Is the Threat of a Lawsuit a Real Fear?
As a small business owner, you may be one of the 48% concerned about frivolous or unfair lawsuits. According to the U.S. Chamber Institute for Legal Reform, actual lawsuits and the fear of lawsuits cost U.S. small businesses $98 million in 2005. That figure may seem large because it includes money spent on damage awards, settlements, legal costs, liability insurance premiums, and costs incurred by insurance companies on behalf of policyholders. Is the fear of lawsuits a real fear? Unfortunately, yes. Anybody can sue anybody over anything at any time. In reality, 46% of small business owners have been threatened with a lawsuit, 34% have been sued in the past 10 years, and 62% have made business decisions to avoid lawsuits. Indeed, small businesses bear 69% of the total cost of the tort system to all U.S. businesses.
What is the Best Course of Action?
What’s a small business owner to do? For starters, realize that the best defense is a great offense. While most small business owners fear the law, it is much wiser to use the law as a protective shield. There are many business and legal components that contribute to creating the strongest shield possible – business entities (the type of structure that governs your business), insurance, and intellectual property (copyright, trademark, patent, and trade secrets) to name a few.
As a former full-time practicing attorney and now a small business owner, I have been on both sides of the fence when it comes to the legal issues a business owner may face. It is imperative that entrepreneurs understand the basics of the legal side of running a business, and how to use the law as a shield to protect yourself and your business.
Creating a Shield Through Business Structure
The first item a small business owner should consider is the structure of the business. There are 4 basic types of business entities: sole proprietorship, partnership, corporation, and limited liability company. A common misconception of small business owners is that the business entity itself always creates a legal shield. In some instances (a corporation, or limited liability company, for example), this is generally true. However, if you are a sole proprietor (and, if so, you are not alone, as 78% of all small businesses in the U.S. are sole proprietorships), then you essentially have no shield. As a sole proprietor, you are personally liable for all business debts and other obligations. Fortunately, the law is not the only means to create a shield to protect your business. If the business entity itself does not provide a shield, then you can create one by acquiring appropriate and adequate insurance coverage. Thus, a sole proprietorship that is adequately protected by insurance may have an effective shield.
In the case of partnerships, another misconception is that the partnership is a distinct legal entity that provides a shield. A partnership is essentially a sole proprietorship run by two or more individuals. Thus, the structure itself provides no shield. Again, insurance can be used to fill in the gap, and/or a different business entity can be chosen. For example, did you know that you can create a corporation and the same two people that would have created a partnership will now be shareholders? What about a limited liability company with more than one member? There are many ways for two or more individuals to own a business together. Carefully consider which makes the most sense, not only from an operations and decision-making standpoint, but to garner the most legal protection for the owners involved.
Even with corporations and limited liability companies, there are limits to the force of the shield. Simply creating a business entity is not enough. The business must be operated as a distinct legal entity, including refraining from co-mingling of personal and business funds, keeping personal guarantees on behalf of the company to a minimum, maintaining corporate/business records, and paying business-related taxes. If the business entity is a sham or the owner does not follow the rules in terms of keeping the business shield up, the legal doctrine of “piercing the corporate veil” may be applied by a court if the business is sued. Piercing the corporate veil allows a litigant to pierce the business structure and reach the owner personally. Granted, piercing the corporate veil is only applied in very limited situations, but it should be used as a reminder to keep that shield up at all times when it comes to operating your organizing business as a distinct legal entity.
Creating a Shield Through a Written Client Agreement
When you agree to perform services for a client, and the client agrees to pay you for such services, you and your client have entered into a legal contract. The terms of the contract, however, are difficult to recall and prove unless in writing. A written contract is pivotal as it puts clients on notice of business policies and terms, sets a professional tone, promotes consistency of policies, and is legally enforceable in court (the decision whether to sue a client to enforce a contract is, of course, a business decision, as well as a legal one, and should be carefully considered). The contract, thus, helps to prevent misunderstandings and clearly defines the expectations of the parties.
Some entrepreneurs choose not to use contracts for fear that a written agreement may be too formal or legal in nature and, thus, may scare a client away. Again, this is a business decision that should be given consideration, and you should determine if this is a real or imagined fear by communicating with your clients to test the waters. You can also use a “letter agreement,” which may be less intimidating for clients. In the corporate arena, a written contract is generally expected. Another disadvantage of using a written contract is the cost of creating and advising if you use an attorney. While there are standardized contract forms available online and in books, be careful not to accept such standardized forms carte blanche. I often see small business owners fail to adapt contracts appropriately, which causes embarrassing typos, inappropriate clauses, and general confusion. Not only does this look unprofessional, but in extreme cases it can also result in unenforceability of the contract in court. Therefore, it is a good idea to have a business lawyer review the agreement to make sure it adequately protects you, contains the relevant terms, and fulfills the goals you want to accomplish. It is an expense worth paying for to secure adequate protection in the long term.
A word of caution: stay away from “legalese.” Use plain English so that the agreement is easy to understand and helps, rather than hinders, the understanding between you and your clients. If you do use a client agreement, here is a list of sample clauses you should consider including:
- Definition of the parties (define your status as an independent contractor if the contract is for corporate organizing);
- Services to be performed;
- Code of ethics for your professional association, if applicable;
- Pricing and payment policies (pricing structure, retainer guidelines, travel time or expense, charges for supplies or products purchased on the client’s behalf, cancellation policy, when payment is due, fee for bounced check, credit card acceptance, payment of expenses, etc.);
- Provision of materials, equipment, and office space;
- Assurance of insurance coverage;
- State law governance;
- Permission to take and use photos for marketing purposes, if appropriate;
- Term of agreement/termination of relationship.
Now, go forth with shields raised!