A sole proprietorship is usually the cheapest and easiest way to set up a business. In many cases you may not have to do anything other than start working and voila – you’re a sole proprietor! It’s not hard to understand why sole proprietorships are the most common form of business in the US.
Unfortunately, there are significant risks to running your business as a sole proprietor. This article lists six of them:
- No legal separation between business and personal assets. This is the biggest risk, which is why I listed it first. As a sole proprietor, your personal assets may be used to pay the debts of your business. To put it another way, if an adverse party successfully sues your business, one day a Sheriff might show up at your home and take your jewelry and TV and car and computer and anything else of value you have lying around the house.
- Business failure rates are high. In 2017 the US 10-year business failure rate was 70%, which means most new US businesses fail. If you are a sole proprietor and your business fails, it is likely that you are going to owe creditors some money. For a reminder of what can happen to a sole proprietor when a creditor gets a judgment against her business, see #1.
- Risk goes up with success. Larger, more successful businesses are more attractive targets for lawsuits. As revenues grow, so does your business’s visibility. The longer a business stays around, the higher the chances are of a legal dispute occurring. For a quick refresher on what could happen to a sole proprietor’s personal wealth in the event of a legal battle, see #1.
- Difficulty obtaining capital. If you intend to use investors’ money to fund your business, you’re going to find it challenging as a sole proprietor. The most typical way a business accepts investment is by issuing equity in a business entity like an LLC or a corporation. As a sole proprietor, you have no equity to offer. Unless you’re prepared to agree to some ill-advised creative arrangements, your likely only option for accepting outside money will be taking out a loan. Just to recap the likely outcome of defaulting on a business loan as a sole proprietor, see #1.
- Credibility issues. Right or wrong, customers tend to have more confidence in a business that has an official sounding name. Smith Computer Repair, LLC has a more professional ring to it than Joe Smith’s Computer Repair. If you operate in a competitive industry where it is important to gain an edge over your competitors (and who doesn’t?), operating as a company rather than a sole proprietor tends to lend an added element of credibility to your business.
- You die, the business dies. As a sole proprietor, your business assets will likely be treated as part of your personal estate when you die. With careful estate planning a sole proprietor may be able to pass her business along as intended. On the other hand, a contested will or a dispute over a loved one’s belongings could drag on for months or even years. Properly drafted company documents can help avoid these types of situations.
In most cases, a good first option for a sole proprietor is a “single member” (i.e., a single owner) limited liability company (LLC). In most states, it is fairly simple and inexpensive to form an LLC. Be aware, however, that filling out a form and sending the paperwork to the state might get you a pretty file-stamped and dated certificate of existence, but it does not mean your LLC has been properly organized to provide you with the legal protections discussed above. In my next article I will discuss some of the additional steps that are necessary to correctly structure a single member LLC. In the meantime, if you are a sole proprietor considering forming an LLC, we would welcome the opportunity to speak with you to see if we might be able to help. I can be reached at chris@clark.law.
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