Looking at advice on different corporate structures I often see “Limited Liability” being listed as one of the benefits of Limited Liability Companies. In spite of the words appearing right there in the name, I don’t believe that it is any benefit at all in practice for most young companies. Here’s why.
Most start-ups incorporate as Limited Liability companies fairly early on, and that is almost certainly the right thing to do for most of them. I’ve heard it said at seminars given by both lawyers and accountants that “limited liability means that you can’t lose your personal assets such as your home to creditors if the company fails”. It’s a lovely idea, but in practice there are a number of circumstances in which personal assets of founder directors can still be at risk.
This may sound irrelevant at a time when bank finance is hard to come by, but there is still finance out there. Company credit cards and invoice finance remain widely available. Asset finance for capital equipment and commercial mortgages can still be found too. As the banks have become more risk averse, they are more likely than ever to insist on personal guarantees from the directors on any finance. This means that if for any reason the company cannot pay back what it owes, the directors will be personally liable. Of course directors are under no obligation to sign personal guarantees, but without them finance is unlikely to be granted.
Investors buying equity don’t have any direct claim on the founding directors if the company fails, however, investment agreements usually require that the directors give certain warranties. These usually cover the accuracy of all information supplied during the investment process, and also the completeness of the information supplied. The former is much easier to be sure of than the latter. How can any founder possibly disclose everything they know about the market, customers and competitors? No director can in practice be aware of every potential intellectual property infringement or weakness the company could be subject to. Yet that’s essentially what the warranty requires. I have never heard of a UK case where investors pursued these warranties (perhaps readers can advise me of one?), but they are real nonetheless, and frequently exercised in the USA.
Any director of a company has duties under the 2006 Companies Act, which must be exercised with reasonable skill and diligence. If a director behaves in a way which is fraudulent or negligent, the company and its investors and creditors may have a civil claim against that director in addition to any potential criminal proceedings. The directors personal assets are at risk in these proceedings.
It is quite usual for suppliers to extend credit to their customers – for example where invoices for received goods are payable within 30 days. However, when suppliers extend credit to relatively small companies this too may require a personal guarantee from the directors.
In the event of actions in any of the above areas, innocence on the part of the founder or director may not be enough to protect them. Particularly where intellectual property is concerned, the costs of proving innocence may be huge – tens or hundreds of thousands of pounds. The only reason I don’t say millions of pounds is that few founders have that much money – so they will run out of money to fight with long before it gets to that stage.
Some risks can be insured. For example, directors liability insurance can protect against some aspects of negligence in executing the duties of a director.
In practice, there’s often no escape for founding directors of small limited liability companies. Many of the relationships these companies enter into will have clauses that “look past” the liability shield supposedly provided by a “Limited Liability Company” and will put their personal assets on the line. That’s the reality of starting up a business.