Michael J. Hays – Entity formation is one of the key tasks of a business lawyer. Clients large and small seek our assistance in forming a corporation, limited liability company, or other business entity that will protect them from personal liability for the new entity’s obligations. But those clients often leave the lawyer’s office when it comes time to plan for the new entity’s finances: how much capital it needs, how to raise it, budgeting for the entity’s operations, and so forth.
In many respects, leaving financial matters to other advisors is the right choice. Entrepreneurs beginning a new start-up will need to work closely with accountants and bankers. These professionals are best-suited to provide much of the advice the new organization needs. But the lawyer has a role to play in the financial discussions, too. We must remind our clients about the risks of undercapitalization. As one judge explained, “If the shareholders do not invest enough equity, such that the corporation is undercapitalized, there is no basis for rewarding them by limiting their liability, and, in fact, doing so would only encourage risky behavior.”
The entrepreneur does not want to hear this. He or she wants to focus on the tales of successful enterprises born in a garage with nothing more than $500 and a dream. But a new venture could be considered a legal sham if it “has so little money that it cannot operate its business on its own” Should the business fail—another thing no client wants to discuss—the hope is to simply fold up shop and close this chapter without exposing personal assets. To achieve that, the client must respect corporate formalities, follow the bylaws and other governing documents that control the organization, and keep the entity’s affairs separate from personal affairs. All of this is no surprise. But the legal formalities need some financial substance to go with them: the entrepreneur also must put adequate capital at risk.
So how much is adequate? Will $1,000 be enough? What about $25,000? It won’t really take $1 million will it? When I tell the client, “The legal test . . . provides little in the way of specifics,” she starts to wonder why she’s paying me. The best I can do is describe what Indiana courts have held:
- A real estate development company with “between $250,000 and $300,000” of paid-in capital was undercapitalized in light of evidence that bank requirements and market analysis showed it needed at least $400,000 in start-up capital.
- An airplane repair business was not adequately capitalized because “it did not have sufficient financial resources . . . to pay its ordinary, ongoing corporate expenses.”
- A real estate holding company with only $25,000 in capital was adequately capitalized, even though it held a long term rental obligation of more than $2 million because it had a stream of sublease income to meet that obligation.
- An agricultural business was not undercapitalized at the time it expanded operations to include raising hogs because it was issued state licenses that required a thorough review of its financial condition.
Every case is different, and judges view matters differently, too. In one leading case, the trial court pierced the corporate veil and held two owners personally responsible for the corporation’s debt, but the Indiana Court of Appeals sent the case back to be decided with more evidence regarding adequate capitalization—even though the entity had $1 million of paid-in capital and a facility worth more than that.
Every business is different, too. The entrepreneur’s financial advisors will have to help the client come to some understanding of what it will take to “operate its business on its own.” Once that number is known, do not suppose it can all be in the form of loans. Outside of certain holding company arrangements, a court will normally consider a venture undercapitalized if its primary funding is debt instead of equity. In fact, when courts evaluate whether to hold investors personally liable, they normally determine adequate capitalization by looking only to the equity investments. Businesses may have many valid reasons for taking on debt, but “the need for a shareholder loan at the outset of a new business signals that the initial equity investment was insufficient” and is “another sign of undercapitalization.”
If you are looking for a rule of thumb, all the equity contributed at the time a business is formed (whether in cash, property, or some other form) should be more than any loans to the business at the time of formation. And the law is well-established that formation is the relevant time for assessing “adequate capitalization.” A business that is adequately capitalized at the start and loses money over time is not “undercapitalized” in the legal sense. Even so, there is nothing wrong with starting small. Corporate growth from modest beginnings is an enduring part of the American dream. But entrepreneurs must understand they should not start so small the business lacks the funds to “operate its business on its own.” And in most circumstances, they should not plan to make up the bulk of needed funds by lending to the company. Business owners who do not invest enough or have “assured themselves the preferred status of creditors if [the business] fails” will lose the very protections they sought in forming their entity in the first place.
Michael J. Hays is an attorney with Tuesley Hall Konopa, LLP, a South Bend, Indiana law firm that provides business counsel, civil litigation, and estate planning services for business owners and individuals throughout northern Indiana and southwestern Lower Michigan. Michael practices in the areas of civil litigation, employment law, business transactions, and real estate, to view his complete bio visit his company’s website, thklawfirm.com. Michael can be reached at [email protected].
 Laborers’ Pension Fund v. Lay-Com, Inc., 580 F.3d 602, 612 (7th Cir. 2009) (citing Frank H. Easterbrook & Daniel R. Fischel, Limited Liability and the Corporation, 52 U. Chi. L. Rev. 89, 114 (1985)).