Tuesday, March 24, 2009

Business Contracts in Your Personal Name = Bankruptcy

This article is part of a series of stories about the tragic consequences that can result from common (and easily avoidable) legal mistakes that many entrepreneurs make. These are real-life examples that we have seen in our business law practice.

I received a call this week from Jane, an entrepreneur who was shutting down her business. Two years ago, Jane created a company to distribute fabric made from organic and renewable resources using farming methods that had a low environmental impact. She sold wholesale to apparel manufacturers.

This was Jane’s dream business.

I’m sure you can guess how the demise of her business played out. The Dow plummeted, credit dried up, consumers had little money to spend on fashion, and everyone from retailers straight down to the suppliers was crushed.

Suddenly, a once clever (and socially responsible) product niche became a luxury, not a necessity. Jane’s market dried up.

When Jane started the business, she rented a small commercial office space in an office building in Manhattan.

At the time, Jane was going back and forth with her accountant about the best corporate entity for her to use (LLC or S-Corp). In the interim, the rental agent played some high pressure games with Jane. Fearing that she would lose the office while waiting for a corporation to be formed, she signed the lease in her personal name.

This situation is frequently how business owners get burned. Before organizing their corporate entity, in the rush to get things off the ground, they make contractual commitments in their own name. Problem is, if business goes bad, you are still personally on the hook for the failed business’ debt.

This is particularly dangerous for the entrepreneur whose business has a high cost of goods sold. For example, if you have a business where you purchase expensive inventory or supplies on credit, the cost of which is built into the price you charge your customer, if you shut your business down and no longer have customers to pay for the debt, you’ve got a problem on your hands. If you’ve signed for the credit personally, the debts may be much higher than what you could ever afford to repay from your salary if you then go out and get a 9-to-5 (which is what Jane did).

In Jane’s case, she has 11 months left on her lease, or about $14,000 owed to the landlord. While not the biggest business debt, together with the other debts she incurred as a result of her failing business, it has pushed her very close to filing for bankruptcy.

With a quick incorporation that could have been done for $250 by LegalZoom or around $1,250 for a lawyer, Jane would have avoided this mess.

While your vendors and suppliers may be cautious with extending credit to businesses without personal guarantees, there are always other vendors and suppliers who are hungry for your business—especially in this market. Insist that they live with only the corporation being liable for business debts, otherwise, take your business elsewhere.

Learn about 7 Deadly Legal Mistakes that cost entrepreneurs thousands. Visit www.7deadlylegalmistakes.com to get a copy of our free mini course.