Starting and operating a business—whether a small business, startup, or government contractor—involves a myriad of risks, many of which can lead to costly and potentially damaging litigation. While these risks evolve over the life of a company, early-stage businesses, especially those in the process of entity formation and drafting corporate governance documents, are particularly vulnerable. In this first part of PilieroMazza’s blog series, “Managing Litigation Risk During the Business Lifecycle,” we explore how understanding these risks and taking proactive steps to address them can help safeguard your business from future disputes that could compromise its operations and financial viability.
Entity Formation and Early-Stage Litigation Risks
The first step in any business’s lifecycle is determining its legal structure—whether it is a limited liability company (LLC), corporation, partnership, non-profit, or other entity. This decision has significant implications for liability, taxes, and governance, and errors at this stage can lead to litigation down the road.
- Choosing the Right Entity: One of the biggest concerns owners have when starting a business is protecting their personal assets from litigation involving the company. If a decision is made not to form a legal entity, it will result in the business becoming either a sole proprietorship, where the business is indistinguishable from the owner, or a partnership, where profits and losses are shared by two or more individuals. In either case, business owners remain personally liable for the debts of the business, and their assets are unprotected from liens and legal judgments. To avoid this liability, two popular entity structures for business owners are LLCs (owned by members) and corporations (owned by shareholders), both of which provide liability protection to their members and shareholders, respectively. Entity selection should be assessed on a case-by-case basis in consultation with legal and tax advisors. For more information on certain tax considerations for either entity structure, please review PilieroMazza’s blog series on S Corporations.
- Limits on Limited Liability: Small businesses, especially those formed as LLCs or corporations, are typically intended to provide limited liability protection to their owners. However, if proper formalities are not observed, such as maintaining separate finances or failing to adhere to corporate governance rules, courts may “pierce the corporate veil” and hold individual owners personally liable for business debts or obligations. As a result, engaging with legal counsel can ensure that you are not only selecting the optimal entity structure based on business needs, tax considerations, and long-term goals, but also adhering to corporate formalities to avoid personal liability risks.
Drafting Corporate Governance Documents: Operating Agreements and Bylaws
Once an entity is formed, a business owner may be inclined to employ the use of boilerplate governance documents, including operating agreements (for LLCs) or bylaws (for corporations), or perhaps bypass governance documents altogether. However, these foundational documents must be tailored to a business’s operations and tax status and must clearly define the rights and responsibilities of the company’s owners. Ultimately, carefully constructed corporate governance documents can serve as a roadmap for how your business will be run, preventing disputes that could lead to litigation. On the other hand, ambiguous and poorly drafted governance documents often serve as the cause of many litigation disputes.
Key Areas of Risk
- Disputes Over Membership Control and Voting Rights: The company’s governance documents should outline voting rights and the decision-making processes for majority and minority members or shareholders as well as for the board of managers and board of directors (as applicable). Without clear provisions, owners may disagree on major decisions such as adding additional members, issuing additional shares, sale or merger of the company or sale of assets of the company, dissolution of the company, or the company declaring bankruptcy. A failure to define voting thresholds for specific decisions could lead to disagreements or a deadlock that ultimately results in costly litigation. Further, certain government contractors may wish to pursue a socioeconomic status, such as Woman-Owned Small Business (WOSB) or Service-Disabled Veteran Owned Small Business (SDVOSB), among others. Proper drafting of governance documents is crucial to obtain and maintain government approval for these statuses, and failure to comply with the relevant rules and regulations can create litigation and government contract “protest” risks.
- Transfer of Membership Interests or Shares: Restrictions on a member or shareholder’s ability to transfer their interests are frequently incorporated into the company’s governance documents or required by law. For example, in the case of government contractors, the ability to transfer ownership interests is often restricted due to regulatory requirements. The government may also require notice or approval for certain ownership changes. If the governance documents are unclear or silent on this issue of transferring interests, statutory defaults will apply, and disputes can arise when a member or shareholder attempts to transfer their interests. Such disputes may be preempted by tailoring protections such as buy/sell provisions to facilitate orderly transfers of economic interests for minority shareholders upon triggering events in addition to negotiating Right of First Refusal options for members, shareholders, and the company itself.
- Disputes Over Capital Contributions: Businesses often need substantial capital to finance operational needs. However, not all members may contribute the agreed-upon capital, either because of financial difficulties or disputes over the amount owed, which could expose the business to operational and solvency risks. As a result, remedies can be incorporated into the governance documents and enforced against defaulting members including, but not limited to, dilution of ownership interest or loss of voting rights and control in the company, liquidated damages, forfeiture of interest, or having the defaulting member’s interest be deemed a loan by a non-defaulting member. Another common area of litigation involves disputes over the return of capital contributions, especially when members expect to recover their investments upon withdrawal or dissolution of the entity. If the governance documents do not adequately specify if or how capital is to be returned or how losses are to be handled, this may lead to disputes among members and shareholders.
Conclusion: Proactive Legal Planning is Key
For small businesses, startups, and government contractors, the early stages of business formation, governance document drafting, and capital structuring are fraught with litigation risks that can threaten the viability of the business. By working closely with legal professionals to establish clear and enforceable corporate governance documents, defining the responsibilities of members and shareholders, addressing the transfer and return of capital, and creating mechanisms to resolve disputes, business owners can protect themselves from costly litigation and set the stage for long-term success.
If you have any questions regarding entity formation, corporate governance, or the associated litigation risks, PilieroMazza attorneys are here to assist you. Please contact Todd Reinecker, Abby Baker, Geoffrey Williams, Akinyi Orinda, Cole Fox, or another member of the Firm’s Litigation & Dispute Resolution or Business & Transactions practice groups.
____________________
If you’re seeking practical insights to gain a competitive edge by understanding the government’s compliance requirements, tune into PilieroMazza’s podcasts: GovCon Live!, Clocking in with PilieroMazza, and Ex Rel. Radio.
Related Attorneys
