If you’re not fully conversant with how being under capitalized creates personal liability you need to read this. Here’s a quick primer on why it’s important to properly fund your business.
UNDERCAPITALIZATION AND CORPORATE LIABILITY
A little-known problem associated with undercapitalization is that it can increase the likelihood of the owners of a corporation being held personally liable for business-related matters. One of the main reasons that entrepreneurs choose the corporate form of business organization is to protect themselves against personal liability for business debts and court judgments. Incorporation does not afford automatic protection, however. Corporate owners can be held personally liable in a number of situations, including cases where personal and corporate assets are commingled, the corporation does not keep adequate records, or corporate owners intentionally defraud their creditors.
But perhaps the most critical factor in determining whether there should be personal liability for corporate debts is whether the owners provided sufficient capitalization for the business. The ultimate test is whether there are enough corporate assets to satisfy corporate obligations. For example, an entrepreneur could not contribute only $500 to start a new business, knowing that it actually required an initial capital outlay of $10,000, and expect his or her personal assets to be protected in case the business became insolvent. In this instance, a court would be likely to rule that the extreme undercapitalization of the corporation made the owner personally liable for its debts.
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Here is another quick study from an Oregon law firm on personal liability for undercapitalization …
The Oregon Court of Appeals held that the shareholders’ failure to adequately capitalize the corporation, in light of the anticipated expenses of the business, is the type of gross undercapitalization that permits a court to pierce the corporate veil and impose liability on the shareholders. The court noted that the sufficiency of the capital is determined at the time the corporation is formed and at the beginning of its operations. Accordingly, it is important to obtain competent professional advice when forming and capitalizing the new entity.
Merely filing articles of incorporation with the Oregon Secretary of State’s office and commencing business operations is no longer sufficient. Adequately capitalizing the new business is essential. Determining the capital necessary to cover reasonably anticipated liabilities, given the nature and magnitude of the business, and the normal operating costs of the business must be accomplished at the outset. The court held that a later infusion of capital was not enough to negate personal liability for the corporation’s owners.
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Bottom line —
This is not likely to be a personal problem for a minority owner of an LLC – in Texas — if most of your assets are in your home, and Texas has a very strong protection for home equity against creditor claims. If your ownership is small (under 20%), you can still be dragged into the costly inconvenience of defending against a “pierce the corporate veil” litigation if the business comes on hard times like running up a 30 day LOC for inventory… and can’t pay according to terms.
Your share of the nuisance cost to defeat such a creditor case can easily be $15k — and a year of frustration, even if the company management agreement provides for indemnification.
Think through all your creditors contracts and other suppliers. Your most dangerous exposure is the first year — when you will likely to run up your LOC and then rely on vendor terms and if your only capital contribution is … an SBA loan … it creates the wrong impression to a judge that you and your partners were negligent from the start.
The issue of being under capitalized is considered from start up — not after later capital contributions are made. Case law indicates that future profits (retained earnings) put back into the company — do NOT cure original under capitalization if the company later falls on hard times during a down turn in the market, or trying to expand too quickly.
Start with a realistic business plan that accounts for known contingencies — make your best guess, and press on. What jumps off the page of many startup plans I review that rely on SBA loans and supplier financing to launch is… it’ classic under capitalization from the start.
The problem is this happens all during the startup and while things are going incredibly well so you will never realize it until it’s too late. Most startups have to pay up front to their suppliers before they will consider you for purchasing on credit. You need to realize that 30-day payment terms are considered 30 day LOC financing … so once have a track record with your suppliers they will be willing to lend you $300k or $400k in supplier financing. It’s done all the time … and suppliers usually prefer to work out terms and give time to solve problems with future sales — rather than pierce the veil.
Disclaimer: I’m not an attorney. You will want to discuss this with your attorney when setting up your company… like I did!