The forming and launching of a startup is an exciting, possibly life altering event. However, if you and your fellow co-founders are not careful to take certain precautions, being a co-founder has potential to be life altering in a negative way. In this post, we’ll talk about an oft-posed question I get as a Phoenix startup company attorney: What is my liability as a co-founder of a startup?
Ways Your Startup Could Be Liable
When I talk to startup clients about their liability concerns, I find it helps to break the universe of potential liability into two main camps: tort and contractual. Note: I will save a potentially large—but no less serious—third category of corporate tax, payroll tax, and pension liabilities for another day/blog post.
In its most basic terms, tort liability is where you, whether deliberately or negligently, commit a harmful act against another for which there is a civil remedy. In its most extreme case, a tort could be bad enough to lead to criminal liability, but that is a question for another blog post—and another blog!
For example, a tort could be a mistake or defect in your product or services that injures a customer, or it could be one of your business’ trucks hitting someone. Torts can also be more deliberate wrongdoing such as invading a customer’s privacy or doing something that defames a competitor. While not specifically torts, something like your company engaging in patent or trademark infringement can also potentially give rise to civil liability.
Contractual liability, on the other hand, is a little more straightforward. You enter into a contract and later fail to perform, whether deliberately or through factors beyond your or its control, which failure causes (usually) financial harm to the other party.
Let me say also that tort and contract liability are not mutually exclusive. In other words, depending on the circumstances, a plaintiff could bring both types of claims against your company.
Now we can take a look at what a co-founder’s liability under both areas might look like, starting from the macro level (the company itself) and zeroing down to you, the co-founder, personally.
Liability of The Startup Company
In general, the liabilities or debts of a company validly operating as a legal business entity (e.g., corporation or LLC) stay with the company. In other words, they will not normally spread to its owners/shareholders. One major exception is if you are operating your startup as a sole-proprietor (which I strongly advise against doing).
If your startup commits a tort such as, say, an error in some code you built ends up costing a customer business or downtime, then it can expect to be sued for the tort of negligence (and possibly breach of contract, or both). The good news is, provided you yourself had no hand in the acts or failure to act giving rise to the mistake, then the lawsuit should be confined to the company itself, meaning that a plaintiff suing the company could only collect against whatever assets the company itself has. The exception to this is what is known as “piercing the veil”, which we’ll cover here in a second.
In addition, if you or another employee, officer, or director of the startup injures a third-party or causes damage to their property within your or their scope of employment, it is possible that the startup could be found to be liable for your or their actions. This is a concept known as “vicarious liability”.
Because your startup might have actual, valuable assets (e.g., intellectual property, equipment, real estate, cash on hand, etc.) someday, one of the first priorities you and your fellow founders should have before launching is to purchase proper business insurance in the name of the company.
Just like you (hopefully) wouldn’t drive without having your auto insurance in place, your startup shouldn’t even consider conducting any business with third-parties without having the proper insurance coverage (specifically commercial general liability or “CGL”).
Insurance is one of those things that none of us like to pay for, but you definitely want to have it when the time comes because the alternative could be disastrous financially. By having business insurance coverage in place, your company will be able to notify the insurance carrier of any actual or potential legal claims against it and have that carrier step forward to manage the claim and, if necessary, hire defense counsel to settle or represent the company against the lawsuit in court.
From the contract standpoint, again, company liabilities and debts will usually stay with the company. However, a major exception to this is when you or your co-founders sign to a personal guarantee of the company’s obligations. Most sophisticated parties like landlords and lenders will understand the “judgment proof” nature of brand new businesses like startups. Frankly, there will be times where you may not be able to avoid the requirement of a having to sign a personal guarantee for, say, your company’s lease or a business loan. However, in all other instances, as a co-founder you should never just sign an agreement in your own name but instead make sure you’re signing as an appropriately authorized officer of the startup.
Now I mentioned above that there may be situations where a court might allow you as a business owner to be held liable for the debts or liabilities of the company through a concept called “piercing” the corporate veil. In other words, allowing a party with a judgment against the company to break through the limited liability form of your business and go after your personal assets as an individual owner.
This piercing can ordinarily occur in one of two ways:
The first is what I call the “American Greed” scenario: your company is a total sham and was just set up by you or your co-founders to perpetuate some type of fraud or criminal activity. This is an easy one.
The second is what the law calls a failure to observe “corporate formalities”. In English, this means that, although you are operating the business through a legally formed entity like a corporation or LLC, in reality the business operates as basically just an alter ego of yourself and/or your fellow co-owners.
A failure to observe corporate formalities can take a few different forms, however some common examples might be that your company does not have its own tax ID number, its own bank accounts separate from yours, it does not report or pay its own taxes, its assets are indistinguishable from your own personal assets, etc. These are omissions which, while they do not necessarily harm the public or customers per se, can set you up for a compelling argument that the limited liability business form you’ve created is not really separate and distinct from you or your other co-founders and, as such, should be ignored entirely by the court.
Liability of Startup Directors and Officers
Generally speaking, as a shareholder of a startup, you are only liable for the company’s liabilities or debts to the extent of your investment. In other words, let’s say you have invested $10,000 into the company, but it now faces a judgment in an amount over its insurance limits (if insurance even covers the type of claim leading to the judgment) and liquid assets. Result? The company is insolvent and you will lose your $10,000, likely for good.
However, as the founder of a closely held business, in addition to the exposure of your investment, the potential liability exposure to you personally is increased by your likely role as not just a shareholder but as a director or officer of the company that is actually engaged in its direction or management, respectively.
This is because when you serve as a director or officer of your startup, the law requires you to exercise a duty of care with regard to the responsibilities of the position. In other words, your actions (or, in some cases, inaction) must be reasonable and prudent under the circumstances. In such role, you also have a duty to put the company’s best interests first. Fail to do these things, and you could expose yourself to legal action by the (other) shareholders for any damage or harm your failures may have caused to the company.
Your Liability Individually as Co-Founder
Finally, let’s get around to what really matters: you. Can you be found to be personally liable for your activities as a co-founder?
The question doesn’t lend itself to a short answer and will largely depend on whether or not the action or inaction that harmed another were within your scope of employment or duties to the company.
Basically, whether you’re a co-founder or not, the law will hold you to account for your own personal conduct. For actions outside the scope of your employment, such as trespassing, punching someone, or driving your car into someone’s fence, then you can probably expect to be sued personally.
From the contract law standpoint, as mentioned above, you can be held legally responsible for breaching any contract that you entered into personally, as opposed to executing on behalf of the company.
Tips for Reducing Your Exposure as Startup Co-Founder
- Bylaws – One way that companies protect employees, directors and officers is through Indemnification provisions in the by-laws.
- protect the officers and directors is through directors and officers insurance (D&O Insurance).
- take care to ensure that: (a) the company is following corporate formalities to mitigate the likelihood of having the corporate veil pierced, and
- don’t commit fraud or do crimes
- Have commercial general liability (CGL) policy in place—not to mention whatever other coverages the company purchases.
- If entering into any agreements on behalf of the company, always want to sign as an officer of the company (e.g., Vice President, CEO, COO, etc.) or in whatever capacity you are actually authorized.
BHANDLAW, PLLC routinely assists startup founders and early stage company directors and management teams. For more information, feel free to contact me at the phone number or e-mail address below or use the contact form to the right.
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Ben Bhandhusavee is the Managing Attorney for BHANDLAW, PLLC, a Phoenix business and technology law firm working with start-up companies, creative intellectual property, Internet and digital media matters, and complex corporate M&A and technology transactions. Ben can be reached at (602) 222-5542 or by e-mail at email@example.com