5 signs it’s time to form a legal entity

In 1992 a 79-year old woman pulled up to a drive-through window at a restaurant, bought a $0.49 cup of coffee, stuck it between her legs, and drove off. The coffee spilled and burned her, and a jury determined that the restaurant should pay her $2.86 million. The restaurant was McDonald’s, and they ultimately settled for far less, but the point remains: We live in a highly litigious society.

How should you think about that as a founder? If someone comes after you personally, right or wrong, you could stand to lose your savings, your house, or other belongings. Setting up a legal entity like a limited liability company (LLC) or corporation creates a wall that separates you from your company. Generally speaking, that forces disgruntled parties to go after your company’s assets, but protects your personal assets.

But when is the right time to go establish a legal entity? Start too soon, and you may waste time and money forming a company around an idea you’ll decide not to pursue. Wait too long, and you’ll expose yourself to personal risk. Here are a few signs you’re ready to form a legal organization (Caveat: This is advice from a founder, not a lawyer, so consult your lawyer for advice about your particular situation):

1) Partners. When you decide to take on a partner, be sure to agree to terms early on, so there are no surprises. Get everything in writing, if just to be sure you’re on the same page. Then, when the business gets close to hitting the milestones below, take the plunge and set up your legal entity, along with an operating agreement or partnership agreement.

2) Investors. If you are taking a loan from a close family member, you can often get by with an agreement in writing between the two of you, personally. But before taking investments from angels or other third parties, play it safe and form your legal entity.

3) Customers. Once you have paying customers, you’ve got exposure to risk. Customers could potentially file lawsuits against you claiming that your products caused them damages.

4) Contracts. A contract is a legal promise. Break that promise, and there may be legal consequences. Before you sign a contract, consider setting up a legal entity. That goes for service agreements, leases, trademark applications, and even bank accounts.

5) Employees. You can usually get by without a legal entity if you are hiring freelancers for fairly inexpensive short term projects – provided you’ve checked their references or worked with them before, to minimize the chances of disputes. But establish a legal entity before you hire full time employees, or hire outsiders for projects of more than a few thousand dollars.

What other triggers tell you it’s time to get your legal act together?

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