Six Dangers of Operating as a Sole Proprietor (Part 1 of 2)

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:

  1. 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.  
  2. 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.
  3. 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.
  4. 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.
  5. 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.
  6. 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.