.  Here are the categories and types of insurance that, depending on your business, would be invaluable for you to invest in:

  • Property Insurance. This would cover any physical damage or loss your business may suffer, from the building to the supplies and equipment you use.
  • Business Interruption Coverage. This would protect your business’ earnings in the event that you have to close your doors due to an incident. (Note: if you operate your business out of your home, do not assume that your homeowners insurance would cover this loss; check with your provider first.)
  • Commercial Vehicle Insurance. If your business uses vehicles regularly to operate (whether you own them or rent them), this is important coverage to have.
  • Life Insurance. If you work with one or more business partners, life insurance will cover the finances that need to be handled after the death of a partner.
  • Liability Insurance. There are three types of liability insurance, each suited for different business types:
  1. General Liability: covers injury, property damage, medical expenses, and lawsuits.
  2. Product Liability: covers safety issues related to the malfunctioning of a product.
  3. Professional Liability: covers small business owners who provide a service, in the event of malpractice or error.
  • Workers Compensation Insurance. It is possible that, if your business has employees, you have a legal obligation to purchase workers compensation and unemployment insurance; this is the case for any business in the state of Illinois.  You may also be required to have disability insurance to cover an employee’s sickness or injury outside of work.

Remember: Insurance is not just about protecting your business as it exists today, but also to protect your business in the future when it comes time for you to pass your business on to a successor.  As we pointed out in last week’s post: You should always be planning for growth and succession!

The Early Years of a Business, Part 2: Capitalizing Your Business

This post is Part II in a five-part series on our blog about the early years of a business.  Click here to read Part 1.

One requirement to preserve your business structure and limit your personal liability is to adequately capitalize your business entity.  But what exactly is considered “capital” in your company?  Capital can be any asset, whether tangible or intangible, that is held in your company for the sake of long-term investment.

Small business capital can come from three different sources:

  1. Investors.  For business start-ups, the investor is typically you.  However, it is common for outside investors to provide capital in small businesses as well. When you invest money as capital into your company, you typically won’t receive that capital investment back until you sell your business.  This often scares small business entrepreneurs from investing any of their personal cash or savings as capital in the first place.  You will often find that outside investors hold the same hesitancy when investing in a small business; so, many investors prefer a loan structure over a capital-contribution structure.
  2. Retained Earnings.  Retained earnings are the earnings of the business that are not otherwise distributed to you or your investors as salaries, bonuses, dividends, etc. and are thus retained by the business.  These earnings are reported on your balance sheet and they evidence that (a) your business operated at a profit, and (b) you, as the owner, had the discipline to leave this capital in the business instead of distributing it.  For business start-ups, this type of capital is often very hard to attain, and is thus the least common structure for capital investment.
  3. Borrowed Money.  Loans are, by far, the most popular form of capital investment in a small business.  Loans don’t have to just come from a bank; loans can come from family members, friends, investment groups, private equity firms, or private investors.  When borrowing money as capital, remember two things: (1) the interest, and most often the principal, must be repaid systematically in the form of established, regular payments, and (2) your business must have sufficient cash flow in order to make those regular payments.

So, how do you know if you are adequately capitalizing your business?

Begin by asking yourself “Am I able to pall all of the expenses, including the payment of debt, that are necessary to operate my business?”  Project your sales, estimate how long it would take for you to collect your receivables, represent the capital needed and when you would need it.  This gives you your operating cash.  If you are unsure of how to work with these numbers, find an accountant to help you adequately assess your capital needs.

Not only should you plan for short-term capital needs, but long-term needs as well.  I tell all of my clients to plan for growth; in the future of your business, will you be making any large capital purchases?  Hiring employees?  Requiring the research and development of any new products?  Avoid using the operating cash you come up with from earlier to make large capital purchases.  Instead connect with a commercial banker to get an equipment loan with a low interest rate and fixed terms.  You will want to use your own retained earnings for growth and future needs; this may feel like a lofty goal, but sufficient planning and baby steps will get you there!  Remember: It takes more capital to stay in business and grow it successfully than to start it in the first place.  Always be planning for growth!

The Early Years of a Business, Part 1: Selecting a Business Entity

The foundational step in protecting your personal assets from your business risks is by forming a business entity.  Here are several forms of popular business entities that you can choose from:

Corporation

  • Articles of Incorporation are required to be filed with the Secretary of State in order to form the entity.
  • A corporation is a legal entity separate from its owners, who own shares of stock in the company. They are called the shareholders.
  • Corporations can be created for profit or nonprofit purposes.
  • A special structure called a Professional Corporation may be used when the corporation provides a certain professional service (i.e. law).
  • Profits are taxed both at the corporate level and again when distributed to shareholders. This is referred to as “double taxation.”
  • Shareholders are not personally liable for corporate obligations unless corporate formalities have not been observed; such formalities provide evidence that the corporation is a separate legal entity from its shareholders. Failure to do so may open the shareholders to liability of the corporation’s debts. Corporate formalities include: issuing stock certificates, holding annual meetings, recording the minutes of the meetings, and electing directors or ratifying the status of existing directors.
  • The shareholder’s interested are managed by an elected group, the Board of Directors. The Board of Directors is responsible for election of the officers that run the day-to-day business of the corporation.
  • The shareholders and/or Board of Directors may adopt Bylaws setting for the management and the affairs of the corporation.
  • Shareholders may adopt a Shareholder Agreement which sets the rules for how the shareholders interact.

Subchapter S Corporations

  • Identical to the Corporation, except a tax election is made that enables the shareholder(s) to treat the profits as distributions and have them pass through to their personal tax return. This avoids “double taxation.”
  • A shareholder that works for the corporation must pay him/herself reasonable wages.

Limited Liability Company (LLC)

  • Articles of Organization are required to be filed with the Secretary of State in order to form the entity.
  • The LLC is generally considered advantageous for small businesses because it combines the limited personal liability feature of a corporation with the tax advantages of a partnership and sole proprietorship.
  • Profits and losses can be passed through the company to its members or the LLC can elect to be taxed like a corporation.
  • LLCs do not have stock and are not required to observe corporate formalities.
  • Owners are called members, and the LLC is managed by these members or by appointed managers.

Series LLC

  • Illinois is one of the few states that recognize the Series LLC.
  • Identical to LLC, except that the debts, liabilities and obligations incurred, contracted for or otherwise existing with respect to a particular series shall be enforceable against the assets of such series only, and not against the assets of the limited liability company generally or any other series of the LLC.

If you aren’t sure which entity is right for you, reach out to a small business attorney’s office, like Sparks Law Office, P.C., to get your business rolling in the right direction.

How to Protect Your Business for Future Succession, Part Five: Using Independent Contractors

IC

A couple weeks ago, I asked you to consider whether your business is susceptible to employee risks. A popular alternative to hiring employees is entering into agreements with independent contractors. There are both positives and potential risks involved with utilizing independent contractors, and I want to be sure you are thoroughly informed before you staff positions within your company.

Advantages

There are several reasons a business owner might decide to staff their company with independent contractors. Perhaps, it is to simply save some money. Independent contractors might cost you more in hourly wages, but they don’t require the costs of benefits, an office space to keep them, equipment for them to use, and other contributions such as Social Security and worker’s compensation insurance.

Another reason a business owner might like to utilize independent contractors rather than employees is to work under a more flexible business structure. If the workload for your particular business fluctuates often, it will be more economical and efficient if your turnover for workers happens through independent contracts rather than employee turnover. Moreover, your independent contractors are likely to be specifically trained and experienced in the work they do for you, making your need to hire and train employees a worry of the past.

I’m not just here for business advice, though; I’m here to point out the legal threads that run throughout your business structure. Legally, there is a reduced risk of exposure to liability if you have agreements with independent contractors than if you hire employees. Employees, by definition, are protected by specific state and federal laws. This increases the possibility of legal action being brought against you by an employee due to violation of rights. Though we hope to be conducting our businesses in the most ethical and legal way, employee rights can come up against business practices and, in consequence, you as the business owner.

Some of the rights for “at-will” employees that you wouldn’t need to navigate with independent contractors are:

  • the right to receive at least the minimum wage and possible overtime compensation at a one-and-a-half rate,
  • the right to form a union, and
  • the right to quit before the work is completed.

Obviously, the laws that protect these rights for employees are here for a good reason. However, as a business owner, your agreement with an independent contractor is a common-ground to run your business efficiently with limited risks.

Disadvantages

Entering into agreements with independent contractors does not come without disadvantages and risks, however. You will have less control over the quality and quantity of work due to an inherent autonomy that independent contractors have. Employees, who agree to all the details of your business practices upon being hired, can be closely monitored. Independent contractors will essentially be free to work at their own pace, do things their own way, etc. Also, since independent contracts yield quick turnover, you may experience a significant level of disruption in your day-to-day business by having to account for the comings and goings of each contractor.

Now, for the fun part: legal risks that come with hiring independent contractors.

  1. Written Agreements. If you do not have written agreements with people who are contracted to work for you, then put that on your very urgent to-do list. I am faced too often with my clients suffering the consequences of simply shaking hands with a person doing work for them. Even if this contractor is your best friend, or even your spouse, do not go for too long without putting a written agreement in place where you describe some of the most important policies to your business: work flow expectations, rate and amount of pay, non-disclosure or non-compete clauses, termination of relationship, etc.
  2. Many businesses that hire contractors are businesses where workers are exposed to the possibility of injury. Since independent contractors are not covered by your worker’s compensation insurance, independent contractors must be required to maintain their own coverage, or an injury may lead to a lawsuit against you for the contractor to recover damages.
  3. Depending upon your business type, you may be hiring contractors to create work that can be copyrighted, such as writing or creating graphics, then your company may not own the copyright on the work done by the contractor unless you have a written agreement specifically signing that ownership over to you.
  4. State and federal agencies, including the IRS, favor the traditional employer/employee relationship or the less than traditional business relationship with independent contractors. In addition, the insurance company providing your workers’ compensation coverage has the right to audit your books and records on an annual basis. In either case, if you do not have sufficient information to evidence your business relationship with your independent contractor (e.g. written agreement, insurance certificate, etc.) that person will be deemed an employee and you will incur unexpected liabilities in taxes, penalties, interest or additional premiums.

As a small business attorney, I am in the business of educating you about your risks and helping you to minimize them before it is too late. If you want more information about how to minimize these risks with your independent contractors, don’t hesitate to contact me as soon as possible. Prevent problems now, so that you don’t have to recover from them later.