Are Your Legal Ducks in Row? A Cautionary Tale

What happens when you don’t have your legal ducks in a row? You lose $500,000.  As business owners, we are so focused on running the business that we forget to get our legal ducks in a row. Why does it matter? Think about how much you have always wanted to run your own business and how hard you have worked to become your own boss. Now think about how you need money to run your business and keep the doors open. You ask family and friends, and they can’t help you. You ask your bank for a loan or a line of credit, and the bank turns you down. Through a lot of heartache, you finally find a private investor who is willing to listen to your story and invest in your business.  Here’s what can happen if you don’t have your legal documents in order.

I received a call one day from a client who was very excited about a business investment. This startup was going to be the first in its space to create software that every business eventually would need and buy. The startup needed $500,000 to finish the software, and my client was going to make the investment. Before any money changed hands, we needed to make sure my client’s investment would be secure. I sent my due diligence list to the startup asking for corporate documents and ownership percentages for my client. The startup responded by saying it had no corporate documents and no ownership structure was legalized, however, shares were promised to everyone who worked at the startup.

Due to the unpreparedness of the startup, it looked too risky to invest in a business that had no corporate documents or legal contracts with any of the employees.  This investment opportunity looked less desirable to my client. As a prudent investor would, my client decided not to invest, as the new business was not ready. The startup lost its hard work, hopes, and dreams—not to mention $500,000. This happens more often than you think because business owners don’t know what they don’t know and fail to prepare for these types of situations.

There are a host of legal requirements that must be followed not only at the corporate level but also at the state level. Your company must be in good standing with the state where it is incorporated. To remain in good standing, states require annual filings and payments of fees, in addition to your company being represented by a registered agent for service of process. However, entities that do not stay on top of their compliance obligations can lose their good standing, and your business will then be considered delinquent, void, suspended, or dissolved. The primary reason a company loses its good standing status is due to not filing its annual reports or paying its franchise tax obligations.

Losing your good standing status can lead to serious consequences, such as:

Possible loss of access to the courts

This may be the most serious consequence, and one that many businesses are not aware of. In many states, a company that is not in good standing may not bring a lawsuit in that state until good standing is restored.

Personal liability

This is the second most serious consequence of losing your good standing with the state. The ability to protect your personal liability is no longer available to you and you can be sued personally by creditors of your company. If your company is not in good standing, the state can hold individual owners of the company personally liable for conducting business on behalf of the company while it was in a delinquent status. These penalties can be severe and levied on each officer, director, or employee who know­ingly acted on behalf of the noncompliant company.

Difficulties in securing capital and financing

Most investors and lenders view a loss of good standing as an increased risk and may not invest or approve any financing for the company. Without access to money, your company becomes dangerously close to filing for bankruptcy.

Tax liens

If a company does not pay its franchise tax and loses its good standing status, the taxing authorities can place a tax lien on the company and possi­bly the owners of the company. Again, lenders will not generally loan money to companies that have tax liens attached to them, as tax liens take priority.

Fines and penalties

Some states impose fines and penalties on companies that do not comply with the requirements to maintain a good standing. These can add up quickly and become a burden on the company.

When you are considering incorporating your business, make sure you do your homework and consider taking the following steps:

1. Get advice from a good certified public accountant.
2. Get help from a good business attorney.
3. File the paperwork and pay franchise taxes as required.
4. Obtain the necessary licenses and permits.
5. Have sufficient capital to run your business.