Starting a business is risky. New business owners have to deal with many uncertainties, such as whether clients will find value in their offering, whether they’ll be able to turn a profit, and what they’ll do if the business fails.
Many business owners fear losing it all if their business goes under or if someone sues them. This is especially true for those who fund their businesses with their own capital, or if they don’t have any business insurance. However, even if you are self-funded, you can take measures to protect your personal wealth from the risk you’re taking on as a business owner.
Set Up the Right Legal Entity
Protecting yourself from business liabilities starts with choosing the right legal entity. If you are operating as a sole proprietorship, your personal assets including your home, investments, and personal property can be seized in the event of a lawsuit or if you owe creditors.
Setting up a corporation or a limited liability company (LLC), however, can help shield you and your shareholders from personal liability in the event of judgments or debts against the business. With either an LLC or a corporation, only your business assets would be used to pay creditors if you can’t meet your obligations. The primary difference between these two entities is that the profits and losses of a corporation are taxable to the corporation, taxed at the corporate rate, while the profits and losses of an LLC pass through to the owners or shareholders, who can choose whether they want to be taxed as a corporation or as an individual.
You can also layer different legal structures for different parts of your business to add more protection. For example, if you own a retail store and receive rental income from tenants who live above the store, you could set up separate legal entities for the store and for the building ownership. If your tenants were to sue you, the retail business would not be affected. Setting up a layered structure puts more distance between you and any incidents that might result in business debts or lawsuits.
Get Proper Business Insurance
Each entity you set up should have its own business insurance policy to add more layers of protection between you and your business liabilities. However, even if you set up a legal structure that protects your personal assets, you still could be exposed to risks.
For example, say you stand accused of breaking intellectual property laws, or a client sues you for fraud. In such a scenario, you may have to pay a settlement from your own pocket, as opposed to from your business account.
Every small business owner should have a Business Owner’s Policy as a first line of defense against general liabilities. This type of policy offers broad protection against several claims that could put your assets at risk, such as copyright infringement or injuries that occur on business premises. It can also help cover the costs of legal defense.
If you have a private practice, such as a law firm or doctor’s office — or run a professional services company, such as an accounting firm or consulting company — you may be exposed to other risks and need a more specific type of insurance to protect your personal wealth from business liabilities.
Professional liability insurance, for example, helps cover you against claims of negligence, or errors or omissions, that might arise from services you provide to clients. This type of insurance is offered as an addition to a Business Owner’s Policy, but check with your insurance agent to make sure you have the right kind and amount of insurance coverage for your business.
Separate Your Business and Personal Affairs
Once you’ve registered your business as a corporation or LLC, use the company name on all documents, including property or equipment leases, supplier agreements, and employment contracts.
Keep your business and personal finances separate by setting up a bank or checking account in the company’s name. Think about who else might need access to the account and designate signing authority to those individuals as well. You may want to require two signatures for any large checks over a certain amount.
If you have good personal credit, you should also consider getting a business credit card to help keep track of designated business expenses. While business cards allow you to start building business credit and give you more financial leverage, they do need to be personally guaranteed, so there is still some risk to your personal wealth.
Make sure you are diligent about maintaining corporate records in what’s known as a corporate book, and keeping current with required filings. Many states require corporations to submit minutes and other annual reports. These requirements also differ depending on your type of legal entity, so it’s a good idea to check with your state or local authority, or with your accountant. Missing the deadline for such filings can result in penalties and late fees or, at worst, suspension of the LLC.
Have a Contingency Plan
Tough times for your business can put a lot of pressure on your personal finances. Put a plan in place to protect yourself and your family against any downturn in business activity.
If your small business is your only source of income:
- Think about creating other revenue streams, such as taking on consulting work or generating passive income from ads on your business blog.
- Maintain good relations with previous employers in case you ever need to return to a former day job.
- Set aside savings when things are going well to build up a rainy day fund.
- Have a conversation with your family about how you can support each other during tough times, and what measures you might need to put in place to reduce your household’s spending.
- Maybe your spouse’s salary can support your household to help relieve some of the financial pressure riding on the fate of your small business.
A contingency plan can be helpful not only to protect your personal wealth, but also to build it. Being diligent about replenishing any funds you may have invested into your business, as well as building up personal savings, can one day fund your next business venture.