The forming and launching of a new startup company is an exciting, possibly life altering event. But if you and your fellow co-founders ignore or fail to take certain precautions, being a co-founder has potential to be life altering in a negative way. So just what is your 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 (or fourth, if you count regulatory) 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 (as opposed to criminal) 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 legal blog!
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 obvious. You enter into a contract and later fail to perform (whether deliberately or through factors beyond your or its control), which failure causes financial (but possibly other) harm to the other side of the deal.
Let me say also that tort and contract liability are not mutually exclusive. In other words, depending on the circumstances, a plaintiff could bring, and your business could be on the hook for, both types of claims against your company.
Let’s now 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 Itself
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, liability of a company does not normally attach to its owners/shareholders personally.
The one obvious exception to the above rule is if you are operating your startup as a sole-proprietor (which, btw, I strongly advise against doing, and I know faithful readers of this blog are smart enough not to do).
Tort Liability and your Startup Business
If your startup commits a tort such as, say, an error in some code you created leads to customer downtime or lost revenue, 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 personally had no hand in the act or omission giving rise to the accident, then any liability 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 business 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., equipment, intellectual property, inventory, real estate, cash on hand, etc.) someday, one of the first priorities you and your fellow founders should have before launching is to always purchase business insurance in the name of the company as the named-insured.
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, something known as commercial general liability or “CGL” along with any other applicable coverages and endorsements specific to risks which your business may face (e.g., cyber risks, etc.)).
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—and maybe not just for the business you’ve built.
By having business insurance in place, your company will normally be able to notify the insurance carrier of any actual or potential legal claims against it and have that carrier step forward to takeover a response to the claim and, if necessary, hire defense counsel to settle or represent the company against the lawsuit in court.
Contractual Liability and your Startup Business
From the contract standpoint, again, company liabilities and debts will usually stay with the company. Simple, right?
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 and your co-founders 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 officer of the startup business itself. In other words, even if there’s not a “Title” or “Its” line underneath the dotted line where you sign, you should always add a “, President” or “, Chief Operating Officer” to your printed name, just to play it safe.
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.
To put it another way, 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 any one of these things, and you expose yourself to legal action by the (other) shareholders for any damage or harm your failures may have caused to the company.
Liability Individually as Co-Founder
Finally, let’s get around to what really matters: You. So, can you be found to be personally liable for your activities as a co-founder?
Unfortunately, the question doesn’t lend itself to a short answer and will largely depend on whether or not the action or inaction that harmed the other party 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 responsible for your own personal conduct. For actions outside the scope of your employment, such as trespassing or punching someone (neither example of which are hopefully in your job description), 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 entering into on behalf of the company in some official capacity.
Ways to Reduce Your Exposure as Startup Co-Founder
While every new company, and structure and relationship of the individual founder teams, is different, below are some general ways that you as a startup co-founder should consider to help reduce or minimize your legal exposure as the owner or co-owner of a startup business:
- Adopt Bylaws – One way that companies protect their directors and officers is through a solid set of Bylaws that include thorough indemnification provisions in the company Bylaws;
- Insurance – In addition to the CGL policy mentioned above, your company can further protect its directors and officers through directors and officers insurance (D&O Insurance);
- Corporate Formalities – Routinely review (or have an outsider review) your startup business’ structure to make sure that the company is observing corporate formalities to lessen the chances of having its corporate veil pierced
- Fraud – Don’t commit fraud or crimes through your startup (it’s also not a great idea personally either)
- Contracts & Important Documents – If entering into any agreements on behalf of the company, always sign as a specific officer of the company (e.g., Vice President, CEO, COO, etc., so long as it’s true) or in whatever capacity you are actually authorized.
Image “Liability” courtesy of www.creditdebitpro.com
Ben Bhandhusavee is the Managing Attorney for BHANDLAW, PLLC, a startup, technology, and e-commerce law practice advising founders and management teams on company startup, corporate and technology transactions, e-commerce, as well as Internet privacy concerns. The firm serves corporate and individual clients throughout Arizona, the United States, and internationally. Our offices are conveniently located along the Camelback corridor in Phoenix’s financial district. For more information about our Startup and Corporate law practice, feel free to reach out using the contact form on the right or call us at (602) 222-5542 to schedule a meeting. Connect with Ben on LinkedIn or Avvo.