10 Common Legal Mistakes Made by Small Businesses

It's easy for small business owners to make mistakes that can expose them to legal risks.  Here's a short list of common mistakes and how you can avoid unintentionally assuming liability risk.

1.   Not Starting a Business as a Limited Liability Entity

If you start your business as a general partnership or sole proprietorship instead of a limited liability entity, not only are your investment in the business and the business assets at risk in the event of a lawsuit or other problem, but so are your personal assets.  It is important to separate and protect your personal assets from your business by forming an LLC, corporation or even a limited liability partnership.  Choosing the right entity type is also important. Incorrectly setting up a legal business entity can potentially cost your company thousands of dollars in revenue, affect potential funding and raise other issues.  

2.   Not Having Good Written Agreements  

You must put all your business agreements in writing and to be sure that those written agreements clearly define each of the roles/obligations/duties of each party as well as the remedies available if either party violates any of the terms of the agreement. This is essential not only for your contracts related to goods and services, but also for your contracts with your business partners.  It is vital for business partners to discuss and clearly define in a written agreement issues such as:

• How much time and effort is each person expected to contribute? 
• How much capital will each person contribute? 
  
• What happens if the business needs more capital? 
  
• What happens if one person wants to leave the business? 
  
•  If the partner is married, what rights and interest in the business will the spouse have in the event of divorce or death of the partner?
  
• Will the company buy back the stock or interest from the estate of the deceased partner or from the partner leaving the business?
  

The internet is full of websites offering free and low-cost documents that promise to take the place of spending time and money with an attorney.  The problem with these forms is that they are typically very generic, full of legalese that few people understand completely, and rarely contain particular nuances required by state and local laws in order to be upheld in your local jurisdiction. Every business situation is unique and you increase your legal risks if you attempt to apply a generic one-size-fits-all contract or generic legal advice to your situation without having a professional evaluate the facts, terms and understanding of the parties, as well as federal, state and local requirements, and confirm that your contract addresses all of the relevant issues.  

If you are presented with a contract to sign by another party, you should have it reviewed by a business attorney before signing it to have the attorney explain all the key provisions in the document so you can ensure that you understand what it is that you are agreeing to and what the consequences are of failing to abide by its terms.

3.   Not executing Contracts in the Name of your Entity

Make sure that all of your written contracts with customers, business partners and affiliates, employees vendors, landlords or renters are executed in the name of your entity and never by you personally.  When you sign a contract using only your name, you are obligating yourself personally to fulfill the terms of that contract.  For example, if your company is entering into a contract with another party, the contract should be between your company and the other party - you should avoid being identified personally as a party to the contract.  Moreover, you should sign the contract only in your capacity as the owner, president, or manager of your business.  

If you are named on the contract and due to unanticipated circumstances your business is unable to fulfill its obligations under the contract, the other party can sue you personally, which places your personal assets at risk.  If, however, you ensure that you are not personally named in the contract other than as a signer on behalf of your company, the other party is limited to suing your company.  Also, try to avoid signing personal guaranties whenever possible.  If you fail to observe these rules, you lose the limited liability protection for which you formed your legal entity.  

4.   Setting Unclear Expectations and Rules for Employees

If your employees are "at will" employees, which means they can quit or be terminated at any time without exposing your business to liability, be sure to have them sign something acknowledging their understanding of this employment status. Inform your employees that discrimination, sexual harassment, and other illegal acts won't be tolerated, but be careful when preparing employee handbooks because they are often treated as an enforceable contract by Arizona courts. An employee handbook is a great way to outline your expectations for your employees and keep the employer-employee relationship on a professional level.  An employee handbook can also set forth the rules regarding the disciplining of the employee; however that is a double-edge sword in that the same document can be used against your business to protect the employee.  Work with a human resource consultant and attorney to draft a handbook that fits your situation and make sure you clearly understand what is contained in the handbook.

5.   Treating Independent Contractors Like Employees

Use caution in how you deal with independent contractors.  Many business owners think that by calling someone an independent contractor they can save thousands of dollars in payroll taxes.  This can be true, but even if the business owner and the independent contractor agrees to this arrangement, the IRS can still step in and decide otherwise. The IRS provides detailed information and a multiple point test to determine whether the independent contractor you've hired is actually a W-2 employee in disguise (see, for example: http://www.irs.gov/pub/irs-pdf/p15a.pdf). It is imperative that you review that test and understand the legal risk and consequences of not complying with the rules related to independent contractors.

If you have a legitimate independent contractor situation, it is extremely important: (1) to ensure the contract you have covers the entire agreement and protects you in the case of a breach, and (2) that you continue to observe the rules and limitations relative to your relationship with the independent contractor throughout the term of your working relationship.

6.   Ignoring Intellectual Property, Disclosure and Solicitation Issues

Whether you realize it or not, your company likely has intellectual property issues that may be important to the future success of the business and which should be protected.  For example, do you require your employees and consultants to sign confidentiality and non-disclosure agreements? How about invention assignment agreements?  Have you registered for a trademark for an important company logo or product? Are your trade secrets adequately protected? Do you have key employees sign non-compete/non-solicitation agreements so as to avoid a scenario in which an employee leaves your company, starts an identical business nearby, and takes your other key employees and customers with them? 

7.   Not Hiring a Good CPA 

Whether you realize it or not, your company likely has intellectual property issues that may be important to the future success of the business and which should be protected.  For example, do you require your employees and consultants to sign confidentiality and non-disclosure agreements? How about invention assignment agreements?  Have you registered for a trademark for an important company logo or product? Are your trade secrets adequately protected? Do you have key employees sign non-compete/non-solicitation agreements so as to avoid a scenario in which an employee leaves your company, starts an identical business nearby, and takes your other key employees and customers with them? 

8.   Not Hiring a Good Business Attorney 

By helping you manage legal risk, a business lawyer can be the ounce of prevention your small business needs to keep it healthy.  You should always expect the best outcome for your business, but it's critical that you plan for the worst outcome.  Utilizing well-drafted contracts from the beginning that protect your legal rights will reduce the risk of your having to file a lawsuit later over a business issue that was not contractually provided for.  A well-drafted contract for goods and services is just one way to prevent needless costs before they arise.

I have seen countless situations that could have been avoided or at least minimized had the client sought legal advice early on.  It can cost ten times more to work though a legal problem than it would have to identify the potential legal issue early and handle it before it spirals of control.  Isn’t it better to identify and avoid potential legal problems with the help of an attorney than it is to watch your hard earned revenue pass directly to the legal system and an opposing party? 

9.   Not Carrying Sufficient Insurance Coverage 

Whether you run a small or large company, having sufficient general business liability insurance is important. Depending on your type of business, you should also have other types of insurance coverage, such as product liability, professional liability, commercial property or home-based business insurance. Insurance protects small business owners from things that can happen during the course of business -- whether a customer gets hurt using a product, you make a professional mistake, you damage someone's property or there is some kind of disaster. It covers the business and the business owner from any claims by covering investigations to defend the business and either settling with the claimant or by representing you in a lawsuit.

10.  Not Planning Your Transition Out of Your Business

You will transition out of your business. Whether you work until you drop, or decide to sell or shut down your business at some point, it will happen.  It's never too early to begin making plans for the future of your business. By starting early, you can be sure you're the one at the wheel, building and managing your transition plan with your own team of advisers.  This becomes even more critical if you co-own your business with partners, as was discussed earlier.  Successfully transitioning out of your business is all about setting and reaching goals. 

Most of the time the legal mistakes made by new business owners are not intentional, but are simply due to lack of knowledge. You can prevent future costs by making sure that your company is organized properly and then educating yourself on the things you need to do and observe to protect not only your small business, but your personal assets as well. Having a good relationship with your business attorney is an effective way to manage your small business’ risk and to prevent unnecessary future legal expenses. If you have questions about your small business, contact us today. We'll help you reduce the risks faced by your business.