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The "Legal Check-Up": Common (And Avoidable) Issues For Business Owners

The day-to-day life of the business owner is very unpredictable – from managing employees, trying to drive sales, watching expenses, collecting receivables, and on and on, there is very little time left for business owners to focus on legal issues that may become an issue for them in the future.

As advisors, one of our jobs is to proactively anticipate legal issues that business owners commonly encounter, and then provide the owner with the steps that can be taken now to avoid them. Oftentimes the “rub” in this equation is that the business owner does not see the need (read “value”) in addressing issues that are not an immediate problem. Said another way, trying to get the business owner to slow down enough to act on issues they would just as soon ignore is oftentimes a real challenge from the advisor’s perspective. What oftentimes happens is that the issues the advisor tried to get the business owner to focus on eventually do surface, at which time it is too late and both the advisor and the business owner are left with picking up the pieces to an issue that could have likely been avoided altogether with proper planning.

The purpose of this article is to highlight several common (and avoidable) legal issues that business owners might encounter. While each of the issues addressed in this article will not necessarily apply to every business in every industry, the issues addressed are frequently present, and can have very undesirable outcomes for the business owner if they are not properly dealt with.

Protecting the Customer and Employee Base

Businesses spend a significant amount of time and resources to build long-term relationships and goodwill with their customers and employees. Because of this, it is critical that the business takes all precautions necessary to protect its customer and employee base from improper acts by competitors and former employees.

Nebraska courts recognize that a business has a protectable interest in its customers and employees. Having said that, the law in Nebraska is very specific with regard to exactly what is protectable and what is not. For example, generally speaking, a business is allowed to restrict (i.e. post-termination) key sales employees from soliciting customers of the business with whom the employee had direct contact while working for the business. This rule oftentimes trips up business owners, who believe they can impose broader restrictions on departing employees than the law will allow. And because this issue only comes to light after the key employee gives notice of their departure from the business, the business owner discovers that the restriction is unenforceable and is left exposed to the former key employee now working for a competitor, directly soliciting the customers that they have strong relationships with.

From a planning perspective, business owners should identify all key employees within their organization and put written agreements in place which outline specifically what the employee is not allowed to do following their termination of employment. In addition to protecting the business’ customer base, the business owner is also allowed to restrict departed employees from soliciting remaining employees of the company for employment purposes. This is another important provision, as it helps to prevent a business from being “poached” by a departed employee (who likely knows who the best employees of the company are, those who may be somewhat unhappy or disgruntled, etc.)

Business Partners

When two or more people join together to start a new business or buy an existing business, the excitement surrounding the future business opportunity often clouds many of the issues that the business owners should be most focused on. And because money can be extremely tight when a business first starts up, the business owners are reluctant to spend money to have an agreement drafted to address the various “what ifs” that exist when there are multiple owners involved with a business.

Thus, while the owners have a clear understanding of exactly which office will be theirs at their new space, none of the owners have thought through the “what ifs”. “What if” there are disagreements between the owners – how will those be resolved? “What if” one of the owners dies or becomes disabled – what happens to their share? “What if” one of the owners is not contributing their “fair share” (at least in the eyes of the other owners) – how is that handled? “What if” an owner goes through a divorce – is their interest in the business at risk to the soon to be ex-spouse? Once the newness and excitement of starting a new business has worn off, and there is friction among the owners over a certain issue, the memories of the owners will differ as to what their “deal” was, and the fight ensues. It is at that time that the owners will wish they had talked with a lawyer about a “Buy-Sell” Agreement.

With a properly drafted “Buy-Sell” Agreement, the owners will know their rights and obligations, and the Agreement will give a clear understanding of what options are available to the owners under each of these various “what ifs”. Without a properly drafted “Buy-Sell” Agreement in place, dissention among the owners can put strain on the business and the relationship between the owners, and potentially threaten the very existence of the business. In addition, without a “Buy-Sell” Agreement in place, a disgruntled owner might be forced to ask for judicial dissolution of the business. Not every request for judicial dissolution is granted, as there are specific criteria that must be met for such an action to be deemed proper by the court. In addition, a judicial dissolution is subject to the timing and delays that come along with any court proceeding. Such court actions can also be extremely costly from an attorney fees standpoint, and a major distraction from a personal time commitment.

Personal Guarantees

One of the primary benefits of forming a corporation or limited liability company as part of a business startup is the liability shield that these entities offer. Generally speaking, an owner of a corporation or LLC which is properly formed, capitalized and operated is not subject to personal responsibility for the liabilities of the business. Said another way, if the business fails, the owner of a corporation or limited liability company is generally not personally responsible for paying the debts of the company. While most business owners understand the concept and importance of the liability shield, oftentimes business owners are quick to give up this protection when it comes to personal guarantees requested by banks, vendors or other third parties.

While a request for a personal guaranty from a bank in connection with a new loan may be a perfectly proper (and standard) request from a credit perspective, business owners should discuss this request with the bank prior to blindly putting up a personal guaranty. For example, does the business have sufficient financial strength to support the loan without the need for a personal guaranty? If the financial strength is not there today, what would it need to be in order for the guaranty to go away (a so called “sunsetting” of a personal guaranty). Similar conversations should take place with vendors who ask for a guaranty. For example, some vendors will allow a limited line of credit for their customers without the need for a personal guaranty (but you need to ask for it).

In the event the business owner is required to put up a personal guaranty in order to get a loan or to do business with a certain vendor, the business owners should then try to negotiate a “cap” of their maximum liability under the guaranty. In the situation of multiple owners of a business, consideration should be given to having each of the owners put up a guaranty that is proportionate to their ownership in the business. Thus, in the event there is a $100,000 loan which will only be approved on the basis of personal guarantees from the owners, the two 50/50 business owners should try to each execute a guaranty in favor of the bank with a maximum liability under each guaranty of 50% of any unpaid amount. That way, in the event the business fails and the guaranty is called when $30,000 remains unpaid, each owner would only be responsible for half the unpaid balance ($15,000). Without such a limitation in place, the bank would likely be allowed to proceed against either owner for the full amount that remains unpaid. An owner that pays more than their ownership share in the business would then be left in the unenviable position of having a potential lawsuit against their former business partner, for the excess portion that the other owner should have paid for.

One last comment on personal guarantees. In the event personal guarantees are required to be put up by a business owner, the owner needs to keep track of exactly what guarantees they put in place. Because oftentimes personal guarantees do not have an expiration date, a business owner who has signed a personal guaranty can sometimes find themselves responsible for a debt that is incurred years after the business owner has sold their company or ownership interest to another party. If the business owner has kept track of the personal guarantees they have put in place, then upon a sale of the business, the beneficiaries of the guarantees can be notified, and the exposure to possible future liabilities under the guarantees can be cut off.

Contracts/Terms and Conditions

Oftentimes in the business owner’s eyes, contracts (including purchase orders, invoices, etc.), are simply seen as the paper that gets exchanged as part of the normal process of doing everyday business. The fact is that contracts impose legal obligations on the parties to the contract, and they can significantly benefit one party to the detriment of the other party, depending on how they are drafted. So while business people may describe a certain contract as “standard” or “just boiler-plate,” the owners of a business need to be mindful and aware of what the contracts they encounter in everyday business actually mean. In addition to “paper” forms like purchase orders and invoices, business owners need to be on the lookout for contract terms that are incorporated by reference from a party’s website or terms and conditions that may appear in an acknowledgement or similar form issued by a party.

Virtually every business, regardless of whether it sells products or services, benefits greatly by having a master set of “terms and conditions” reviewed by legal counsel that it can use to conduct business on an everyday basis. Although the specific circumstances of each business are different, key provisions within the terms and conditions often center around limitation of liability, termination rights of the parties, indemnity, choice of law and venue, among others.

Use of Independent Contractors

Business owners are often tempted to bring on a new worker as an independent contractor. Whether the business owner thinks that the independent contractor will only be with them for a short time (and thus is not worth the hassle and paperwork involved with bringing on a new employee, trying to save on employment taxes, or some other reason deemed proper in the business owner’s eyes), such action can result in a business having both independent contractors and employees who are performing substantially similar functions within the company.

The U.S. Department of Labor has for the last several years had a major initiative of cracking down on the misclassification of employees as independent contractors. That initiative has resulted in a significant number of businesses being audited for independent contractor compliance. In addition to potentially exposing the business to unpaid employment taxes and related penalties for those people who are improperly classified as independent contractors, the business owner can also unintentionally expose some of the business’ intellectual property to a question of who owns such intellectual property.

The issue surrounding the ownership of intellectual property is caused by the fact that generally speaking, intellectual property developed by an employee is owned by the business, whereas intellectual property developed by an independent contractor is generally owned by the independent contractor who developed it. In order for the business to own the intellectual property developed by an independent contractor, the business must have a signed written agreement in place which clearly states that the business owns all such intellectual property.

It is for these reasons that business owners need to evaluate their use of independent contractors to determine first, whether they are properly treated as an independent contractor from a tax perspective, and second, in the event they are, whether the business owner needs a proper agreement in place to address the ownership of intellectual property.

McGrath North’s Business and Corporate Practice Group has developed a “Legal Check-up” process designed to proactively address legal issues specific to a particular business. The “legal check-up” is a complimentary service of the firm. If you feel that you, or a client, would benefit from going through a “legal check-up,” please give us a call.