Rarely a month goes by that a new founder or business owner I’m meeting with asks me some version of the following: “But we already formed a corporation (or LLC), why do we need liability insurance?” or “Aren’t my personal assets protected as it is [by the legal formation of the company]?” In this blog post, I’ll try an answer those questions, explain the specific types of insurance that a new startup should consider, and how to get started.
Doesn’t legal formation of my business protect my personal assets?
Well, yes and no. First off, let me be absolutely clear– operating any business under a validly formed legal entity is one of the first things you should be doing as an entrepreneur who’s about to actually market and sell goods or services to the public. Operate a business in your own name (or as a general partnership with someone else), and you’re asking to get whacked legally-speaking at some point. It’s only a matter of time.
Having a valid legal claim made against your not legally-formed business (or one that is just “not formed yet”), or a judgment entered against it, can be disastrous and a real tragedy if your product or service is actually something that people need or want and with a tremendous future. In a worst case, it could put you out of business for good.
Why is legal formation so critical? In general, the owners of an LLC or corporation (I won’t get into limited partners of limited partnerships, since we rarely ever see these in the tech startup context) cannot be held personally liable for the debts or obligations of the company itself. In other words, in most cases, whoever sues your company and gets a money judgment against it can only pursue or attach the assets of the business itself, not the personal assets of its owners. This is why, although it’s not mandatory in most cases, legal formation of your company is a no-brainer.
However, this doesn’t mean you and your co-founder can just form a legal entity like an LLC or corporation and now you’re now totally in the clear. I said “in general” in the paragraph above for good reason; the basic principle that the owners of a company can never be individually responsible for the obligations of the company assumes a couple of things:
- That the company isn’t just a sham and that you and our co-founders are not committing fraud or other criminal conduct through the legal entity. This is the number one reason why a judge in a lawsuit against the business might just allow a plaintiff to essentially ignore the legal entity formed altogether and instead go after its owners or shareholders individually. This is a well-established equitable legal doctrine called “piercing the corporate veil”.
- That you and your company have strictly followed all necessary corporate formalities. Under certain circumstances, a court might grant a plaintiff or creditor’s request to “pierce the veil” where it can be shown that the company was merely a front for, or simply an “alter ego” of, its owners. You want to eliminate any chance of this argument by doing (and documenting) all of the basic things that are normally required of an actual, valid corporation or LLC by your state or jurisdiction. Fortunately, most of these things are common sensical and aren’t too hard to do and keep up on.
- That the plaintiff suing your company is not also naming you in the lawsuit, either individually, or as an officer or director (or both). Keep in mind that plaintiff’s lawyers do not typically err on the side of naming as few people as possible. Rather, (for various procedural and practical reasons beyond the scope of this article) they will usually name a laundry list of individuals and entities that could be implicated in the underlying claim or lawsuit. Chances are, if your business is sued, you (and very possibly your spouse (as a “Jane” or “John” Doe)) could be named in the lawsuit as well. If you don’t respond to the lawsuit, a default judgment could be applied for and ultimately entered against you (and your spouse), bringing your personal assets into play to satisfy the judgment.
- That you and your company have the time, resources, and emotional stamina to handle a claim or lawsuit against it (and possibly even you as an individual/officer/director), including the out of pocket expenses of investigating any claim, responding to a lawsuit, and especially settling or fighting the litigation on your own.
If any one (or more) of the above assumptions doesn’t apply to your situation, you could very well be facing personal liability, as opposed to just having the financial exposure limited to the company’s assets. In other words, your individual assets could be exposed.
Which is why the act of forming your company legally is only an important first step in putting your company on a solid legal position. This is where exploring and obtaining commercial insurance and, if necessary, additional coverages, comes in.
Why Your Startup Needs Its Own Insurance
Just as you drive your car to work, or have people over to your house for a BBQ, without ever thinking about the possible risks involved, getting proper business insurance gives you and your team peace of mind to focus your energies entirely on what you should be doing– developing the business, getting to a minimum viable product (or service), getting it to market, and scaling.
More importantly, having commercial insurance in place means that you also have an experienced team to step in, respond to, defend and hopefully resolve the claim or lawsuit against the company, rather than you and your team having to spend valuable time, energy (and money!) looking for, interviewing, and ultimately retaining a lawyer to represent the business in the lawsuit.
Insurance companies have law firms on retainer that do nothing but defend claims on behalf of the insurance companies (er, I mean, the insured ;). I know; I used to be one when I was a young buck, fresh out of law school. These guys are very good at fighting claims and getting them reduced or dismissed outright.
Common Types of Insurance and Coverages
So, what types of insurance should your startup or young company be looking to get? The following, while by no means exhaustive, is a list of some of the most important types of coverages your company should be discussing with your agent or broker:
Commercial General Liability (CGL). This is an acronym you as a startup founder absolutely need to become familiar with. CGL insurance provides coverage for your business in the event of an accident involving its premises, operations, products, or services. As such, it is really the main, “flagship” policy that you absolutely must have.
Cyber Risk. If your company will be using, storing, or accessing any private, confidential, or protected information, be sure to price out and get cyber risk insurance. Maintaining cyber risk insurance will ensure that you are covered in the event of data breaches and malicious actors targeting your business, basically a given these days.
Property and Casualty. This is similar to why you have insurance on your car or your home. This type of insurance protects your company’s property (e.g., inventory, devices, servers, etc.) from covered risks such as fire, damage, theft, etc.
Professional Liability/E&O. Depending on your business, this might not exactly apply, however, this coverage protects professional services and similar businesses from errors and omissions (E&O) in the performance of their professional duties. Examples might include software design, development, or implementation. If your business’ negligence in providing services could result in financial losses to a customer, you will want to strongly consider E&O insurance.
Business Automobile Liability and Workers’ Compensation Insurance. Both of these coverages protect your startup by ensuring that the company is adequately insured if any accidents occur when goods or services are being delivered by a vehicle being used for business purposes (in the case of the former) or injury to one of your employees that occurs in the workplace. While both coverages are typically mandated by state law, your company should make sure to find out and maintain the minimum limits or be absolutely certain that you qualify for an exemption from the statutory coverage requirements. And, by the way, if you’re thinking of trying to avoid Workers Compensation insurance because your workers aren’t really “employees”, please don’t.
Umbrella and/or Excess Coverage. Umbrella or excess insurance provides coverage that sits above any of the primary coverages listed above. While excess coverage sits above only a single type of coverage, umbrella policies can sit above multiple different types of coverage. Because they don’t typically kick in until the underlying policies are exhausted, these types of coverage are often way less expensive to purchase than primary coverage, making them a pretty obvious choice to obtain.
How Do I Buy Insurance for My Startup Company?
Now that you and your founder team (hopefully) understand the importance of insurance specifically for your company, how do you go about getting coverage?
Obviously, you can find out from your peers and from similar businesses or verticals who they’re using. This would probably be the most time-saving way. Alternatively, assuming you’re happy with them, we recommend talking with the same agent that insures your house or automobile or other personal coverage. Ask her if their office handles or writes commercial policies. (Note: some say they do, but you really want someone who focuses on the commercial side and does this sort of thing all the time).
They will be in the best position to discuss (and understand) your specific risks and exposures and make the best recommendations as to coverage and addressing any coverage gaps.
Finally, if you hit a dead end, our office has a number of business insurance professionals that we regularly refer our clients to. Feel free to drop us a line using the contact form to the right of this page. We’re glad to help.
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 Company Startup 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.